Know where your money goes.
Budgets are sexy…or boring….or somewhere in between. In fact, few personal finance topics alternately put as many readers to sleep or incite them to take up their digital pens as the topic of budgets. Budgets are perceived as taking too long to create, remind us of our failures, and seem destined to fail. But, a budget can also be a path to freedom.
I’m a full fledged nerd, so the idea of allocating funds into spending categories and then tracking each expenditure to the penny is right up my alley (hopefully, few others are afflicted with this particular disease). I also recognize the need for automation and simplicity. So, let’s look at a couple different approaches to budgets.
1) The balanced money formula (50/30/20)
2) The anti-budget
The Balanced Money Formula
When I first read about the balanced money formula, I was pretty early in my personal finance journey. My wife and were newly married, had bought our first home together, and were definitely “house poor.” We were both used to living on student stipends, but we cobbled together enough to buy into a townhouse with “resale potential” and a big mortgage in the meantime. If only we new about the balanced money formula! This idea was originally put forward by Elizabeth Warren and Amelia Warren Tyagi in their book, All Your Worth: The Ultimate Lifetime Money Plan.
50% of your after-tax expenses go to needs
30% of your after-tax go to wants
20% of your after-tax go to savings
It’s simple. It’s easy to calculate (no crazy tiered categories to track). It builds self-esteem as each of the categories are simply targets, meaning no post pay period angst when you realize you exceeded your laundry detergent threshold (seriously!?).
So what are needs? Housing? Check. Utilities? Check. Food, insurance, medical expenses, basic transportation, and basic clothing. All check. Just so we’re clear: your Tesla, Manolo Blahnik’s, and Morton’s steakhouse visits are not needs.
This is a site primarily dedicated to personal finances, so lets talk savings next. Savings include clear cut categories like 401(k), IRA or other retirement vehicles. They also include any funds allocated for your emergency fund. If you have debt that you are paying back or making advance payments, go ahead and lump that under savings too. Neat, huh! I would also include savings that were/will be allocated towards other investments and rental properties.
Finally: wants. Everything else. The fun stuff. $7 coffees, cell-phones and associated bling, pet supplies (As a co-pack leader with two dogs, I cringe as I write this), late-night QVC impulses, and even usb sushi for your collection. The balanced money formula give you a place to live life a little.
- Pull Your Savings off the Top.
- Relax about the Rest.
Cool! Anyone should be able to do that. Now, we should qualify, “savings” a bit further. Paula’s recommendation of defining savings as anything that increases your net worth makes a lot of sense to me. Everyone’s situation is unique, so you’ll have to decide how much you can save. As you progress on your personal journey, continue to increase the amount you’re able to save. Wherever possible, automate these transactions so you don’t have to think about them or continually resist temptations to deviate from your plan.
Unlike the first two budgeting methods, envelopes can take a bit more effort to set up and maintain. I find that the envelope approach is well suited when you have lots of regularity in your life: fairly consistent income and recurring expenses. Originally, the envelope system was used with an all cash mindset. Now with tools like Mint, it’s possible to track all of your categories in real time and still get the benefits of a credit card. Here’s how it works:
- Determine what categories you want to track within one pay period. For example, Savings, Housing, Food, Transportation, Entertainment, Debt Payoff, etc. are logical categories to start.
- Allocate funds to each category. If you’re really old-school, write the name of each category on an envelope and stuff it with cash. Of you’re using a tool like Mint, create budget amounts for each category (and sub-category if you’re feeling obsessive).
- Live your life with one rule. You can spend money on anything you want within a category. But, when the envelope or category is empty, you can spend no more until the next pay period.
- Any leftovers can supplement savings.
- Refill the envelopes once your next paycheck arrives.
Can you believe you made it through almost 800 words about budgets!? Consider bookmarking this page in case you have a sudden fit of insomnia. I included budgets in the basics category because I think knowing where your money goes is foundational in order to achieve some of the bigger goals in life. Without a consistent budget you cannot have positive cash flow. Without positive cash flow, you’re losing ground.
What budgeting approach are you finding successful? Why have you been able to stick with it?
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