Budgeting: The Bedrock of a Financial Plan

Today, we're talking about what a budget is.

The concept of a budget is discussed so often that any financial advice I give about it is usually met with, "Sure, yeah, budget, but what else?"

The truth is that a budget is the bedrock of a financial plan. If we cannot pinpoint where your money is going or what it is going to, we cannot stop the proverbial bleeding to help you accomplish your goals!

A budget is a target. It's a series of goals regarding how to spend your money, and it must consider the hurdles you face month to month.

One of the best things about setting a budget for anyone is a reality check about how much you are actually spending. And you know, I've been just as guilty of this as anyone: an impulse buy here, something you "need" there, and soon enough, your entire monthly pay is gone.

Here you are, sitting and waiting for the next paycheck.

Here you are, saying to yourself, "Aren't I making more money than this?"

The good news is, it often turns out you are. You are just spending a lot more of it than you realize. What a budget does is allow you to face this problem. So, how do we start something like that?

First, you list your expenses—all your bills, including your mortgage, rent, phone, power, and water bills. You also want to include anything you have subscribed to, like Hulu or Amazon.

You set these expenses against your income. This comparison is the core of the budget: money in and money out.

You also want to include your goals. For some, this may come later when you are more able to plan for the future and start goal setting, or even once you have your current habits a bit more under control. The key is that when you have a goal you're saving for, you must treat that as an expense.

If you read The Richest Man in Babylon, it talks about paying everyone else first. Sort of a strange point; what does it mean?

That means that as soon as you get your money, you're handing it out to whatever merchant has the shiniest thing you see—new clothes, gadgets, etc. Maybe you are no longer making a choice, and automatically, it is going to Hulu, Amazon, or another subscription you have forgotten about.

So, paying yourself first means putting funds aside for your emergency savings or retirement, allowing them to grow and be available for necessary use. This should be considered an expense. The funds will leave your budget to go to your emergency savings and other goals and should be considered "spent."

After reviewing every expense, you should eliminate unnecessary expenditures. Maybe those expenses are a subscription or an expensive coffee habit for something you could replicate at home. Whatever they are, identify them and rid yourself of them!

I'll warn you beforehand: Removing online subscriptions will be irritating, but you must stick it out.

Richard Thaler's book Nudge explains the psychology of decision-making and the obstacles many online retailers put in your path to make it difficult for you to remove these subscriptions.

We often default to the path of least resistance. One example Thaler uses is one we have all seen: we open a website and get asked about cookies! Have you ever noticed how large and prominent the "accept" button is and how tiny and almost invisible the "reject" often is? Many will click the more prominent, easier button to get on with their life, and many subscription services employ a similar strategy for their cancellation. So, you must take the time to parse through those as best you can.

Another obstacle you may encounter while creating your budget is a variable expense. For example, your internet bill is probably the same every month, but your electricity bill depends on your usage.

The changing cost dependent on your usage is what makes the electric bill a variable one.

So, how do we budget for these uncertain items?

My answer has always been to be conservative and overestimate the amount. It allows for wiggle room and a lighter mental load than tracking every dollar would create.

I realize this isn't always possible. Sometimes, if you are really struggling, you must limit your travel to reduce the variability of the gas you use for your car or consistently turn off lights to bring down your electric bill as much as possible.

But most of us can practice this overestimation. You might say, "I spend anywhere from $200 to $280 in gas. It's a wide range, but let's call it $300. Let's call it $300, and if I spend less than that, that's a good thing, right?"

When we "Zero" our personal balance sheets each month, these surpluses (if there are any!) can contribute to our goals so we can reach them sooner.

There's another thing that we can do to simplify the budgeting process. However, this one has to be used with caution because a lot of people are irresponsible with credit cards. I cannot overstate that this method in particular should not be used if you are counting the cents in your budget.

This is a method to ease the mental load, not a hack.

I use my credit card for almost all of my bills, and this allows me to get through weird pay periods. Using a credit card will allow you to spread necessary expenses out over the entire month instead of relying on one expense. Sometimes a work schedule dictates that the first pay check in a month is half of what the second one for that month will be. This is the scenario this sort of strategy is meant for.

The caveat is that you have to pay that off every month! You cannot spend so much on your credit card that you can't pay it off because then you'll start to develop interest.

Interest is the cost of borrowing money. You don't want those balances to exist over the 30-day rolling period. Otherwise, you now have a monthly expense that you cannot afford!

This strategy only makes sense if your pay periods are irregular and might causes missed payments of utilities or something similar. For instance, most of your utilities may come in at the beginning of the month, and if you have a tight budget your paycheck may not cover it all. You can transfer that expense to the credit card so that you can make even payments across the same month. Lets review an oversimplified example.

You make $2,000 a month, and your monthly bills are:

$1,000 a month in utilities

$1,000 a month in food

If your bills are all due on the first paycheck, then you are forced to choose between food and having the electricity turned off. However, if you put your expenses on a credit card, you can have both and pay before the statement cycle without incurring interest.

You should not be using this strategy to accrue card benefits, if that is the only reason you are using it. It is too easy to allow yourself to use this strategy to buy things you shouldn't and before you know it, it gets away from you.

A card's benefits are exaggerated by using points or things like airline miles. If you earn 30,000 airline miles for signing up, it sounds like a lot, but the monetary reality is that the money it translates to is nothing compared to the interest they make off of you if you misuse the card.

But if you can be disciplined about it and have the income to allow for this sort of flexibility, they are another way to ease the mental load of maintaining your budget.

As a final note, having cash floating in your account for unusual expense timing is much safer.

To actually execute the budget, you've got to find what works for you, and this is different for everybody.

I found that my "spending money" (which you should also budget for and consider an expense) would last much longer if I had it in cash. Each pay period, I'd take cash out and say, "OK, this is my money for chips at the gas station or impulse purchases at the store—all that stuff."

This worked for me because I would see something I wanted to buy, grab it, and then go to the cash register. Then I had to dig through my wallet for the cash and get out the actual amount of physical money, and it would make me stop and think, "Hang on, I've only got a couple of these pieces of paper left." It was successful for me because it made me stop and think for a minute about the resources I was using.

Now, this might only work for some. You might do better with just writing everything down. The key is some form of mindfulness to make you look at the amount you're spending.

You might have heard of the Dave Ramsey "envelope method" where you have cash for everything and it all goes in the envelope.

"This is for groceries. This is for Gas..." It's whatever works for you. You can find a myriad of different budgeting techniques online, but you really need to find one that works for you. No two people are the same, so you might need to make adjustments to any one strategy, but you need to be honest with yourself about it.

The budget is a learning curve. You should not expect to write something down in a notebook and instantly be financially disciplined. That's just not how it's going to work. You should not expect immediate compliance. It is challenging to battle with yourself about your wants and to parse out your needs from those wants, especially in a life where the unexpected is every day, and we are constantly barraged by advertising from every angle.

You need to be persistent about your budget.

You need to be honest with yourself.

You need to be mindful of the difference between what you're spending and what you must spend.

You need to work on discipline.

I promise you that the more you work on your financial discipline, the more rewards it will pay.

In financial planning, your goals will inform your budget. I mentioned earlier that paying yourself should be treated as an expense. Here is an example of what that would look like.

You've got a trip you're saving up for next year, and you're putting $400.00 away each month. You're putting that down as an expense because it will be an expense in the future. That might feel bad, but the alternative is that when the trip comes, you put it all on credit cards, and now you're just paying interest on the $4800 trip cost for a long time—now the trip costs more! You could have paid it up front, enjoyed your vacation, and then returned with a clean slate. It feels bad now and rewards you later. (A trip is not necessarily paying yourself, but it is a decent example of the expense philosophy.)

If you look at any good habit, the good habits generally don't feel as good in the moment. Working out, you don't see or feel the immediate gratification that you would from eating chips. But when you are in shape, you feel and move better and are in a state of higher gratification. If you were eating chips all the time, you would feel the dissatisfaction of being out of shape and overweight.

So I do have a book suggestion, it's called Nudge by Richard Thaler and it is essentially about the psychology of decisions. It is worth a read because it highlights the design of many of the products, stores, websites etc that we give money to.

Start a budget and stick with it. It will pay dividends and give you greater freedom!!

Thanks for reading; stay tuned for next time!