(This article was originally published at ThinkingAboutMoney on June 11th, 2006.)
Everybody knows that one of the first critical parts of getting your financial house in order is to create a budget. How can you know if you are living within or beyond your means without one? How can you figure out where best to cut expenses if you don’t know how you’re spending your money?
I was talking to a friend this evening who really needs a budget but doesn’t have one. Her reason – it’s just too much trouble.
You know what? She’s right. In fact, I don’t have a budget either – at least not the kind that would make a financial expert happy. What I have is, at best, a partial budget. But it turns out that’s good enough.
Budgets, at least as presented by most experts, are very much an all or nothing proposition. What good is a budget that doesn’t include all your expenses? Quite good as it turns out.
Traditional Budgeting
The main purpose of a budget is to help you live within your income (or better yet, reduce your expenses to the point where you can start saving or investing).
The common recommended approach for budgeting is to figure out everything you spend money on, to allocate a portion of your income to that expense and to avoid going over that amount each month. This approach often fails for two reasons. First, few of us have the time, patience, or interest to track our expenses that closely and maintain such detailed records. Second, a monthly budget has a tough time handling expenses that aren’t monthly – things like annual expenses or sudden surprises like car repairs or braces for the kids.
The good news is that like many things in life, you can spend a fraction of the effort to come up with a solution that is about 90% effective. That’s because most people will find that most of their expenses go to a relatively few places: housing, insurance, taxes and utilities.
A Simple (But Effective) Budget
So here’s a simple budgeting approach that shouldn’t take you more than half an hour a month to deal with – maybe less. But will serve you almost as well as a detailed budget.
Step 1. Figure out your expenses.
First, figure out your regular monthly bills. The big ones – like rent or your mortgage payment, your typical credit card payments, car loans, and so on. Be sure to include things like cable TV that have a regular monthly bill.
Next, look at those bills that come in less frequently (quarterly or annually). Insurance bills often fall into this category, as do property taxes, car registration, etc. Figure out how much they come out to on a monthly basis.
Next, look at your variable bills – like your electricity or water bill. Those vary throughout the year. See if you can track down your highest and lowest for the past year and take the average of the two, then add a bit for good luck.
Finally, and here’s the clincher – figure out how much you think you’ll need over the course of a year for major expenses. These might include a contribution to an IRA. Or money for a vacation (even if it’s still a year or two away). Maybe money to cover the deductible on your medical insurance.
You may have 20 to 30 items on the list, probably less. Even that may seem too much to keep track of, so go ahead and group them into categories, like insurance, entertainment, utilities, housing, saving, etc. You’ll probably end up with less than a dozen categories.
If the monthly amount you’ve come up with is more than your income, or close to your income – you’re probably in financial trouble. It’s a good sign that you need to invest more time to get control over your financial situation – maybe talk to a financial advisor. But if your take-home income is higher than this amount, you’re on the right track.
Step 2. Open a second bank account for your expenses.
Your next step is to open a second bank account. Every month you pay into that account the amount on your list (the best approach is to transfer the appropriate amount right after each payday). Keep track each month of how much you contributed into each category (a program like Quicken can help with this, though I personally track it on a spreadsheet).
Every bill that falls into one of those categories gets paid out of that account, not your main account. When you pay the bill, you subtract the amount paid from the amount assigned to that category.
At first, you’ll find some adjustment is needed – you may need to move some extra money into the account to make sure a category has enough cash assigned to it, especially in cases of variable or periodic bills where you haven’t been depositing money long enough to accumulate the cash to cover a current expense. You’ll also want to reevaluate the budget at least once a year, more often if there are significant changes (like a new car loan).
After a while you’ll find that for most of your bills, there is always enough money to cover paying it in full. By the time that property tax bill comes along, you’ve already saved enough to pay it. Same for car registration, your IRA deposit, even that vacation you’ve been waiting for (trust me, a vacation is all the sweeter when paid for in advance).
And the tracking is easy – because you’re dealing with a small number of bills. What you’re not doing is tracking every penny you spend, worrying about the cash you’re carrying around and stressing over small expenses.
What about your main bank account? From a budgeting point of view you don’t have to worry about it at all. If there’s money in it, you can save it or spend it. Buy groceries or eat out, depending on what the account looks like. If it’s heading downward, try to spend less or hold off until your next payday. If it’s going up, transfer some of it to savings or an investment account. What you shouldn’t do is stress over it. This is your truly “disposable” cash.
Why This is Awesome
At this point most financial experts will be screaming. “Those small amounts of money add up” they’ll say. “It’s exactly that kind of discretionary spending where people get into trouble!” they’ll shout.
And they’re right of course. But they’re also wrong. Because we’re people, not businesses. And while many of those who read sites such as this one may have the patience, time and discipline to watch their income and expenses in the kind of detail that would make a bookkeeper happy, many don’t. And it’s those that don’t who get themselves in the most trouble because their answer to the hassle of budgeting is not to do it at all.
The approach I’ve described has the advantage of being very simple and, because it emphasizes paying yourself first and saving for periodic expenses, can help avoid the most common financial problems. And if it’s only a 90% solution, that’s a great return for 10% of the work.
Financial planning, like investing, is as much a matter of psychology as it is finance. If you can create a simple system that works for you and that you can follow consistently, go for it. It will prove infinitely more useful than a “better” and more complex system that you set up and then ignore.