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In this article, you’ll learn how to manage your money to power you toward your financial goals.
The practical way to do this is by budgeting – monitoring your income and spending to generate savings that can be used to achieve your financial goals.
Here, we discuss our budgeting strategy, developed from the learnings of all budgeting methods.
When you put this into practice, you’ll develop the discipline and money management habits that will guarantee your success.
What Is Budgeting?
Budgeting is a spending plan. It allows you to determine what your spending will be in advance, so that you can ensure you have the income to satisfy your planned spending and create excess money to allocate to savings.
When you develop your personal budget, you should consider your financial goals and your regular expenditure. A good budget will ensure that your human necessities are satisfied. It will also ensure that you have the money available to save or to spend on luxury expenses – the choice is yours to make.
There are several ways to monitor your budget. You could set up a spreadsheet or keep details of your spending in a dedicated cash book. Or you could use an online budgeting tool to help you control and track your money.
Let’s get stuck in. How do you create a budget and stick to it?
There are many budgeting systems that you can choose from. We have researched them all and found that success is dependent upon the same factors in each. In developing the DollarBreak budget strategy, we have condensed these factors into seven easy-to-follow steps.
Step #1: Set Your Financial Goals
Write down all your life goals, revise them as financial goals, and prioritize them. As you do this, remember that you will have short-term, medium-term and long-term goals.
When we discussed Joe and Peter’s financial goals in our article ‘Financial Goals – The Blueprint to a Wealthy and Happy Life’, we learned that Joe wants to spend a year traveling the world, while Peter wants to be debt free and invest in college funds for his two daughters.
When developing these goals, Joe and Peter assessed how much money they would need to achieve them:
- Joe doesn’t own his own home, so while away will have no property to maintain in the United States. However, after a lot of research, he has calculated that his travel and living expenses while globetrotting will be around $25,000 for the 12 months he plans to be away.
- Peter owns his own home but considers the mortgage as a cost of living rather than a debt. However, he would like to eliminate his auto loan of $10,000 and his credit card balance of $5,000. He also wants to save money toward his daughter’s education – which he has calculated to be $35,000 each (a total of $70,000). They will be going to college in eight years.
Like Joe and Peter, once you have written your financial goals and allotted them a value, you can move onto the next step.
Step #2: Predict Your Income
You now know your priority goals, and the amount of money to allocate to each. The second step is to predict your income. For many people, this is relatively easy:
- If you are employed in a single job, your income will be your salary.
- If you have more than one job, your income will be the total amount you earn.
- You should only include bonuses or commissions if they are guaranteed.
- If you have other regular income (for example, from investments), include this.
A good way to forecast your future income is to review your previous bank statements. Take the last six- to 12-months and add up the credits into your account. Then divide by the number of months to calculate your average monthly income (minding the points above). Now you can predict your income for the next 12 months.
Let’s see how that works out for Joe and Peter:
- When Joe calculated his income, he found that his previous 12 months’ earnings were $72,000. However, of this, $12,000 was a one-off bonus. Consequently, Joe predicts that his income would be $60,000 over the next year – or $5,000 per month.
- Peter’s finances are more complicated. He earned $90,000 and his wife earned $20,000 from her part-time job. Peter’s earnings include commission. This is paid monthly and works out at an average of $2,300 per month. However, the lowest amount if commission he was paid in any one month was $1,500. Being prudent, Peter decides to include only $1,500 of commission each month in his forecast earnings – meaning that he predicts an income of $80,400 for the next 12 months, plus his wife’s income of $20,000. This equates to $8,367 per month.
Step #3: Predict Your Expenses
How much do you spend, and what do you spend your money on? These are the key questions you must answer when analyzing your expenditure. This takes a little more work than assessing your income, but the same method applies.
First, decide which categories your income is consumed by. For example, you might spend your money on:
- Cash withdrawals
- Debt repayments
Look through your last 12 months’ spending and allocate each amount you have spent into a category. As you do this, you should also split this spending into ‘necessity’ and ‘luxury’. For example, you may find that one month you spend $400 on clothes. Of this, you spend $100 on a pair of boots for work, $200 on protective clothing, and $100 on a pair of jeans you couldn’t resist. You have $300 of necessary spending and $100 of luxury spending.
You now know your expected income and expected expenditure for next month. You can then work out what you are able to save.
