Budgeting: Why All the Negativity?
OK - let's start with the elephant in the room: the word budget. Most people equate the word budget with the need to cut back. Like some kind of financial diet....which makes most people cringe.
So if the headline to this post turned you off, let me say now that I'm not advocating for you to cut back on spending in order to save more. In order to circumvent the negative feelings we have toward the word budget, I'm going to propose that we use a different term that doesn't spark innate vitriol: cash flow management.
My sense of budgeting is really more like cash flow management. It's not necessarily eating out less or nixing your fancy cable package. Budgeting is more understanding the cash you have coming in each month, and where it typically goes. The difference between the two, of course will either pad your savings every month or take from it. And understanding these moving parts gives us a sense of how quickly we're growing net worth, and when we might reach our various financial objectives.
A Cash Flow Process You Can Live By
Now that we understand that budgeting doesn't necessarily mean tightening your belt, let's review a cash flow management process you can use to your advantage.
1) Grab Data
First, gather all the data you can that concerns your monthly income and spending. This would include pay stubs, bank statements, credit card statements, or anything else that might shed light on your monthly transactions.
Web services like mint.com are excellent resources for data aggregation. I've spoken with many people who have privacy concerns about these types of programs - and for good reason. My take on internet privacy is that our information is out there already. Whether it be companies that we frequently use, like Target, or companies that gather our information without our consent, like Equifax, our "stuff" is out there whether we like it or not. While nothing on the internet can be totally secure, mint.com is just about as secure as it gets online.
2) Categorize Your Transactions
Once you have all the data in a spreadsheet, sort it by category. You can categorize any way you like, but I'd recommend trying to consolidate where you can. It's helpful to separate discretionary spending like eating out with necessary items like groceries, but getting too granular becomes confusing. Your best bet is to use major categories like housing, utilities, transportation, entertainment, etc. Once you've done so, calculate the average for each category over the last several months.
3) Review the Ratios
Categorizing your expenses is helpful to understand how much you might be spending in certain areas. And most of the time, you'll identify things you could eliminate without affecting your lifestyle.
In my opinion, the bigger benefit to categorizing expenses is that you can use the categories to run a ratio analysis. Reviewing how much of your gross or net income is put toward debt, housing, or taxes is a very helpful exercise. Plus, there are a few benchmarks you'll want to measure your numbers against to ensure you're setting yourself up for long term success:
Consumer Debt Ratio
This is the monthly amount you pay on your consumer debt, divided by your gross income. Consumer debt includes credit card payments, student loans, auto loans, etc. Shoot for your consumer debt ratio to be under 20%.
Housing Cost Ratio
Housing costs include fixed costs for your home, including rent, principal, interest, HOA, taxes, or insurance. They do not include utilities, as they tend to fluctuate. The housing cost ratio is the total of your monthly housing costs divided by your gross income. This number should be less than 28%.
Your savings rate is anything you're stashing away for later, divided by your gross income. This includes anything you're adding to your bank accounts, investment accounts, retirement accounts like an IRA, Roth IRA, or 401(k), or anything else. It doesn't include funds your employer is depositing on your behalf, though. Shoot for a savings rate of at least 10% before retirement. Doing so over the course of your career will set you up for financial security once you stop working.
If you're spending ratios are higher than the guidelines above, don't sweat it. Just understand that these are some of the ratios bankers review when deciding whether to extend you credit (as well as how much). I typically recommend that my clients stay inside these numbers, just in case they need to access financing on short notice.
Using a Budget to Boost Savings
Once you understand how much is coming in each month and where it's going, you can hone in on your savings. Most Americans have little insight into how and why they spend money, because they do very little cash flow management. If they do happen to save money, it's because they happened to have a little left over at the end of the month.
Instead, I advocate for a more surgical approach. By managing cash flow in a more calculated fashion, you'll know exactly how much you can save each month, where it's going, and how you might be able to increase that amount.
And here's the secret weapon: automate your saving. Virtually all bank and brokerage accounts allow you to deposit a certain amount on a recurring basis each month. Maybe your monthly deposits should be routed to your savings account to build up a cash reserve. Maybe they should be sent over to your Roth IRA to fund the account for the year. Whatever the destination, automating your saving by establishing recurring deposits will make your like a lot easier.
This is the approach we take with our clients. If you'd like to learn more about how we help our clients optimize their finances, feel free to schedule an introductory chat: