The meaning of 'living within your means'

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Do-it-yourself investing

More Videos

Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
• Getting help

More from Money Magazine

Make money in 2010 Be a smarter charitable giver 3 ways to save money on health insurance

Best Places to Live Current Issue Subscribe to Money

NEW YORK (Money) -- Question: I've been having an argument with a co-worker about the difference between living "within your means" and living "below your means." I'm hoping you can settle the issue for us. What do see as the difference between the two terms? --Mark E., Peoria, Illinois

Answer: I think the conversations that you and your co-worker are now having touch on an important issue that many Americans are now having to face after more than a decade of frenzied borrowing and spending -- namely, the need to downsize a lifestyle that's proven to be unsustainable.

Whether it was by racking up huge credit-card balances, taking out mortgages with low teaser rates or using a line of credit to tap the equity in a home, many of us were able to bankroll a way of living that was out of line with what we could actually afford based on our earning power.

But the party has come to an end. And many Americans must now deal with the inevitable hangover. For better or worse, some will get government help. Wednesday, for example, president Obama announced a $75 billion plan aimed at helping up to nine million homeowners avoid foreclosure. Many more people will have to make a variety of other painful adjustments to live a more modest lifestyle, if they haven't begun doing so already, voluntarily or not.

So, to put it in your terms, does that mean more of us will have to live "within our means" or "below our means"?

I don't know of any universally accepted definitions for these concepts. But if by "means" we are referring to someone's resources, I think you could plausibly say that someone living below his means is spending less than he can actually afford to spend given what he earns. Which means he is saving some money. Someone who is living within his means, on the other hand, would be spending all he earns, but no more.

But that distinction is too simplistic. I think it's perfectly reasonable that someone might consider regular saving a necessary annual expense. A person who thinks that way could very well see meeting that expense as a natural part of living within his means, not below his means. In other words, for some people living within their means might automatically assume the need to save.

And there are other issues to consider, such as debt. Suppose you cover all your expenses from earnings and you also manage to save regularly, but a large chunk of your budget goes to make the minimum payment on huge credit-card debts you've racked up. Are you living below your means? Within your means? Above your means?

All of which is to say that I don't think I can settle your argument with your co-worker. Terms like within your means, below your means and above your means can mean different things to different people.

What I can do, however, is throw in another phrase, "leading a financially responsible life" -- which I would loosely define as arranging your financial affairs so that you have the best shot at creating financial security for you and your family now and in the future -- and suggest two actions you should take to lead such a life.

Make regular saving a priority. There are two main reasons you need to save. One is to build a reserve to help you deal with normal financial setbacks such as a layoff or big unanticipated expenses that you can't meet from your salary. To create such a cushion, you've got to plow some money into a secure stash like a savings account, CD or high-quality money-market fund. People can disagree about how much is necessary, but three to six months' worth of living expenses is a reasonable guideline.

But you also need to save so that you can support yourself later in life. You know that at some point you'll no longer be able or willing to work. The only way to assure you'll have resources to fall back on at that time is to spend less than what you earn today so that you can spend it in the future.

Essentially, that's what the Social Security program is all about. The payroll taxes deducted from your paycheck go to current retirees who have previously paid their payroll taxes. But unless you don't mind living on Social Security alone -- which isn't very cushy, as you can see by checking out the Social Security Administration's Retirement Estimator tool -- you also need to save on your own.

Of course, there are other reasons to save: to buy a house, educate yourself or family members, start a business, to name a few. And, admittedly, some people may simply not make enough money to cover even their basic expenses. But such dire circumstances aside, if you're not at least saving regularly for the two main reasons I've mentioned, then you're not being financially responsible.

Control your debt. I like to divide debt into two categories: good debt and bad debt. Good debt is the money you borrow for something you truly need or that can enhance your financial security or that of your family. Here, I'm talking about a mortgage to buy a house, a loan to buy a car, borrowing to fund a college education or a business.

Bad debt is the debt you take on for things you could do without. Tapping home equity to fund lavish vacations would be an example of bad debt.

Of course, the line between good debt and bad debt can get blurry. For example, the money you borrow so you can have a car to get to work certainly would constitute good debt. Borrowing for a $70,000 Statusmobile when you're earning $50,000 would push that debt into the bad category. The same principle applies to buying a more expensive house than you can actually afford, even if some stupid or unscrupulous lender is willing to give you the loan.

By the same token, it's not as if every time you borrow for something that's not an absolute necessity that you're being financially reckless. An occasional splurge is fine; indeed, it can make life more pleasant. While I certainly don't advocate using credit cards as a way to live large, as a practical matter it would be unrealistic for most of us to live our lives completely on a cash basis.

The key when it comes to debt is to avoid clear abuses like borrowing heavily for things you don't need or can't afford and, most important, making sure that you're able to comfortably manage the payments on whatever amount you borrow. People can disagree about what portion of your budget should go to debt service. But I think warning flags should go up once you start devoting 40% or so of your income to repaying debt, if not before. (To see how your debt holdings compare with those of other Americans, check out the debt section of the Fed's Survey of Consumer Finances).

There are certainly plenty more things you can do to improve your financial prospects -- work hard, manage your career, invest prudently, monitor your finances periodically. But if you save on a regular basis and avoid bingeing on debt, you'll be living in a financially responsible way. As for whether this constitutes living within your means or living below them, I'll leave that to you and your co-worker to settle.

Need help with a financial dilemma? In an upcoming issue, Money magazine will be answering reader questions. Email money_letters@moneymail.com.