When it comes to taking the stress out of your personal finance adventures, the budget is king. It doesn’t matter how much or how little you earn: building a structure for your income and outgo gives you some degree of control over your financial life. And a feeling of control goes a long way toward calming one’s nerves.
Creating a budget is surprisingly easy. You need these things:
• Something to keep track of income and expenses. This can be as simple as a spiral notebook or as sophisticated as a program such as Quicken or Mint.com. I’m now using a spreadsheet in Google Documents; I back it up by downloading it to disk as an Excel file each time I make entries in it.
• Pay stubs and other statements of your income. If you work a regular job, your pay statements should appear online. Find out how to access these and print them or copy to disk as PDFs. If you have a business, whether full-time or on the side, you should be sending customers receipts for payment and keeping copies. (Not doing it? Horrors! Start now!)
• Statements from providers of services that require regular, routine payments, such as utility and phone bills, insurance bills, and mortgage or rent bills.
• Receipts from purchases, whether by check, cash, credit-card, or debit card. Do not toss these out! Keep until you can use them in your budgeting scheme.
• File folders, or a good scanner and a computer with hard-drive or cloud back-up. Use these to store statements and receipts, whether in hard copy or digitally.
There. You’re ready. Let’s assume you’ve never done a budget before, even though most FaM readers probably budget themselves silly (and we’ll get to that issue!). Here’s the strategy.
First, figure out how much income normally comes into your coffers.
Gather all statements of income: pay statements, alimony or child support records, amounts received from side jobs or enterprises, disability checks, Social Security, whatever. If it comes in regularly, count it as part of your monthly income. Write these figures down (on paper or in a computer program) and add up the total. This is your total monthly income.
If you receive money from sources that come in, say, quarterly, prorate the amount over a year and add the resulting monthly figure in to your total available monthly income. Let’s say you receive a student loan of $4,000 per semester, or $8,000 a year. Divide $8,000 by 12 to give you the amount available per month. If you know you will have a summer job, you could divide the amount by 9 to give yourself a slightly higher amount during the academic year.
Next, figure out how much you normally spend. Distinguish between what you have to pay, come Hell or high water, and the expenses over which you have some control.
1. Gather as many statements as you can find showing the amounts you’ve paid out regularly over the past year for things that you can’t change. This means utility bills, insurance premiums, alimony or child support, the yard man, the pool service, minimum payments on credit-card debt…whatever. If you pay it out regularly and you can’t weasel out of it, count it as part of your monthly nondiscretionary, can’t-get-out-of-it expenses.
Now, for these regularly occurring monthly expenses, try to find the largest amount you pay in any given month over the course of about a year. Use these largest figures to calculate your monthly nondiscretionary expenses. Add them up and write that figure down. This is the amount you will regard as your monthly required, can’t-change-it expenses. Let’s call that nondiscretionary spending. For example:
2. Over the course of a month, write down every other expense you’ve run up: groceries, clothes, hair styling, gasoline, car repairs, dog food, donations to the kids’ soccer club, craft supplies, yard sale items…in other words, everything that is not a monthly recurring bill goes into this category.
As you record these costs, instead of lumping them all together, you should organize them in categories. For example, groceries, eating out, personal entertainment, hobby, home maintenance, pet expenses, etc. You have full control over these categories. Create as many or as few as make sense to you.
Distribute the charges among the categories, write down the charges for each category, and subtotal each category. Then take the subtotals and add them together to give yourself the total amount you spent that month. This figure represents your discretionary spending. For example:
3. Gather the statements for bills that come in annually, semiannually, or quarterly. These may include things like taxes, car insurance, and car registration. Add these up and prorate them over a year; the total divided by 12 will give you the monthly amount, on average, that you need to set aside to cover these costs. This figure represents the amount you need to set aside in a sinking fund to cover costs outside monthly spending.
Okay, the groundwork is now laid. You’ve now finished one of the most difficult parts of the budgeting process: figuring out what you really spend (as opposed to what you think you spend or to what you think you ought to be spending). Now all that remains is to use these tools to gain control over income and expenses and set things up so you can start building wealth.
Remember, you have monthly income (all sources of income prorated over 12 months); monthly nondiscretionary spending (all regular bills that you can’t get out of paying, some of them prorated from annual, semiannual, or quarterly billing), figured at its maximum amount; and monthly discretionary spending (all other expenses).
Take an hour or two to sit down and study these figures. First, of course, you want to determine whether your expenses exceed your income. If so, write down the amount by which this is happening. If your monthly net income is, say, $3,000, and you’re spending $3,300, you need to know that so that you can figure out how to rein in that out-of-control three hundred bucks.
