Budgeting is one, if not the most important, lesson you can learn in personal finance. Budgeting is a plan to match inflows with outflows – or more explicitly, how you intend to spend the money that you earn. Having a budget will help you to take charge of your financial future and could help to significantly improve your quality of life.
Budgeting is a simple concept, but it can often be difficult to stick to. You’ve probably experienced this to some degree. Have you ever told yourself, “I know it’s expensive and I shouldn’t buy it but I have to have it!” I think it’s human nature to consume now and fret about consequences later. It’s in our DNA.
You’re never too young to learn to budget. In fact, the earlier you start in life, the easier it will be for you to follow throughout your life. If you earn an allowance or have a part-time job, get started now. Budgeting is simpler when you have less responsibilities, because you’ll have less expenses. Your expenses now may consist of entertainment, gas money, or even car payments. The budgeting process becomes much more complicated as you get older, become more independent, and gain responsibilities. You’ll go from having few expenses to having more than you care to have, such as rent, mortgage payments, car payment, insurances, gas, food, utilities, clothing, repairs, water, entertainment, and hopefully, some sort of savings. Keeping track of all of these can be overwhelming. Writing it all down is a must. There are tools to help here. Excel or Google Docs are perfect for this sort of task. If you are unfamiliar with these programs, there are tutorials available on-line. The basics are fairly easy to learn.
The first thing you need to do when crafting a budget is to get a sense of what your current financial situation is. Start by listing your sources of income. If you’re salaried then this is pretty straight forward. If you are hourly or commissioned, estimate your monthly income, based on the previous year or two. Be conservative here. Budgeting won’t work if you give 100% probability to unlikely beneficial outcomes, such as landing Google as an account. You don’t want to overstate your income, because that can lead to excess expenses. However, if you are certain of future raises or other sources of income, be sure to include these.
Next, list your expenses. This can often be difficult to do from memory and you are likely to miss some things. Start keeping track of your expenses. When you run across one that you haven’t documented, simply add it to your spreadsheet. Your bank statement or credit card statement may offer you additional insight into your spending habits. Bank and or credit card statements often have itemized lists of the purchases you made throughout the month. Often you can get historical statements as well. Browse through these if you have access to them. If you have expenses that occur less often than monthly, then convert them to monthly. So, for example, if you pay insurance once a year, divide this amount by 12 to get the monthly amount.
When listing your expenses it’s important to differentiate between fixed and discretionary expenses. Like the name implies, fixed expenses are those where there is no flexibility in payment. For example, if you have a car loan and the monthly payment is $300, you cannot simply pay $200 of it now and make up the difference later. You don’t have control over how much to pay. Discretionary income, on the other hand, is flexible. If you typically spend $100 on going out to eat in a month, you have control as to whether you want to increase your spending or decrease your spending.
Once you understand your income and expenses, you are ready to assess your financial situation. Hopefully, you are spending significantly less than you’re making. Likely though, you are spending close to what you’re making. This is very common. It seems to be human nature to spend as much as you make. Living beyond your means can happen at any level of income. Did you know that 78% of NFL players and 60% NBA players go bankrupt within 5 years after retiring?! Professional baseball players are 4 times more likely than the average person to declare bankruptcy. Just think, many of these guys were making millions of dollars a year. They think their income will last forever and they spend accordingly. They buy the fancy cars, party with entourages, buy mansions and private jets. They don’t bother saving any money or planning for retirement. In most cases, they are simply uneducated with respect to personal finance.
After you have assessed your current financial situation, take control of it by budgeting. Even if you’re not living beyond your means, the chances are good that you can become more efficient with your budget. Every person’s budget is personal and each of us has our own particular goals, so there is no “one size fits all” in terms of budgeting, but there are some basic fundamental when making your budget.
Start with your monthly income and subtract your fixed expenses. Remember, these are the bills you have to pay each month. There is no wiggle room with these bills. The money you have left over after paying these bills is the money you can use to exert more control over your budget by reducing discretionary expenses. To be a master at budgeting, you need to reduce discretionary expenses wherever you can. For example, cut back on small expenses that add up over time. Is the $5/day for coffee worth it? $5/day over the course of the year adds to $1825. Does that make you think twice about the coffee? Limit dining out, buy generic brands at the grocery store, use coupons, reduce your cable bill, or phone plan, etc. Everything helps. After reducing your discretionary spending as much as you can, hopefully, you have money left over. Use this money to set financial goals for yourself. Make the goals realistic and measurable. It doesn’t make sense to plan for a Ferrari on the average income. You’ll have to decide for yourself what these goals are, but I will share some that you may want to consider. Pay off your debt, especially revolving credit, such as credit cards that charge you interest, as soon as you can. If you have multiple cards, pay off the ones with the highest interest rates first, but make sure to pay at least the monthly payments on the others in order to avoid penalties. Once you pay the balance of your credit cards, do your best not to keep balances on these. Paying interest on credit cards is wasteful. Save for an emergency. Emergencies are unexpected. It’s important to be prepared for a hit to your finances in the case where you lose your job or have to go to the hospital. This is where budgeting pays off. 6 month of income is ideal. Set a fixed proportion of your income aside, like 10%, for retirement. The earlier and the more you save, the better off you’ll be. Don’t forget to have fun to. Save for a vacation. Remember, you want to have specific dollar amounts in mind when setting goals. This will help you to stay motivated, measure your progress, and ultimately achieve your goals.
Treat your budget as the law. Stick to it and don’t overspend. Not overspending is the cardinal rule in budgeting and personal finance in general. It all sounds easy, but isn’t always. Always be mindful of where your money is going. You are in charge of you money, you control it, don’t let it control you. That said, have fun once in a while and don’t forget to treat yourself – as long as you remain within your budget. Budgeting is a great way to get ahead.