How do you know if you're spending too much money, and where to cut back? Two methods can help you get on track.
When it comes down to it, saving more money is a simple equation. Either you can spend less money, or make more of it. But simple doesn't mean easy. How do you know when you should cut back, and whether you're saving enough to cover retirement, emergency funds, and other important savings goals?
Do you spend too much?
The best savings interest rates won't be enough if you are spending more than you make. That's why athletes with multi-million-dollar contracts can end up filing for bankruptcy. In fact, it's worthwhile to look at some statistics of these former millionaires. Sports Illustrated reports that "by the time they have been retired for two years, 78 percent of former NFL players have gone bankrupt or are under financial stress because of joblessness or divorce" and "within five years of retirement, an estimated 60 percent of former NBA players are broke." Someone with just a small fraction of a pro athlete's income, however, can be financially sound.
If you aren't sure if you're living well enough below your means, it's critical that you write down your financial picture on paper. Personal finance expert Suze Orman writes:
Security begins with getting debt under control, and that begins with getting a clear, honest picture of how your expenses stack up against your income. Until the numbers appear on paper, we often don't realize what our spending really looks like. I suggest making a detailed spending log from the previous year. I've found that before doing this exercise, most people underestimate their average monthly expenses by at least $500 to $1,500. If expenses exceed income, can debt be far behind? For many of us, debt is too big a part of our overall money picture not to give it the respect that it's due.
If you're in debt, there's a good chance you're overspending. Orman's process works as follows:
- Review your list of expenses for the past year and mark the areas where you could cut back. Do you need to eat out every single night? Did you pay a lot of late fees? Could you mow the lawn yourself?
- Choose 10 easy-to-make changes you can implement right away, and write an action step for each one. For example, you could write, "I will make dinner at home four times per week."
- Commit to making those changes for one month, and write down how much you didn't spend each time those action steps save you money.
- Add up your savings at the end of the month, multiply that figure by 12, and see how much those easy changes could save you in a year.
Are you saving enough?
Another method to determine if you're spending too much is to see how your expenses measure up with the 60 percent budget solution created by Richard Jenkins, former editor-in-chief of MSN Money. Jenkins notes that a higher income means little when you aren't living within your means:
As I looked back over the past 20 years of budgeting, I saw that there were a few years when my wife and I believed we were fairly on top of things, even with a much lower income. How did we manage? The key was a drop in our fixed monthly expenses...That left us with some extra money each month to set aside in a savings account for those irregular expenses.
We later moved to a bigger house with a much bigger mortgage payment, higher maintenance costs and utility bills, and obscene property taxes. The monthly mortgage payment was only 20 percent of our gross income, far lower than the 33 percent that most lenders will allow, but, suddenly, we were struggling again.
In Jenkins' budgeting method, fixed expenses should be about 60 percent of your income. Fixed expenses include the following:
- Basic food and clothing needs
- Necessary household expenses
The remaining 40 percent is divided up into 10 percent chunks for the following purposes:
- Long-term savings (rainy day fund such as a high interest money market account)
- Short-term savings (planned expenses like gifts or vacations)
- Fun money
This method includes important saving categories to help you determine if you need to cut back to save more. Let's say, for example, that your fixed expenses make up 60 percent of your income. Sounds like you're saving plenty, right? Maybe not. If you aren't saving anything for retirement because your "fun" money category is eating up 20 percent of your leftover cash, it's time to think about ways to spend less money.
Spending less might mean making some lifestyle adjustments, but the payoffs are huge. Start small with easy ways to cut back, and work on incorporating new ways to save money over time. You'll hit your savings goals before you know it, and you might even find new, less expensive ways to entertain yourself.