Importance of Allowance in Personal Budgeting

Importance of Allowance in Personal Budgeting
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  • 0:00 Personal Allowance Definition
  • 0:57 Setting Up an Allowance
  • 2:37 Staying on Track
  • 4:40 Lesson Summary
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Lesson Transcript
Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

An allowance can help a person maintain a balanced budget while still having a bit of fun. Let's look at how to set one up and how to stay on track to meet personal finance goals.

Personal Allowance Definition

Ethan has been paying a lot of attention to his personal finances lately and is working on a budget. One consideration that came up was the idea of using a personal allowance and adding a line on the budget for that. What is a personal allowance? Well, Ethan's budget already includes the big things, like his rent check, car payment, utilities, gas and groceries. But what about the discretionary, or non-essential, things like a cup of fancy coffee, a new video game, or a night out on the town with friends?

An allowance covers these items and allows someone to plan for these expenses and avoid spending more money than the budget allows. Allowances permit Ethan guilt-free spending as long as he doesn't exceed his limit. Since the funds are accounted for in advance, these expenses won't cause him to break his budget, as long he follows the budget.

Setting Up an Allowance

So how does Ethan figure out how to set his allowance? The thing about personal finances is that, by nature, there is no hard and fast rule. The first things on the budget should be the essentials: food, housing, utilities, and the expenses necessary for work and getting to work. After that, he needs to look at the less urgent but still important things like retirement savings or setting money aside for a new car or a wedding. If he has debt, like student loans or credit cards, that will reduce the amount of his discretionary income. Remember, discretionary income is the money Ethan would need for that cup of coffee, the video game, and the night out with friends.

Ethan has a couple options for setting up an allowance line on the budget. One method would be to add up all his other expenses, subtract them from his income, and use what's left as his allowance. The downside of this technique is that it might not allow any discretionary spending. He could also set a specific percentage, say 5% or 10% of his income as a personal allowance. With this technique Ethan must be careful to ensure he isn't short changing any other items on the budget. The important thing is that the amount is an intentional decision.

If a percentage method is used, Ethan must define what kind of expenses fall under the personal allowance category. If he includes clothes for example, the ratio might be as high as 30% of his total income. Maybe the allowance covers special wants instead of baseline, modestly priced clothes. Part of establishing an effective budget is being absolutely sure what line item or pot of money each expense comes out of and being able to keep track of it all.

Staying on Track

The big challenge with a personal allowance is that sticking to it is much trickier than picking a number. Ethan will need to first make a decision about how to use the money. Will he take out that amount in cash each month? The advantage of that method is that once the money is gone Ethan can't spend any more. A debit card would be convenient, but requires a lot more in the way of self-discipline. But at least with a debit card there's the limit of what's in the checking account. A credit card is an option, but failure to stick to a limit that can be paid off at the end of the month will rack up high interest debt.

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