Using your income-to-expense ratio to ensure you have a stable financial house.
Secrets to a balanced budget.
Balance your budget so you can stop living paycheck to paycheck. A balanced budget ensures all your expenses fit the foundation of your income so you can maintain stability through any challenge. But what’s the right balance for your budget? When you live paycheck to paycheck, your expenses don’t fit your income. To create balance, your expenses need to be proportional. That means checking your income to expense ratio. Divide your total monthly expenses by your total monthly income. Your ratio should be less than 1, ideally 0.75 or less. This means you spend less than 75% of your income, leaving 25% as free cash flow in your budget. Some of that cash flow can be converted into savings. This helps increase the amount you save to support your financial goals. Savings should be a resident in your budget, which means it gets housed with your fixed expenses. Aim to save at least 5 to 10 percent of your monthly income. If a large expense arrives unannounced, you have money saved and you can keep your financial house in balance. Cash flow and savings help accommodate these expenses easily, so you don’t have to invite credit card debt in. Because credit card debt shouldn’t be a welcome solution to address budget challenges.
For more great advice for your budget, visit ConsolidatedCredit.org
As you can see from the video, with one simple calculation you can assess the strength of your financial house. Living paycheck to paycheck doesn’t always feel like struggle. If you haven’t had any major expenses or unexpected emergencies pop up, you may feel like you’re “doing okay.”
However, the truth is often that you’re effectively one setback away from financial distress. If your air conditioner breaks or your car’s transmission goes out or you have a medical bill that’s not covered by insurance, it can throw you into a financial tailspin. That’s why you have to check your income-to-expense ratio and pad your budget accordingly.
Additional resources to help you build an effective budget
Use these resources to help you maintain a balanced budget:
- Budgeting Made Easy
Learn how to create an effective budget step by step
- Infographic: Budget Balancing Act
More data to help you assess if you have the right balance
- Credit Dojo: Building a Well-Fortified Budget
Take our interactive course to see if you’ve truly mastered budgeting
How big should an emergency fund be?
One question you may have is exactly how big your emergency fund should be to support a healthy outlook. Most experts recommend that a robust emergency fund should cover 3-6 months of budgeted expenses. That means you can effectively cover all of the fixed and flexible expenses in your budget with savings for three to six months. That way, if you lose your job or can’t work for a time, you don’t have to rely on credit.
During times of high economic uncertainty, you may want to increase your emergency fund to cover 6-12 months of expenses. This ensures that if you lose your job and can’t find employment that you can stay afloat without an issue.
Of course, saving that much money and being able to maintain that amount in your savings account can be tough. Emergencies inevitably happen that drain those funds. You may also have a major purchase or want to take a vacation, so you use the savings you have. So you may want to start lower with a more manageable goal. You can start by aiming to maintain a balance of $1,000 in savings. Then increase that to $5,000. Then aim to save for 3 months and work your way up from there.
For more information on how to create an effective saving strategy, visit Consolidated Credit’s Guide to Saving Money. You can also watch our Penny Wise video series for more great tips.
What to do if you have a reduction in income
One of the biggest challenges for any budget happens when there is a significant reduction in income. This can happen for any number of reasons:
- Your hours get cut back at work
- Your company starts to limit overtime
- You take a new job at a lower salary
- You switch to a new profession with a lower salary range
In most cases this type of change means you need to go back and work your budget out from the ground up. Start by totaling up your fixed and flexible expenses; see how much cash flow is available if you cut out everything discretionary. Then start adding the nice-to-haves back in to see what you can reasonably afford. It may require some tough choices, but it’s better than the stress you’ll add if you turn to credit. Using your high interest rate credit cards to cover income deficits is a fast way to problems with debt.