Budgeting In 4 Steps
I few weeks ago I gave everyone a homework assignment. It’s simple assignment really- no algebra or physics – I just wanted you to download and configure any one of a number of budgeting / expense monitoring apps and then just spend money. Why? Well, experts agree that a budget is the essential first step in understanding and controlling finances. A budget ensures that you save for retirement and a rainy day, cover all your monthly bills, spend only what you have allotted toward any expense category and can sleep well at night. But the point that most people seem to miss is that before we can hope to develop a budget we need to first understand where our money is going. That’s where an app can help. I prefer Mint – but there are other very good ones including: You Need a Budget (YNAB), Mvelopes., Mint, Money Dance and Personal Capital, PocketGuard, and Albert. Hopefully you have been gathering data on where your money has been going. Now we are going to use this data to develop a budget in 4 easy steps.
Step 1 The easiest: determining monthly net income.
Essentially this what we bring home in our pay check after 401K, health plan, taxes, etc. It’s what our employer deposited into our checking account each month. You can find this information on your bank statement or pay stub.
Step 2 Pay yourself first!
Paying yourself first is a common financial phrase that means we automatically – and before anything else - take a specified amount of each paycheck and put into savings. Thus we are paying ourselves before paying anyone else. Such savings includes emergency funds, a house savings account, IRAs, 529, etc. Personally, I also include a savings allotment for vacations. This way my vacation expenses are banked before I ever leave. The more automated the process the better because it decreases the chance we will allocate the funds for something else.
A house savings account is important because no matter how shinny and new your home is; you should expect to spend 1%- 3% of your home’s value each year on “unexpected” repairs. The unexpected is in quotes because no matter how many times experts tell us this, we are totally caught off guard when major expenses occur. So, if you have a $400k home, each year you should be putting between $4,000 and $12,000 into a savings account just for home realted expenses. Sounds like a lot? Try replacing a roof.
Emergency funds are for big catastrophic events. What would happen if you found yourself without a job – how long could you pay your essential bills? By essential we mean that if you had to live a Spartan life-style for a few months, what would you need to survive. Things like rent, mortgage, student loans, car payment, insurance (health, car, disability, etc.), minimum credit card payments, and utilities are all essential. But it’s not all about losing a job - what would happen if your car died and you needed money for a down payment? Experts recommend that we should have at least enough to pay 3 months of “essential” bills in savings. This doesn't include retirement funds or our home savings account. Let’s say for a moment that your essential bills are $3,500 a month. To cover 3 months of expenses you would need $10,500 – not a trifling amount. However, if you save just $50 a week for 48 months you will have $10,500 in savings.
If you are not participating in a 401K or are saving additional monies for retirement, this is where you would account for these funds. Before, not after your variable expenses. Likewise, if you are saving for junior’s college expenses with a 529 account, these savings would be accounted for in step 2 also.
Step 3 - Identify “fixed expenses.”
Fixed expenses are those expenses that are a fixed amount each month and we have to pay no matter what. Things like student loans, rent, mortgage, car payments, utilities and insurance are all examples of fixed expenses. If you have been keeping track of expenses these should be easy to identify. Fixed expenses are usually the largest part of our budget and for some items, such as our mortgage, there is often little we can do in the short term. That doesn’t mean we shouldn’t scrutinize these expenses. Sometimes small efforts - e.g. price shopping for insurance – can produce meaningful financial rewards. Perhaps we have unused subscriptions we could cancel. Others options, such as downsizing to a less expensive automobile may require more effort, but the potential monthly payoff can be substantial.
At this point you should total up all of the fixed expenses as we will be needing them shortly.
Step 4 Discretionary income = Income – Fixed expenses – Savings
There is no way around it. If we take our income, subtract fixed expenses and savings, what’s left over is our discretionary income. To put it another way – that’s what’s left to pay so called “variable expenses”. This is what we can spend on clothes, dining out, that new picture for the living room. It’s also where we allocate funds for groceries, so it’s not all fun and games. Generally, it’s the variable expenses where we have the greatest day-to-day impact on our budget. It’s also the hardest to control. Unlike finding a less expensive insurance policy that automatically decreases our monthly fix expenses, saving money on variable expenses requires a daily conscious effort to live frugally. This is where most people fail in their budget.
At this point you should look at every item in your expense report. Are there fixed expenses we can cut? Perhaps we can find less expensive insurance. Maybe we could do just fine with slower and less expensive internet. How are we spending our discretionary income? Do we really need to eat out two nights a week, maybe we could be just as happy dinning out once? Assign budgetary values for each fixed and variable expense and well as our savings targets and then enter them into our budgeting software. Now you can monitor each expense catagory in real-time.
Now the hard part – sticking to the budget! If you are using Mint or some other budgeting App – you can check how you are doing in real-time by just opening the app. Before you make an expenditure, look to see if you can afford to make that purchase. And if you set reasonable targets for each expense category, the App will warn you that you are going over budget. There is no doubt - the hardest and most important part of living within a budget is controlling the discretionary expenditures. Let technology help make it easier!