I have to admit that I am hostile to the term, “Budget.” The word signifies limitations as if I will have to change my lifestyle. Before I prepared a budget, I felt anxious about doing one. Only one out of three (32%) people prepare a monthly budget, and those making at least $75,000 a year are likely to do so. Why do people not want to do a detailed budget?
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Common Reasons For Not Having A Budget
- It is too much work, and I don’t know where to start.
- I don’t know if I need one.
- Fear of finding out about mistakes I was making.
- “Don’t want to rock the boat,” as it may involve confrontation and change.
The Mistake Of Not Finding Out
I had a vague idea about preparing a budget but was reluctant to do one. Craig, my husband, paid the bills, went grocery shopping, and we dined out most of the time. Financially, we were in good shape, living more modestly than others we knew earning less.
Changes like these often require a financial review. We never really sat down to discuss our finances through the years though we met several times with a financial advisor to draw up a financial plan. We were enjoying financial flexibility, but we wanted kids and more space. At some point, virtually overnight, we had two babies and needed a bigger apartment.
These changes meant thinking through our finances since I had left my lucrative career, and Craig was building his law practice.
As I was in law school, I relied on Craig to work through some of the numbers as to what we could afford in terms of more space. That was a big mistake on my part and unfair to Craig. I was the numbers person, yet unaware of our finances. Many of our assets–land, arts & antiques–were less liquid than I realized. Later on, I found many late notices from delayed payments on bills. And it was the beginning of the financial crisis, and it impacted Craig’s practice.
We had two kids, a dog, a spacious apartment in less than three years, generating lower income and still spending as when it was just the two of us. I felt lost, realizing Craig’s income was down, and I did not have a good handle on our monthly costs.
Where was our money going? I soon realized that I needed to create a budget to review and analyze our finances better. It sounds like a cliche, but it was an epiphany for us. Yes, I found mistakes I didn’t want to admit to making, and yes, Craig and I had arguments. We worked to resolve them together by making changes, some more drastic than I wanted. We still handle money differently, and I am more firmly in the frugal camp.
Start Budgeting Early
Don’t wait to budget as I did, using excuses of not needing one or not knowing how to start. It can be easier to create a budget when you are young because you have less money and few assets. Sure, budgeting is tricky when you are just starting in your life. You may be carrying student debt and renting an apartment while your salary is at the beginner’s level. On the other hand, you have fewer costs to monitor, making it an excellent lifelong habit. Use it as a motivational tool to save more and spend less. Be diligent in improving your money management skills.
Yet, preparing a budget is the cornerstone of a successful financial plan. Budgeting is a lot like dieting. It is hard to start one when there are many choices. Each works differently for each person. Both diets and budgets, may provide lasting benefits and bring you closer to achieving goals.
There are many benefits to having a budget at any income bracket. Even if you were to inherit $100,000 tomorrow, you need to understand how to deploy this money best. A budget can help you. You just need to find the best budget method that works for you. We discuss five different budget methods below.
Reasons For Having A Budget
- Having awareness provides essential financial discipline.
- Make changes to patterns you want to avoid.
- It helps you to achieve your financial goals.
- Be more conscious of how you handle money, so you rein in overspending.
- Improves your ability to pay off credit card debt by allocating saving better.
- When you have better control, you can allocate more savings to investments.
5 Budgeting Methods To Boost Financial Discipline
1. The 50-20-30 Budget Rule
This budget rule is straightforward. It prioritizes your needs over wants to build your financial future.
Essentially, you are dividing your after-tax income into three buckets:
50% For Basic Needs
Paying for your basic needs is your priority. About 50% of your earnings go toward your basic living needs. Housing is the proportionally most considerable amount of your basic needs and includes utilities, groceries, car, loan payments, minimum debt payments, and other monthly fixed expenses.
20% To Savings And Debt Prepayment
This income bucket devotes 20% to savings. This amount is building your financial future. If you have significant debt levels, then a higher percentage should go into this bucket and be reduced from the wants category. Your savings can pay down debt, build an emergency fund, retirement savings, and investing. When paying off your debt, you are likely saving money by eliminating the interest costs you carry on your balance, especially credit cards.
