The 25 Percent Budget Strategy

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This post comes from Mitchell D. Weiss at partner site Credit.com.

For most people, balancing personal budgets is a tedious and time-consuming process. These days, though, the task has become even more challenging.

According to the Federal Reserve, average household debt in the U.S. increased 5.25 percent during the quarter ending Sept. 30, which isn’t surprising given that annualized real (net of inflation) wage growth continues to be negligible — less than 1 percent, according to the Department of Labor.

Household budgeting is a zero sum game: There are only so many dollars to go around before savings accounts are drained and credit becomes scarce.

Also, too often this fundamental tenet of good personal financial management is undertaken in hindsight — long after spending patterns become legacy, rents are locked in and the debts are racked up. At that point, budgets feel more like diets than they do menus.

Fortunately, there’s a better way to approach this task.

Start by dividing your before-tax income into four equal parts and grouping the daunting list of expenses your paycheck needs to cover into four categories: taxes, housing (rent or mortgage), debts (excluding mortgage payments) and living expenses.

The first 25 percent: Taxes

Face it, the money you earn is going to be taxed. Between the various federal and local assessments (including Social Security and Medicare), figure on a bill that could total 25 percent of pretax income for moderate earners, particularly when payroll deductions for company-sponsored health care benefits and retirement contributions are taken into account.

The second 25 percent: Housing

Whether you own or rent, limit your monthly payments to no more than 25 percent of your pretax monthly salary. In other words, figure one week of salary to one month of rent or mortgage payment.

The third 25 percent: Debts

It’s also wise to limit your monthly loan payments to no more than one-quarter of your pretax monthly salary. Speaking as a lender, the closer to 30 percent your total debt obligations are, the less likely you’ll be able to find a creditor willing to say yes to more.

The last 25 percent: Living expenses

If the first one-fourth of your pretax salary is consumed by taxes, the second pays the rent and the third keeps your lenders at bay, the last 25 percent will have to take care of everything else, including an emergency savings stash. Ideally, that should total no fewer than six months’ worth of rent, debt and living costs.

When I do the math this way with my mostly college senior-level students, the reaction is always the same: “Seriously? That’s ridiculous. I can’t live on 25 percent of my gross salary!”

If that’s the case, it’s time to take a second pass at your plan with an eye toward adjusting the allocations within your control — everything but taxes.

Perhaps the rent will need to be shared or a less expensive space found. Maybe an upcoming purchase will have to wait, particularly if financing is involved. Then again, if your debt obligations are already approaching the 30 percent danger zone, you’ll have no choice but to trim the other two categories in order to accommodate that reality.

The point is that juggling a laundry list of expenses is hard to do without a good sense for how they all fit together, the limits that should be set for each category and the strategic trade-offs you can choose to make. And if after all your good efforts the money still isn’t making it to the end of the month, consider a suggestion one of my students made a few semesters ago.

Remember what I said about after-the-fact budgeting and dieting? Well, instead of writing a diet journal, keep a cash journal for 30 or 60 days in which you record every single expenditure you make in whatever form they may take — cash, check, credit card, debit card, online purchase or ACH — and for whatever reason they were made — food, laundry, gas or lattes.

It’ll help you to find the leaks so you can get back on track.

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  • Donna Sako

    so zero for savings?

    • Mitchell D. Weiss

      This is a bare-bones approach to budgeting, Donna–a starting point, actually. Once all the expenses have been separated into each of the categories and checked against the maximum amount for each (25%), you can start shifting between them to accommodate, say, a higher rent bill, or, even, paring them all back in order to make room for savings.

      • Donna Sako

        That makes more sense.

  • Denis Brisson

    Great saying to limit your rent to 25% of your gross salary, but where I live rent is horrendously expensive I am at more like 40% of my pretax income to pay for my shelter. How to lower my rent? Only way is to live in a barn with the critters. I make ends meet only because I have no debt!

  • Gero1369

    Once the debt is gone, make no more! Change the debt category into investment/savings (in addition to the emergency fund savings covered in living expenses). You’ll end up happier, healthier, and retiring earlier!

  • Chris Locke

    Why base the budget on pre-tax income and not the actual take home amount?