Frugal Fridays: Step 1 - Make a Budget
Fri Aug 24, 2007 at 01:13:32 PM PDT
Welcome to Frugal Fridays where we share money saving tips, discuss living frugally and generally talk about personal finance issues. If you are a financial neophyte trying to get a grasp on your financial situation for the first time, the first piece of advice that you will most likely see is: "make a budget." I've said it myself, many times. But rarely does anyone go on to explain exactly what a budget is and how to make one. For the most part we just assume that everyone can figure that out on their own. Today I wanted to go through a detailed description of what a budget is, how to make one and how to make your spending match your projections.
Disclaimer: I am not a financial professional. I'm just a consumer who tries to be educated. Take anything I say with a grain of salt.
What is a Budget
I tend to think that a budget can serve two distinct purposes:
- Tool to Analyze Past Spending Patterns It's comforting to be able to answer the question, "Where did all my money go?" If you find you are not happy with the answer, you can then modify your spending behavior.
- Guide to Modify Future Spending Patterns This is the purpose that most people think of when the hear the word budget. It can be vital to use if you are trying to change your spending to meet a particular goal, such as getting out of debt, increasing your savings, or accommodating a change in income or outflow.
In the second sense, a budget doesn't need to be some sort of financial straight jacket that restricts your life of fun and dooms you to a dull existence. In contrast, it can be one step on the path to freeing yourself from financial worry. If you know that status of your finances and you know that if you splurge on that treat you are eying you will still be able to pay the rent next week, you can enjoy your binge guilt free
In order to make an accurate prediction of the future, you have to first get an accurate estimate of the past. Once you know where you money has been going, you can use this knowledge to make a predictive budget that will allow you to live within your means while meeting your obligations. One important note: all of this discussion refers to your pre-tax income. Be sure to include your tax payments as one of your expenses in your planning.
How to Make a Budget
- Decide on Your Priorities Before you look at how you are spending your money currently, think about your goals and priorities in life and decide how you want to be spending your money. As I have mentioned before, my mom used to recommend the "70-10-10-10 Plan" where 70% of your income is spent on expenses, 10% on charity, 10% on savings and 10% on education. You can adjust these percentages or add your own categories, but you should come up with a goal that fits your life.
- Assemble Your Paperwork Gather together your recent pay stubs, credit card statements, canceled checks, bills, receipts, etc. the goal is to get an accurate picture of all of your income and expenses for the past twelve months. If you are like most folks, you don't always save receipts for everything you buy. If you have a credit card or debit card statement for these expenses, you can usually figure out what you purchased. However, if much of your spending is in cash, you really need to start tracking where that money is going as well either by keeping the receipts or keeping track some other way.
For example, I used to carry a little notebook with me at all times. Every day at the beginning of the day I would write the date and the amount of money I had in cash at the top of a new page. Then, every time I would spend or get cash I would write it down on that page. At the end of the day, the new balance should match what was in my wallet and would go at the top of the next page. As a matter of fact, I still do this when I go on trips in foreign countries, but now I use my PDA. If you just can't be bothered to keep track to this detail, then just include an expense in your budget labeled "cash" and lump all the unknown expenses into that category.
- Pick Your Budgeting Tool While you can make a budget using pencil and paper, I would suggest using some sort of software. This will give you the ability to make predictive changes to your budget and analyze their effects with ease. Plus you will eliminate the possibility of math errors creeping into your analysis. A simple spreadsheet program should be adequate for simple planning purposes and there are free versions available. I like to use either Open Office or Google Spreadsheets. If you plan to keep detailed track of your expenses in the future or if you have a particularly complicated financial situation, you may want to use software specifically designed for financial accounts. I have used Quicken for years now and I am happy (more or less) with it. One thing I really like is that it is relatively easy to import data into TurboTax, which is how I do my taxes. One thing I really hate is that every few years, they change the data format which forces you to buy a new version of Quicken which costs money and forces me to learn a slightly different interface than I am used to. Alternatively, there are lots of shareware and freeware products, or products with free trial periods such as Mvelopes, out there, one of which may be what you need.
