Wednesday, August 14, 2013

Creating a proper budget

As I talked about before, tracking your spending is the first step to getting rid of that "oh shit" feeling when it comes to your finances.

Today I am going to talk about the next step: creating a proper budget. 
Most people don’t have a budget and would rather not know what’s going on with their finances.  Yet most middle-income people are living paycheck to paycheck with no future plan in mind despite making “a good amount” of money.

You don’t want to be like most people.

As you regularly track your income and spending, you will get a grasp of what your money can do for you.  This will help you get started with setting a realistic budget.

Your budget will keep your spending under control.  Your budget will help you avoid financial stress.  Your budget will make sure you meet your financial goals.  And if you ever want to stop working someday, you will want to properly create a budget to make sure you have enough income to retire.

Projecting your income
If you get a regular paycheck, it’s easy to predict your income.  If you are an independent contractor who gets paid for your services, you can take an average of the last 6 months’ worth of income and start with that.  Be sure not to include any money that you aren’t absolutely positive that you will receive: such as work bonuses or tax refunds. 

Your budget can be adjustable
A budget should be flexible, and not something set in stone.   You can fine-tune your budget as your income increases and as your priorities change.  While I have a good grasp of how much I am routinely spending in each of my expense categories, the amount regularly changes.  In over 10 years of tracking my finances, I have never had two months with the exact same expenses.

Managing different types of expenses
There are 3 types of monthly expenses that you should be aware of: fixed, variable, and non-routine expenses.

1.  Fixed expenses
This includes routine bills such as: cell phone bill, electricity bill, internet bill, groceries, car payment, investment contribution, student loan repayment, etc.  These expenses are usually about the same each month and don’t change much. 

Look to these fixed expenses to see what you can cut out.   Small cuts will really add up.  For example, cutting your internet bill by $10, your cell phone bill by $10, and your electricity bill by $15 in the same month will end up saving you $420 a year.  And if you choose to invest that small difference over 10 years, your $35 a month savings now becomes $6055.  Think about how much more wealth you could accumulate if you didn’t have any more car payments, or student loan payments.

2.  Variable expenses
This includes fluctuating expenses such as: entertainment, clothing, travel, dining out, charitable donations, gifts, etc.  These expenses can be quite variable.  For instance, if you go on a vacation during the month, you may find that your dining and your travel expenses are much higher in this month than other months.

Setting a budget on your variable expenses will help you be consciously aware of your spending.  If you overspend in one category, you can balance it out by spending less in another category.

Variable expenses can easily add up if they’re not tracked and kept under control.  For example, spending $7 every weekday on eating lunch with coworkers ends up costing you $140 a month, $1680 a year, and $24,220 over 10 years (if you had invested that amount).  

3.  Non-routine expenses
Non-routine expenses don’t happen monthly.  They include: car insurance, vehicle registration, life insurance, property taxes, home repairs, car repairs, etc.  Non-routine expenses are the ones that always seem to sneak up and hit us hard without warning.  And if you’re living paycheck to paycheck, you have no room for any financial surprises.

Subtract your total expenses from your total income
This is how much money you have left to save, invest, or spend.  I would recommend saving and investing your money first, then spending what’s left afterwards.  I also recommend not buying useless crap.

Save for the unexpected
Sit down and write down a list of all the non-routine expenses that you can think of.  See above for examples.  Next, estimate how much each of those expenses will cost when they are due.  Yes, this will be a depressing exercise.

Break up long term and non-routine expenses into monthly payments
Take the cost of each non-routine expense and calculate how much it would cost each month.  For instance, if your car insurance costs $510 every 6 months, then it would have a monthly cost of $85.  If your vehicle registration costs $204 every year, then it would have a monthly cost of $17.

I pay my life insurance dues once every 3 months.  I pay my car insurance dues once every 6 months.  I pay my homeowner’s insurance once a year.  And I pay my property taxes twice a year.  It would be a financial headache not to prepare for these expenses in advance. 

For both of us to max out our Roth IRAs, we would need $11,000 ($5500 per person maximum contribution for 2013 x 2).  Instead of waiting until the deadline to contribute the full amount, we make sure each of us puts away $458 a month into our Vanguard Roth IRA accounts.

You can’t predict all of your future expenses, but a little preparation can go a long way
Having multiple savings accounts helps me divide up the big payments into nice monthly deposits.  Recently I’ve opened a new Capital One 360 Savings account that I’ve named “Bills Hedge.”  This account contains a total of all my non-routine monthly bills and expenses.  As this account grows in value, all non-routine expenses get paid from this account.  Now I already have money set aside to pay for large bills as soon as I receive them, with ease and without panic.

Make sure you have an "Emergency Fund" savings account that can be tapped for any large unplanned emergencies.

You can use technology to help create your budget
My favorite financial tools are: Mint and ClearCheckbook.  You can also use the old-fashioned pen and notebook technique. 

Trust me, it gets easier
The most difficult part of planning, creating, and sticking to a budget is in the beginning.  After a few months, tracking and adjusting your spending becomes automatic.  Paying for bills no longer becomes stressful.  Reaching your financial goals becomes much easier.  Non-routine expenses become routine.  Oh yeah, and your farts start to smell better too.

As you build your budget, you will be much more aware of the amount of wealth you really have.  The important thing is just to get started.  You can make adjustments to your budget as your lifestyle changes.   Some financial goals you set may be unattainable or too easily attainable.  With time, you will find the right balance. 


Don’t forget to budget in something meaningful for yourself such as a nice vacation.

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