Why Budgeting as a % of Income Doesn’t Work

Occasionally, I come across the method of budgeting that allocates a certain percentage of income towards certain expenses.

For instance, if you use Mint.com, it compares the percentage that you’re spending to other people in the same geography.  In theory, this helps folks know how good or bad they’re spending their money.  But here are a few reasons, why this way of thinking can get folks in trouble.

1.) If your income is different

If your income is lower than most in your area, then it looks like you’re $20/month on Starbucks is a much higher percentage than other folks.  But maybe that’s really low for your area and other folks are simply making more income.  Oops.  Good job spending less, but you might need to re-think your income plan.

2.) It allows for expenses to rise as income increases

I met someone the other day who said that he budgets all his expenses based on a percent of income.  I asked him what he did in months where he had more income and his happy response was “I get to spend more.”.  Which is exactly what happens and exactly what you don’t want to happen.  

In our family, as our income goes up, our goal is to keep our expenses flat and all the extra income fall to the net income where we can use it to pay down debt and/or invest in good assets.  We currently save 50% of our income.  (also called our operating margin)  I expect our income to rise by more than 10% next year, so our operating margin should increase so that we’re saving 60%+ of our income.

3.) It creates a feast or famine mentality

The guy who told me he spends more when his income is higher also said that he often has to drastically decrease spending when his income is low.  And that’s because he didn’t set aside some of the income from his good months to smooth out the bad months.

WHEN IS % OF INCOME A GOOD INDICATOR?

The only time that I can think of this methodology being a good way of thinking is when considering house payments.  There are some decent benchmarks that say 20-30% of income should go towards housing expense.  We are at 10%.  Mostly because we bought a small fixer-upper and put a lot of blood, sweat and tears into fixing it up.  Not something I would recommend, but I was young, bold and had a lot more energy then.

If someone realizes that they are paying more than 30% of their income, then it becomes a question of whether they need to work on their income or lower their expectations.   Both good questions.

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