- Summarize Your Income and Expenses Next you need to make a summary of all your income and expenses. I further like to divide my expenses into discretionary and non-discretionary categories. Discretionary expenses are not necessarily ones I can eliminate all together, but these are the expenses that I have the most control over changing. These distinctions are somewhat arbitrary and you may not agree with my categorization. There is a columnist for the Washington Post, Michelle Singletary, who writes a personal finance column. Here is the budget categorization sheet she suggests you use. I combined her suggestions with my own categories and put together a Google Spreadsheet you can also use. Here are just the categories from this spreadsheet. This is a pretty detailed list, and you may not want to break things down this much.
Income
- Salary (pre-tax)
- Bonus
- Social Security
- Child Support
- Interest/Dividend
- Misc (gifts, part time jobs, garage sales, etc.)
Non-Discretionary Expenses
- Taxes (Federal Income, State Income, Social Security/Medicare, Foreign, Other State/Local)
- Home (Property Tax, Insurance)
- Loan Payments (Student Loans, Credit Card, Other - not including mortgage)
- Savings (401K, IRA, college plan, other funds)
- Health Insurance
- Life Insurance
Discretionary Expenses
- Home (Mortgage/Rent, Repair/Improvements, Garden, Appliances/Furniture/Art, Cleaning Service, Misc)
- Utilities (Gas, Electric, Water/Sewer/Trash, Phone - landline, Phone - cell, Internet, TV)
- Food & Alcohol (groceries and restaurants/bars/coffee shops)
- Auto (Purchase, Repair, Gas, Parking/Tolls, Fees, Insurance, Misc)
- Other Transportation
- Charity (Tax-Deductible and Non-Tax-Deductible)
- Gifts
- Bank Charges & Fees
- Small Business Expenses
- Childcare (Daycare, Babysitting, Child Support/Alimony)
- Medical (Copayments, Direct Payments, Prescriptions, Over-the-counter Medication, Eyeglasses/Other Supplies)
- Entertainment (Books/Comics, CDs, Movies/DVDs, Magazines/Newspapers, Live Entertainment, Games/Hobbies, Computer hardware, Computer software, Misc)
- Clothes (Adult, Children, Work Uniforms, School Uniforms)
- Personal (Hair/Makeup, Gym Fees, Misc/Cash)
- Pets
- Vacation (Vacation Home/Timeshare, Lodging, Travel, Misc)
One important thing to pay attention to is that for all your loan payments, you should note how much is devoted to paying down the principal and how much goes to interest. This is particularly important if you are carrying any high interest debt. If you are, you should make it your top priority to pay down that debt as soon as possible, rather than trying to build up your savings.
- Apply future projections Once you have seen where your money is going, you can try to reduce your expenses in categories where you are overspending and apply the savings to paying down your loans or increasing your savings and investing. This is where a spreadsheet really comes in handy, since you can apply permutations and see the results instantly.
How to Stay Within Your Spending Guidelines
Unfortunately, if you are trying to limit yourself to a set amount of spending, it may be hard to monitor yourself day-to-day or even week-to-week to know where you stand. My aunt used to joke that her philosophy of spending was "when I run out of money, I'll stop by myself". unfortunately, this approach doesn't work in the modern era of easy access to credit. However, if you are having difficulty changing your spending habits and sticking to a budget, you may want to switch to an all-cash approach. If you cash your paycheck each month and assign how much you will spend in each category, you can then take those amounts and put them in envelopes labeled "food", "rent", etc. Only use the cash in each envelope to pay that bill. If you run out of money in one envelope, try very hard not to transfer money from another. This method may be very helpful if you are an impulse spender.
Another way to curb impulse spending is to leave your credit cards at home when you go out and only take the amount of cash you are comfortable spending that day. I've heard of hard core impulsive shoppers who have taken to freezing their credit cards in a block of ice. By the time they chip the card out, they are usually over the irresistible urge.
If you just need a little help in the self-control department, you can switch to using a credit card with a very low credit limit. If you run into your limit before the month is up, you know it is time to stop spending. You may want to keep a separate account with a higher limit for those times you need to make a large purchase, but don't carry that card with you every day. Some folks like to use debit cards for this same purpose, but I don't recommend them since they don't have as strong fraud protection and rather than declining your card for insufficient funds, the bank may permit the charge and then charge you overdraft fees (a double whammy).
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