Destination: Money Balance
It is one of the most-asked questions in the financial world ... and also among the most difficult to answer:
How much money should my family be spending, and on what?
Most any money guru would tell you that it's a good question — with no easy answers. There are, however, suggestions available, as well as batches of good advice to help steer you in the proper direction.
Perhaps the most valuable work in this area has been done by Elizabeth Warren and Amelia Warren Tyagi, in their 2005 book All Your Worth: The Ultimate Lifetime Money Plan. Warren (a law professor at Harvard, turned United States Senator) and Tyagi (a healthcare consultant) have spent more than a decade studying personal bankruptcies. They previously authored the 2003 book The Two-Income Trap, and Warren was a coauthor for the 2001 book The Fragile Middle Class. These two earlier books examine the causes for, and impacts of, bankruptcy as it rapidly becomes a predominantly middle-class phenomenon. (Feel free to check out my All Your Worth review, as well.)
Two-Income Trap garnered the duo sizable notoriety for its extensive research and contrary-to-popular-belief assertions — they've practically become fixtures on TV's Dr. Phil show and the morning coffee-show circuit. However, there wasn't a large amount of situation-specific advice in the book. Surely Warren and Tyagi had learned a great deal about personal finances from their research, and could make some suggestions for the rest of us. At the very least, having witnessed firsthand the turmoil brought about by debt and bankruptcy at the personal level, the two should have some insight into what we might do for our families now to avoid great pitfalls in the future.
Such insight is the foundation of All Your Worth.
So when your parents say that all you need to do to be secure is to work hard and lay off the t-bone steaks, keep in mind that they were once right. When they got married, it was a pretty safe assumption that if someone earned a decent living, drove a typical car, and lived in a regular neighborhood, then the money would work out just fine. Back in their day, if someone was struggling financially, it was probably because they were blowing too much cash on silly stuff.
But the rules of the game have changed.
The old guarantees no longer exist. In today's world, you can get a mortgage that is too big for you — and the banks will help you do it. You can get a car lease that chews up half your income. You can wind up with student loan bigger than some home mortgages. And as sure as the sky is blue, you can rack up credit card debt without blinking an eye, even if you don't have 50 cents to make the payments.You can't take things for granted the way your parents did.
And that's the basis of All Your Worth. From there, the book attempts to spell out some answers. Most of these hinge upon a simple formula:
(1) Figure your monthly gross household income.
(2) Subtract all applicable taxes.
(3) Take what's left, and fit your spending to the following ratios:
In other words, the first 50 percent of your after-tax income goes toward your Must-Haves. The next 20 percent goes to Savings. The final 30 percent may be spent however you wish. Seems simple enough, right?
Wrong. Even for a crusading budgeter and cost-cutter like myself, those are difficult metrics by which to live. After my first two rounds of number-crunching, I barely squeezed my Must-Haves below 60 percent. This is telling, as at the time, I had an above-median income (for my state), no car payments, no credit card debt, and not even a whisper of student-loan debt clogging my monthly budgets. And still I could hardly sniff that 50 percent mark.
Nevertheless, 50/20/30 is a goal at which I will aim.
The more I consider this formula, the more I see the strength in it. The fact that it's hard to attain probably means it's worthwhile.
Balanced Money Formula: Basis & Implications
Warren and Tyagi assert that their 50/20/30 formula is the key to gaining balance with your money. And not just today, or for the rest of this month, but for years to come.
"Testing yourself against the Balanced Money Formula is a little like checking your cholesterol against the recommended levels," they write. "It helps you flag when something is wrong, and it shows you where you need to take a closer look at your money choices."
Let's consider what the formula targets. If you could somehow manage to reign your expenses into the 50/20/30 frame, then you could withstand a 50 percent reduction in household net income, and still have the security of knowing you could at least survive — keep a roof over your head, food on the table, and all that — without incurring debt. You might not even have to do much more than skim from your savings, if that. Financially, that is a pretty strong place to be.
And a place that very, very few people inhabit. Or ever even visit.
Must-Haves: Why 50 Percent?
The authors tell us that their 50% level wasn't just plucked out of thin air. Rather, that number was chosen because it is sustainable, safe, and time-tested.
Suppose you get laid off. . . . With Must-Haves at 50% of your previous salary, your unemployment check could cover your needs for several months. Likewise, if you were in a serious accident and couldn't work, most disability policies would cover about half of your salary, so your basic needs would be met. And if you are married, keeping your Must-Haves at 50% means that you could get by on only one paycheck for a while.
And then there's the flexibility:
Keeping your Must-Haves down to 50% gives you something that is so incredibly valuable: flexibility. If your Must-Haves creep higher — say, to 70 or 80% — there just isn't much room to maneuver. There's not any space to scale back, nowhere you can cut if you need to. But if you can get by on 50% of your income, you have the flexibility to cut back on your spending whenever you need to. You are in control. You can manage an unexpected expense like a car accident or a leaky roof. You'll be okay if your boss cuts your hours. If you keep your Must-Have expenses under 50%, you can stay light on your feet, ready to roll with the punches.