Here’s an example that combines data from my own books with what it might cost to rent or pay a modest mortgage:
My self-escrow for tax and insurance (t&i) is just a guess, because in real life I have no mortgage and so have to pay my property tax myself, pushing t&i to over $300 a month. On the other hand, I have to pay a lot toward health insurance (Medigap and Part D). Utility bills are entered at their highest rates, which occur in mid-summer; in January, these bills are much lower, but I figure them at their highest all year so as to be sure enough is always set aside to cover any little surprises…such as the $116 handyman bill for house repairs that occurred in January. Note that regular monthly savings ($200) is included among the nondiscretionary costs: saving is not optional.
Now subtract the monthly nondiscretionary expenses from your total monthly income. This will give you the amount left over to spend on the daily expenses over which you do have control, in varying degrees.
$3,000 – 1,800 = $1,200
Because you’ve entered your maximum monthly bills (the highest utility bills of the year, for example), the amount you get here will be the minimum amount left for discretionary expenses. In some months you’ll have more, but the smart budgeter assumes the worst and so aims to spend the least amount possible in most budgeting periods. Some utility companies will prorate your bills based on your prior year’s spending, giving you a predictable monthly bill that’s always the same; if you’re comfortable with this, by all means arrange it.
Okay, so if your net income is $3,000 and you spend, at most, $1,800 on utilities, insurance, and rent, you have $1,200 left over for discretionary spending and for savings. Very nice.
You recall that last month, all-told, you spent $3,300, and so you know that you need to cut discretionary spending from the $1,300 that you actually diddled away to the $1,000 you can afford. It’s that, or get a second job!
Some part of that over-spending may have come from longstanding credit-card or department store debt. You need to get rid of this. That means stop spending on the cards and start paying down the balance. To accomplish this, add a regular monthly pay-down amount to your nondiscretionary budget. That’s because getting out from under debt is crucial to retaining financial sanity.
This amount should be more than the interest the
loan shark bank is charging on the amount due, so that you’re paying at least some of the principal down each month. So, if you owe $1,000 at 21%, you need to pay more than $210 a month toward the credit card bill to have any hope of one day getting clear. Let’s make it $250 a month. So for the time being, nondiscretionary saving looks like this:
$1,200 – 250 = $950
This puts a crimp on your style. However, bear in mind that it’s temporary: after you’ve paid off the revolving debt that’s pushing you into the red, you can give yourself a raise.
In fact, $950 is a fairly generous budget for food, clothing, and the like.
My discretionary budget is $800 a month (my income is a lot less than $3,000 a month!). Here’s how I did in January/February:
As you can see, I overspent by about $52 that month. The paint for the repair job and a pair of electric toothbrushes came out of this month’s discretionary budget; I gave one of the toothbrushes to my son as a birthday gift; and I diddled away $66 on a pair of (sale!) shoes. The savings accrued from the monthly nondiscretionary contribution to “Savings” serves as a fund to cover overruns like this. This spreadsheet runs from January 21 to February 20, because I charge all discretionary spending on an American Express card and pay it off at the end of the month. So, the bills above represent what I carry as February spending, to be paid out of February income.
Speaking of savings, you need to decide how much to pay yourself for short- and long-term savings. If you have a regular job, chances are your employer offers some sort of retirement or pension plan. Opt in to the 401(k), so that retirement savings are taken out of your salary in pre-tax dollars. This will cover at least some of your long-term savings. If you’re in debt, use extra dollars to pay off the debt; if not, open a Roth IRA or a regular brokerage account and start making regular contributions with post-tax dollars.
So, you start with two savings categories:
1. Emergency savings. Deposit a regular amount into a savings account each month, to cover unplanned expenses. I put $200 aside, but that amount is hardly graven in stone. Select whatever you can afford. I started with $10 a month…it doesn’t matter. Every little bit adds up.
2. Long-term savings. This is money stashed for purposes such as buying a car in cash, sending the kids to college, and retirement. Naturally, the amount you budget will depend on your needs.
Experience gained during the Great Recession suggests that when it comes to retirement or pension plans, an employer’s word cannot be trusted, nor, in the current political climate, can we expect that Social Security will be preserved for future generations. So, if you’re under about 60 now, you’d better plan to provide for your own retirement 100 percent.
Retirement planning: There’s a subject for another installment!
In the meantime, the budget is your best tool for getting a grip on all your financial issues: spending, debt payment, saving, retirement. It can be as simple or as involved as you like, but its main features should include funding for can’t-dodge-’em recurring bills and enough to put food on your table, gas in your car, and clothes on your back. Anything beyond that is gravy.