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Basic budgeting
I'm just starting to make a budget. Is there a certain percentage of income I should devote to rent?
August 26, 2005: 11:12 AM EDT
By Walter Updegrave, CNN/Money contributing columnist

NEW YORK (CNN/Money) - I'm restarting my life after my divorce. Now that I have to pay child support, I'm not sure how much I can afford to pay in rent each month. Is there a certain percentage of income I should devote to rent and, if so, should I base that percentage on my gross or take-home pay?

-- Jacquie, Hagerstown, Maryland

There are two ways to go about this. One is to see what percentage of income other people devote to rent and use this as a guideline for your own situation. The other is to take a close look at your various expenses and other obligations then make a determination about how much of your income you ought to be allocating to rent.

The first method seems to be more popular if only because it provides people with a target to shoot at. But I actually think the second makes more sense if you're trying to do sensible long-term planning for your financial security. In any case, let's take a look at both.

Looking at the averages

Every few years, the Bureau of Labor statistics releases its Consumer Expenditures Survey, which gives detailed breakdowns of the average spending in a variety of categories for different types of households in the U.S.

The most recent survey has spending figures for 2003. That may seem a bit dated, but if you look at the spending as a percentage of income, I doubt that the figures would change markedly over just a few years.

If you take a look at the most recent survey results broken down by homeowners vs. renters, you'll see that, on average, renters tend to devote about 33 percent of their income to housing.

You get this percentage by dividing the amount listed in the table for housing, \$9,886, by the Income before Taxes figure of \$29,827 at the top of the table. You could just as easily calculate a percentage based on income after taxes, but I think it makes sense to use gross income because most people are used to thinking in terms of their pre-tax income.

That percentage, of course, is an average, which means it can be higher for some people and lower for others. People who live in highly populated urban areas or who prefer prestigious digs would likely pay a larger share of income than those who live in less dense suburban or rural areas and those willing to settle for more modest accommodations. On average, though, I'd say that most people's rents fall in a range of 25 to 40 percent or so of their gross income.

But should the percentage that others pay be the model for what you should be willing to shell out in rent?

I'd say no. There appears to be quite a lot of flexibility in terms of what we can pay for rent. I can choose to live in the most fashionable part of town or a less desirable area. I can rent a palace of an apartment, or I can opt for a tiny studio. I can limit my search to new apartment buildings with amenities like swimming pools and gyms. Or I can rent a furnished room or small apartment in a private house.

That's not to say I have complete control over the rent I pay. Clearly, rent is much higher in some cities than others. But by choosing the location of my rental and the size of the apartment (or house, for that matter), I can choose to be on the upper end of the rent scale in my area or at the lower end.

Which brings me to method number two, which works as follows:

Begin with your gross monthly income. Now deduct expenses you absolutely have to pay. Child support, any loan payments (car, credit card, school loans, etc.) you've got to make, basic living expenses for food, clothing and other day-to-day expenses. Also subtract what you pay in income tax (use last year's tax returns as an estimate) and Social Security taxes (6.2 percent of your salary up to a maximum payment of \$5,580).

At this point, I would also throw retirement savings into my "absolutely have to pay" expenses. At the very least, I'd want to be contributing 5 to 10 percent of my gross salary toward a retirement savings plan such as a 401(k).

I suppose you could say this isn't an absolutely necessary expense in the sense that your life won't come to a screeching halt if you don't save for retirement.

On the other hand, if you don't factor such savings into your core expenses then you'll be living a higher lifestyle than you can actually afford. In effect, you'll be spending your retirement money before you retire.

Once you go through this process, you'll have a pretty good idea of how much money you can actually devote to rent.

Of course, depending on your income, it may turn out that once you tote up all the expenses I've mentioned that you don't have enough money left over to rent any sort of habitable space. In that case, you'll have to go back and look for places to pare your other expenses so that you have enough free monthly cash flow to pay for a decent place to live.

On the other hand, it could also turn out that you have wads of cash left over after totaling your "absolute must" expenses. If that's the case, I wouldn't recommend going out and blowing your money on the most extravagant apartment you can find. Instead, I'd say you ought to consider perhaps saving more for retirement and scale back your living arrangement a bit.

Either way, stay within your means

So, ultimately, the method I recommend for gauging how much rent you can afford to pay -- or, for that matter, how much house you can afford to buy -- comes down to putting housing costs in their proper proportion.

Most people tend to buy as large a house or rent as expensive apartment as they can afford, and then let that decision dictate the rest of their spending habits. Unfortunately, this approach often means people do a lot less saving than they should.

My method takes the opposite approach. Let your other expenses, including saving for retirement, dictate how much house you can afford or how large an apartment you can rent. If your income rises, you can always afford to upgrade later.

If you'd like to learn more about how to set goals and create a budget, I recommend you check out our MONEY 101 lessons on Setting Priorities and Budgeting.

But whatever budgeting approach you take, be sure to factor in regular savings that will help support you during retirement. Otherwise, you'll be budgeting on the basis of sheer fantasy rather than hard reality.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."