But I Wanted EASY!
No, there is absolutely nothing easy about this "Balanced Money Formula." Think about your current rate of savings. Are you tucking away 20 percent of your after-tax income? Most folks have never even dreamt of accomplishing such a feat.
A great many of us spend more than we earn, which means our savings rate is negative. Ever-increasing debt is the order of the day. Very few of us manage to save 5 percent of our income; 10-percent savers are rare indeed. Tuck away anything over 20 percent of your income, and you're in the savings stratosphere, worthy of being honored with a bronze bust at a Savers' Hall of Fame somewhere.
But — and this is the most important benefit of a consistent savings plan — you could handle pretty much whatever obstacles life might dish out. Within a relatively short time, you would have some serious financial cushion.
"If you aren't saving enough," Warren and Tyagi write, "it is because you are spending too much on your Wants or your Must-Haves (or both)." Not exactly an Einsteinian insight, but its truth is undeniable. You cannot save money by spending it.
This becomes a question, put simply, of "What are you willing to do to reach your goals?" Limit your Must-Have expenses to half your after-tax income, and keep your Wants spending to 30 percent of it, and that pie-in-the-sky 20-percent savings rate just became . . .
. . . automatic.
Consider also that this is not an all-or-nothing proposition. The number of people who are already living 50/20/30 when they pick up on the idea is probably miniscule. The ratio is simply a target to work toward. How much better off is the family who, in January, was living at a level of 75% Must-Haves / 2% Savings / 23% Wants . . . but by June has cut some costs significantly, and rebalanced to 62/10/28. Certainly they've increased their financial security. And their happiness has probably escalated as well. As the book tells us:
Remember your mama's advice: Just do your best. If you can't save 20%, can you save 15%? If you can't get your Must-Haves down to 50%, can you get them down to 55%? Getting your money in balance is one of those things where close really does count.
More Details and Guidelines
The term "Must-Have" isn't wishy-washy.
This is the spending to which you are committed, either by contract, law, or necessity. We all have to spend some amount of money on shelter, food, utilities, insurance, and transportation, at the very least.
Warren and Tyagi offer three guidelines to help determine whether an expense is a Must-Have, or whether it's something else. An expense is a Must-Have if:
- You could not live in safety and dignity without it (at least temporarily).
- You would keep spending money on it even if you lost your job.
- You could not live without it for six months.
When deciding what gets included in this category, be sure to sniff out all the Wants that you might at first glance list as Must-Haves. For instance, basic phone service is probably a Must-Have for most people, but Caller ID and unlimited-talk long distance plans are not. Cable TV is not a Must-Have (unless you're under some sort of contract). Clothing is a category frequently listed in the Must-Haves, but really, couldn't you survive just fine for quite a long time on the clothing you already have?
Debt payments are not necessarily Must-Haves.
Interestingly, Warren and Tyagi advise readers to think of certain debt payments as Savings rather than Must-Haves. The assertion is that when you're making extra (read: more than the minimum) payments on credit-card debt, personal loans, medical debts, and most other debts, you are actually decreasing future obligations, and thus increasing your potential for future cash flow. Those additional debt payments now, in other words, make increased future saving possible. Thus any extra payments toward debt principal are grouped with Savings.
It is entirely conceivable that a family could have a ratio of 50/20/30, with the entire 20% of Savings going toward debt paydown each month. (Actually this is what the authors recommend doing if you're carrying credit-card debt, personal loans, overdue bills — basically any debts other than mortgages, car loans, or student loans).
Be cognizant of the "straddlers."
These are expenses of which portions may fall within your Must-Haves and, at the same time, your Wants. It's easy to tally up a three-month average of your grocery spending and plug that amount into your Must-Haves. But that may not be realistic.
"Food," the authors write, "more than anything else you buy, straddles both the Wants and the Must-Haves." In this category, as in others, what you need to live on is probably not what you spend. The "what you need to live on" part is your Must-Have. The rest goes with your Wants. It's not unlike the telephone-service example above. Basic service might be a Must-Have, but all the gadget services are not.
50/20/30 can impact your emergency fund.
Most experts suggest that you keep from 3 to 6 months' worth of living expenses in your emergency fund. Do your Must-Haves constitute "living expenses" for you? If so, then you might decide that using the total figure from your Must-Haves calculation is the way to go when determining how much to keep in your e-fund reserve.
"The general rule of thumb," Warren and Tyagi say, "is to put enough in your Security Fund [Emergency Fund] to cover your Must-Haves for 6 months."
Whether this is how you want to handle your emergency fund or not is up to you. It's worth consideration, anyway. In the end, you should do what allows you and/or your family to feel most secure.
In any case, I suspect that working toward 50/20/30 is a very good start. And for everyone who's still with me on this, here's a BMF-based Spending Plan spreadsheet to help you get started. If you have questions, let me know, and I'll get back to you as soon as I can.