by Gary Foreman
Q - I've heard that you should not spend more than 33% of your after-taxed salary on housing. I have to find an apartment and live on my own. I never had to do that before. I am struggling with a budget and not knowing what I can really afford for an apartment. - Michael
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A - Michael is right to make sure that his apartment expenses don't cripple his efforts to get off to a good financial start. And, he'll find that his choice of an apartment will make a huge difference on whether his budget (and his finances) work.
Before we look at Michael's housing question, let's spend a moment on constructing a budget. They're not nearly as scary as you might think. The purpose isn't to lock your money up where you can't get at it. A good budget simply provides information about your expenses and how they relate to your income. The goal is to help give you data to make good decisions.
Michael asked about after-tax income. There are two ways to do a budget. One includes your taxes and uses your 'gross' (before tax) income. The other uses your 'net income' (after tax). Generally it's easier to use the after tax method. It tends to be a little less complicated.
In an after-tax budget, Michael's take home pay would be his income. And he would not budget for any payroll deductions (i.e. insurance, retirement plans, taxes, etc).
OK, now let's get back to Michael's main question. How much can he afford to spend on an apartment? It's generally accepted that 30 to 35% is about right for housing expenses. That would include rent, plus utilities, any maintenance and decorating.
Some would argue that Michael could spend up to 40% for housing. The trouble with that is Michael has a limited amount of money. His paycheck needs to cover housing, automobile (or transportation), food, insurance, entertainment, clothing, medical/dental, miscellaneous and debt repayment. So an increase in housing expense means a decrease somewhere else.
Michael didn't share what his income is. So we'll have to keep this somewhat general. But, we'll still be able to illustrate the point.
The three biggest expenses he'll face are housing, transportation and food. Along with 30% for housing, he'll probably need another 15% each for transportation and food. So he's already spent 60% of his money leaving just 40% for everything else.
The quickest way for a budget to fail is to overspend these 'big three' categories. If Michael spends 65 or 70% it becomes almost impossible to make up the difference in the smaller categories. Even if he cuts back drastically in areas like entertainment and clothing, he just won't find enough savings to offset the additional expense.
Overspending in these big areas is also a problem because we often make commitments for months or even years in advance. It's not like your electric bill. If it was too high last month, you can start turning down the AC today. But, if you agreed to make forty eight auto payments, there's not much you can do about it for awhile. Or, if you do make a change, it will significantly disrupt your lifestyle.
Let's suppose that Michael's take home pay was $2,000 per month. He really wanted an apartment that cost $800 (40% of his income). Add his car payment ($225), gasoline ($75), groceries ($150) and restaurant meals ($150). That totals $1,400 and only leaves him $600 to cover debt repayment, clothing, entertainment, medical, miscellaneous, savings and any unexpected bills. Chances are that he'll quickly be putting some of those expenses on his credit card and adding to the unpaid balance. At some future point that will come back to haunt him.
If Michael were making a lot more he'd have more flexibility. If his monthly income were $10,000, it wouldn't make as much difference if he spent 35 or even 40% of his income on housing. He'd have more in other categories to make up the difference.
Most of us live with limited income. It's important for us to get our housing, auto and food expenses under 60% of our take home pay if we're going to keep from getting into financial trouble.
So Michael is smart to pay attention to his housing costs. He's identified the cornerstone to a sound financial future. Let's hope he finds the perfect, affordable apartment!
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Copyright © 2005 by Gary Foreman. All rights reserved.