30% For Wants
After the above priorities, allocate 30% for wants or desires. This allocation is for discretionary or flexible spending for entertainment, vacations, and shopping. After your preferences, the remaining amount is for your desires. Overspending here means you will have a debt to pay above.
The Pros of the 50/20/30 Budget Rule
This method is simple as you are only tracking three categories, needs, wants, and savings. You have the flexibility of allocating the savings into other areas, like debt pay-offs.
The Cons of the 50/20/30 Budget Rule
It is not as structured as other methods, and some people just need that discipline. You may have little to no savings but have more debt in that bucket. Then proportion the buckets to fit your needs. Paying off debt may be more of a priority than spending as much as 30% on your discretionary wants.
2. “Pay Yourself First” or Reverse Budget
This budget strategy to pay yourself first aligns well with a lifelong principle of personal finance. It is a reverse budget because, unlike other methods, you are saving before paying your bills. It emphasizes savings as the golden rule to learn early in life.
For some, saving money is hard, let alone putting 5%-10% away, which may be virtually impossible. Instead, set aside even small amounts like $50-$100 for your retirement, emergency fund, and savings accounts first. Automate a savings plan for these accounts. When you can, earmark more money, so you will grow your financial future.
That does not mean you don’t have to pay your monthly bills (you do!) but make savings your mantra. You may need to be more frugal at times to restrain some of your spendings so that you can put some away out of your reach.
The Pros of the “Pay It Yourself” Budget
By prioritizing your savings to a retirement account, you can earn compound interest on interest or pay off your debt if your levels are high.
The Cons of the “Pay It Yourself” Budget
As a standalone budget plan, “pay yourself first” may be too simple. You should understand the trade-offs between paying off high credit card balances, which will grow faster than savings as the card issuers charge far higher interest rates than you will get on savings. However, saving money is an essential personal finance concept that will lead you to invest more at higher returns.
3. The Envelope (or Cash Diet) System
The envelope system may be a more comfortable budget method to adapt to if you are more cash-oriented. If you are paying for everything via credit card, this could be a rigid way to budget. This system entails placing exact amounts of cash into envelopes for each monthly expenditure you make, including your fixed costs. Putting money in jars or socks can substitute for envelopes, but I don’t think you want to walk with that.
Here’s how it works. You need to go to the bank to get a large amount of cash and allocate amounts into your spending categories. You would label each envelope and its amount for each of the following typical costs:
Dog Grooming $75
When an envelope is empty, funds are exhausted for that category, and you can’t take out money from another envelope. This method involves a good understanding of how much you typically spend on each classification. The envelope system provides strict budgetary control and may reduce overspending. You run out of money for dining out, and you may have to change plans.
This budget is essentially a cash diet, and some categories, such as rent or your mortgage payments, don’t translate that well into cash. You can still pay most things with checks. Studies show that people tend to spend less when they use cash payments.
You can use white envelopes for this system if you are frugal like I am. I have seen beautiful Celine envelope wallets ($700+), binders, and there are envelope apps to use like Mvelopes and GoodBudget.
Pros of The Envelope System
You are using cash, which can teach you to be more financially disciplined. It will require you to know your budget and the key categories well. You will likely spend less when you know you are running low on cash.
Cons of The Envelope System
This method is time-consuming, especially at first. It is inconvenient to have to withdraw money and carry cash around. Carrying cash conjures up that scene from The Wolf of Wall Street when Donnie Azoff (Jonah Hill’s character) was lugging around a suitcase filled with bills to deposit in a Swiss bank.
Paying cash is not always welcome. A cash diet may be challenging for particularly fixed costs, like paying your mortgage. Instead, you can try the envelope method for discretionary spending and then see if you can pay fixed costs by check. Using checks may mean more work or creativity on your part.
4. Zero-Based Budget or Every Dollar Budget
The Zero-Based budget originates from a business concept where every expense needs justification by a project’s need. This method is number-crunching heaven for those who need more structure in their budget. Essentially income minus costs need to be zero.
Households can implement this budget, similar to a traditional budget. The primary difference here is the budgeter proactively allocates remaining money, if not spent, to a financial goal.
