Now for the number 3 of my 4 Horsemen of Personal Finance series.
To quickly recap, this series is about creating wealth, and what I consider to be the 4 most important rules of thumb to help you get there. So without further adieu…
3. Budgets are your friend
To many people, “budget” is a dirty four-letter word. People who can’t say the word out loud without making the obligatory “eww” face are probably the same people that are juggling credit cards while they wonder where all their money went. No financial toolbox can be made complete without a working budget. A budget is how you tell your money what it’s supposed to do. Spending blindly, purchasing on credit, and living paycheck to paycheck happens in the absence of a budget. You control your money, not the other way around.
A budget can’t be created in 5 minutes. Before you can lay out a proper budget, you need to first understand where your money has been going. Take a look at your bills, credit card statements, and bank statements over the last 4-6 months and see if you can pick out 3-5 categories in which you do most of your variable spending. Since many reoccurring expenses are somewhat fixed (housing, car payments, insurance, etc.) only pay attention to the areas in which your spending is truly variable. For me that is typically groceries, restaurants, shopping, and health/fitness. while going through this process, ask yourself these questions. How much on average am I spending in this area each month? Do some months vary greatly from others? If so, why? And most importantly, do I really need to be spending this much? By going through this process, hopefully you will get that small knot in your stomach when you realize just how much money your sending out the door each month on stuff that you don’t necessarily need.
Once we understand where our money has been going, now its time to take charge and set a budget. A good working budget should come pretty darn close to accounting for every dollar you spend each month. It is a combination of fixed expenses (like your mortgage/rent) and your variable expenses (as we just completed above). Are you making minimum credit card payments? Put them in the budget. Is your car overdue for an oil change? Put it in the budget. Do you need to make a payment to the IRS before they garnish your wages? You guessed it, put it in the budget.
A sample budget might look like this:
- Rent – $800
- Car Payment – $400
- Student loan – $250
- Groceries – $250
- Restaurants – $200
- Utilities – $175
- Gas/ Car Repairs – $150
- Visa min payment – $100
- Shopping – $100
- Car Insurance – $75
- Health and Fitness – $75
- Personal Care – $50
- Entertainment – $50
- Misc – $20
Since everyone generally knows what they make each month, it is also very easy to figure out what your deficit or surplus is.
Let’s say that after taxes, you earn $3000/ month. Based on the budget above, you now know that after you do everything you need to do in a given month, you should have $305 left over ($3000 – $2695 = $305). This is the money you could and should be using to build wealth.
Now that the budget is set, its time for the hard part – making sure that the extra $305 stays in your pocket, not someone else’s. There are many different ways to do this. The most basic is to set cash aside in envelopes that are marked in accordance with your budget categories. So if we were looking at restaurants, you would put $200 cash in an envelope marked “Restaurants” and this is the only money you are allowed to use for restaurants for the month. Once the envelope is empty, your spending in that category is over. For this method to work (and it does), it requires that all temptation (and convenience) to overspend is removed, which means destroying the credit card (which should have already been done anyway since deciding you want to build wealth).
The method I use to track my spending is the budget tool offered in Mint.com. Mint is an awesome tool that can be used on your computer or smart phone to track all your personal finances. Once you set up your budget categories you can view them in real time to see how your doing with your spending. As your spending in each category increases, the bar will go from green, to yellow, to red. It can also send you emails to let you know when you are approaching the limit. Truly an awesome tool and most importantly, its free. I will spend more time sharing how I do this in a later post, so stay tuned.
If you employ once of these two simple methods you will have a solid footing for taking control of your finances. As you become more familiar with your spending habits it will also motivate you to make improvements in decreasing your overall spending and to eliminate unnecessary expenditures.
Number 4 coming tomorrow… good night!