Not unlike any other projects, the road to financial independence requires the right tools to get the job done. Just like we don’t encounter many mechanics without wrenches, or plumbers without plungers, we should never get caught empty-handed amidst preparation for escaping debt and building wealth. The three essential tools in the personal finance world are a budget, a cumulative cash flow analysis and a statement of net worth. The level of sophistication and detail you decide to invest into these three tools is up to you, but you need to have them. Personally, I prefer a hybrid method of low and high-tech. I use a phone app that streamlines all my online banking information into one platform and refreshes every time I open the app. This is in addition to an excel spreadsheet that I update manually once a month. You can use a legal pad if that’s what you feel comfortable with; as long as you get the desired results. But to see results, you need to have the tools. If you are missing even one of them, you will not have a global picture of your situation. Let’s take a moment to review the different components. We’ll talk about what they are, why we need them and how we use them.
A budget is a financial plan over a period of time. Some budgets are done annually, quarterly and others are done monthly. The purpose is to help you estimate what you will spend the bulk of your income on during the course of the month. As cliché as it is to say: “If you fail to plan, you plan to fail,” it doesn’t make it any less true. You can’t maximize your money if you don’t know where it is going. You also can’t be prepared for the unexpected if you’re not even ready for the recurring events in your life.
14 budgets a year
For a personal household budget, I recommend a semi-annual budget and a monthly budget. You should always start the year with a six-month budget. While you can’t anticipate what your water bill or gasoline consumption will be for the year, things like rent or mortgage payments, car payments, student loans usually remain relatively constant in a 6 to 12-month range. And if you’ve been with your utility companies for a while, you can estimate what your expenses will be with a small margin of error. The purpose of having a semi-annual budget is to help you start the year on the right foot, putting your finances at the forefront, making it a priority. This helps you understand that looking ahead for the long-term, is crucial to improving your short-term situation. It also provides you with the opportunity to reassess and revise your situation half-way through the year if you get off track. Believe me when I say that a 6-month hole is easier to dig out of than a 12-month hole.
The other benefit to a long-term budget is being ready for the bigger, non-recurring purchases. For example, if you wish to take a European vacation with the hubster over summer break, you’ll be better off saving for it starting in January than April. If you start in April and you come up short, you’re more likely to use your credit card to bridge the gap and get yourself in debt. While 14 might seem like a daunting number, it’s not. Two of them are summary budgets done twice a year, once in January and once in June, to give a 6-month snapshot of your financial plan. They do not include the same level of detail as your monthly budget.
The other budget is a monthly, much more detailed budget that you redo every month, because your needs and some of your bills change. Even if the bills didn’t change in a perfect world, I would still recommend reviewing your spending monthly to see where you can cut waste. A monthly budget is key in helping you identify whether or not you’re living within your means. Ideally, you want your standard of living to be well below what you can afford.
How do we do this? I practice what I call a $0 budget. It is understood that you should never be in the read, but I will also add that you should not have idle, unallocated cash greater than $100 every month. If you do, you’re missing opportunities. You’re missing an opportunity to build a robust emergency fund, pay down debt, contributing to retirement and/or build wealth through investments.
Once you know how much money you take home every month, make all of your monthly recurring expenses, including minimum payments on your debts, leaving out anything that is not a necessity. If you already have an emergency fund, that’s great. If not, set aside money for your emergency fund as if it was a monthly obligation. In some ways, it is, because in the event that your car breaks down or someone falls ill, you don’t want to get caught with your pants down, i.e. unprepared and ready to use credit. How much should your emergency fund be? Only you know what your level of job security is so, it’s up to you.
After adding up your expenses (excluding luxuries) and subtracting that balance from your take home pay, what does your number look like? Are you breaking even and under $100? Turns out that you can’t afford your luxuries anyway and you should find ways to eliminate them. Do you have several hundreds or even thousands left? Lucky you. I bet you’re thinking I’m going to recommend that you reward yourself with a nice steak dinner, but you’re wrong. Now go back and look at your debt. Increase the monthly payments to accelerate the debt’s demise.
Rinse and repeat until you’re within the $0-100 range.
When your debt is gone, come back and we can brainstorm on what you can do with all that extra cash.