Step #4: Calculate Your Savings Rate
As you work through step #3, you’ll find that your spending not only falls into categories, but is either necessary (for example, your rent or mortgage) or discretionary (that fashionable jacket you just couldn’t say no to). From your budget work so far, you can now calculate:
- Your maximum savings rate – your income minus necessary spending
- Your minimum savings rate – your income minus all spending
The difference between these is likely to surprise you. For example, according to the Bureau of Labor Statistics Consumer Expenditure Survey, the average household spends $67,801 per year. Of this, discretionary spending is as follows:
- Alcoholic beverages: $484
- Entertainment: $2,913
- Tobacco products: $337
- Miscellaneous: $959
- Food not consumed at home: $3,154
That’s a total of around $653 per month of discretionary spending. And this is before the discretionary spending within other categories such as clothing, transportation, food, personal care products, etc.
Let’s see how this works out for Joe and Peter:
Joe and Peter’s savings rates are as follows:
($5,000 – $3,150)
($5,000 – $4,400)
($8,367 – $6,100)
($8,367 – ($7,600)
Step #5: Evaluate Your Financial Goals
Now, revisit your priority goals and calculate how long they will take to reach at each savings rate.
For example, let’s say that your goal is to save $25,000 for a down payment on a house. Let’s say this is your only financial goal at present. Currently, your minimum savings rate is $200, and your maximum savings rate is $950.
If you continue spending as you are now, it will take you 125 months to save your down payment. That’s more than 10 years.
If you eliminate your discretionary spending, it will take you less than 27 months to save. Just over two years.
When confronted with this harsh reality, everyone I know decides to reduce their discretionary spending to accelerate them toward their financial goals.
You should carry out this evaluation every month, at which point you should also forecast for the quarter and year to come.
In Joe and Peter’s cases, here is how savings at the maximum and minimum rates makes a difference:
As you can see, with good money management and the mindset to stick to a budget, Joe’s dream of traveling the world could be achieved in less than a year from today.
Meanwhile, if Peter does not reduce his spending on luxury items and increase his savings, he will not be able to fully fund his daughters’ college fees. However, if he could save the maximum possible, Peter could achieve his financial goals approximately five years before his daughters are due to go to college.
Step #6: Track Your Wealth
Steps #2 to #6 are all concerned with your personal income statement. They detail your income and expenditure. But this doesn’t tell the whole story. You should also evaluate your wealth with a monthly snapshot of your personal balance sheet.
To do this, note your assets against your liabilities. Your assets go in the ‘plus’ column and your liabilities go in the ‘minus’ column. Here’s an example of what your personal balance sheet might look like:
Each month you’ll see the difference that your budgeting is making to your net wealth. As your net wealth improves, all your financial goals will move closer.
Here is how Joe and Peter’s net worth looks:
To save time and gain an accurate insight to your net wealth, online resources like Personal Capital are great. Once you have signed up (which only takes a few minutes), you can link your accounts. These are then updated automatically. You get a real-time, instant snapshot of your net wealth position whenever you wish.
Step #7: Track Your Financial Goals
At your monthly reviews, you will learn:
- What you have earned
- What you have spent
- What you have saved
- Your expected income
- Your expected spending
You will be able to compare your expectations with what really happened. During your review, you should also review and evaluate your financial goals. Are they still relevant? Have they altered in priority? Are they still correct?
For example, let’s say that Peter reviews his goals and discovers that the cost of a college education for his daughters has increased by 10%. He should review his budget and adjust accordingly to ensure that he remains on track.
By reviewing your budget and financial goals monthly, adjustments will be smoothed with no nasty surprises to cause a ‘budget crash’.
Budgeting – The Skill That Determines Your Financial Health
Budgeting is an essential skill to managing your money better. It allows you to develop a spending plan and track how much you are spending in each category. Following your budget will help you to stay out of debt (or to reduce and eliminate debt you currently have), while also ensuring that you always have enough money for the things that are most important to you.
When you have the budgeting habit, you’ll do what all those who have become wealthy and stay wealthy do – save first, pay expenses second, spend third, and save fourth. Your budget will help you find discretionary spending that you can eliminate, and encourage you to reduce other expenses, too. This will give you the money to accelerate yourself toward your financial goals – as Joe and Peter found.
However, you won’t become a greater budgeter overnight. It’s a habit that you must build and make time for. Whether you record your spending every day or week, you must do it diligently – just like you do with your personal balance sheet evaluations.
Get on the budgeting wagon. If you fall off (which is likely when you first start budgeting), get straight back on again.