Making a budget? Break down the 'Big 4' expenses first
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Dear New Frugal You,
I am 27 years old. I earn $31,000 per year. I just got my MBA and am in lots of debt from student loans. Please help me construct a budget where I can save at least $50 per month. My current budget is: rent $601; car note $375; car insurance: $142 every two months; electric, water, Direct TV: $150; food, etc. $200. I am strapped, and the student loan payments have not started at an estimated $301 per month! Please help. Thanks! -- Poor Graduate
Dear Poor Graduate,
Congratulations! An MBA from TMMU (Take My Money University) is an honor. You should be proud of the achievement. The unfortunate part is that now you're getting your doctorate from the school of hard knocks.
Today's lesson is one that high schools and colleges don't teach. We'll learn that it's hard to repay debt, and there's a limit to the amount of debt you can take on. So let's start today's class.
Your idea of creating a budget is right on. The first thing to recognize about a budget is that it is not a straitjacket. Rather, it's a tool to tell you what's happening so that you can decide what changes need to be made.
Generally, there are four big expense areas. These four items are: housing (about 35 percent of your budget), auto (15 percent), food (15 percent) and debt (10 percent). Among them, they account for 75 percent of your take-home pay.
The other 25 percent is needed for medical expenses, clothing, entertainment, cell phone, Internet, gifts, travel, etc. These smaller categories will not throw most people's finances seriously out of control, nor will they be the solution to any big financial problem.
Now, let's look at your budget. Your income is $31,000 per year, $25,800 after federal income, Medicare and FICA taxes. About $2,150 per month.
So how do your expenses line up with your income?
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- Housing (rent plus utilities): $751 or 35 percent per month. That's right at the maximum.
- Auto expenses (car plus insurance): $446 per month. Add a tank of gas and a little maintenance, and you're at $525 per month or 24 percent. That's too high by 9 percentage points.
- Food: $200 per month. That's 9 percent of your income. Just about where it should be.
Add food, housing and auto, and you've already spent 68 percent of your money each month. It's easy to see how you're pushing against your limit, even before beginning to repay student loans.
Now on to the last of the big four categories:
- Debt: The $301 per month for student loans is another 14 percent of your take home pay.
When added to the rest of the Big Four, there's just not enough money left for everything else. So what can you do? You've got three possible options. Increase income, reduce expenses or get some, or all, of the student loans forgiven.
If you want to increase your income, you'll need another $300 per month in after-tax income to get your budget to balance and pay off the student loans (without any extra for savings). That means you're looking for roughly a 15 percent pay raise.
Given that, cutting expenses is the most likely solution. The big expenses are home or auto. Taking in a roommate or refinancing your car are possibilities. Refinancing your student loans could also help.
Finally, you can see if you qualify for any student loan forgiveness. To qualify, you'd need to:
- Perform volunteer work.
- Perform military service.
- Teach or practice medicine in certain types of communities.
- Meet other criteria specified by the forgiveness program.
Note that bankruptcy will not help. Generally, student loans are not dismissed in a bankruptcy proceeding.
There's a lesson in this for all of us. Just because you can borrow money for college doesn't mean that you'll have the ability to pay it back. Look at starting salaries in your chosen field. A ballpark rule is not to borrow more than you expect to make in your first year after graduation.
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