Expenses are costs, outlays for savings, debt payoffs, investing, and charity. You assign a role for each dollar of your earnings to your expenses, savings, debt payments. Savings is a line item on your budget.
For a family, you would total the household earnings from multiple sources minus costs and allocate the rest of the money to where best it should go. When you have minimal debt, you can add the remaining cash where you need it. It could go to your emergency fund, retirement, or investment accounts. On the other hand, if you have high debt balances, use your savings to reduce those levels.
Preparing the Zero-based budget is a lot of work, combing through many details by itemizing your bills and overall spending. At the same time, you need to consider your financial goals, matching where the leftover budget money may best go. This budget method requires a good understanding of your household’s needs, wants, and financial future.
Pros of the Zero-Based Budget
It is structured to pay your costs and use the remaining money where it best should go. This method is goal-oriented, relying on a detailed account. If your expenses are high, variable expenses fluctuate; and are the best area to cut spending.
Cons of the Zero-Based Budget
It is detailed, time-consuming, and can change monthly. You need a good handle on all your expense items and your goals, understanding trade-offs between saving or paying off debt.
5. Traditional or Line-Item Budget
This budget is a personal income statement for an individual or household. It is similar to the zero-based budget but a bit simpler. It totals net income from multiple sources minus total estimated expenses equal plus or minus amount. I use this budget on an excel spreadsheet, making changes over the years. For years, I did not use a budget for many reasons. There were only two of us; we were financially comfortable; it seems like a lot of work, and we kept postponing the task.
Monthly income sources include wages, tips, commissions, dividend income, and passive income.
Total monthly expenses are fixed and variable costs. Fixed costs are housing, food, transportation, utilities, and loan payments. Variable costs are less predictable and are associated with entertainment, medical, clothing, personal, and discretion expenses.
Total Monthly Income $___________
Total Fixed & Variable Costs $___________
Minus- Total monthly expenses $___________
Total Savings/Deficit $___________
Pros of The Traditional Budget
The traditional budget is a good starting point for understanding your household finances. It pulls a lot of detail together about income sources and expenses. Unlike a zero-based budget, it doesn’t have to a goal per se. Instead, if there are funds left, you can allocate it as you please. That is easy enough to figure out.
Cons of The Traditional Budget
Like the zero-based budget, it is detailed and time-consuming. It is a tool rather than a mechanism to help you identify areas to reduce your spending.
When Our Budget Became A School Project
Whenever I think of the line-item budget, I remember this story. I set up the template that had primarily been a back-of-the-envelope work of art. A few years ago, my son, Tyler, showed an interest, and we worked on it together. At the time, I didn’t realize he had a PowerPoint project due for his computer class.
After a few days, I was comfortable with doing a simple budget table jointly with Tyler. About a week went by, and Tyler came home, telling me that he used the budget we worked on for his project. I remember gulping, tensing up, and asking Tyler, “With numbers?#!” And he said, “Yeah, Mom, they didn’t care about the numbers, but they liked the colors.”
All of these budget methods have advantages and disadvantages. They can be used together, breaking envelopes into three bucks of needs, savings, and wants, and dividing into more categories with our needs, and so forth. In any budget you do, consider paying yourself first, that is, saving before overspending on discretionary categories such as entertainment. Be conscious of your spending, so you have money to save and invest.
About a third of Americans generate irregular or less predictable income. Uneven income can be a problem for many, including us. Craig and I had budgeting challenges for many years, as most of our earnings were irregular and unpredictable. I had a salary with an annual bonus that varied significantly from year-to-year. Craig is a self-employed attorney and receives payment dependent on deal closings or other legal areas. Each area varies.
How do you budget in that case? Depending on your income sources, where there is variability, it is best to look back to the last three years and divide by 36 months to develop a meaningful income figure. The more conservative your estimate is, the better.
The reasons for preparing a budget far outweigh any reasons not to do so. There are at least five different budgeting methods to choose from ranging from simple to more detail-oriented ways to review your finances. Creating and reviewing your budget is the cornerstone of a successful financial plan. It helps you identify your household’s strengths and weaknesses and help you devise a plan to make corrections. Find the best budgeting method for you.
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With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.