PERSONAL BUDGETS
Key Point:
Budget your spending at the beginning of every year at a level you can afford, and do all you can to stick to that budget.
Unless you are really wealthy, I believe all of us should prepare an annual spending budget, and then try to stick to it. Whether one is entering the workplace, starting a family, saving to send children to college or for one’s retirement, or has left the workplace, the best way to be sure of living within one’s means is to carefully budget expenditure and then track one’s monthly spending against that budget.
Let me also say this up front: paying the minimum balance due on credit cards every month is not living within one’s means. The interest rate one pays on credit card debt is very high and should be avoided at all costs. Large amounts of credit card debt are also bad for one’s credit rating. Pay the credit card balance in full every month, preferably by having the funds taken automatically from a bank account. If you don’t have the self-discipline to settle the balance in full every month, my suggestion is to cut up the credit card and use a bank (debit) card so you don’t run up debts.
So how does one prepare a budget for the first time?
Start with last year’s spending
If you have not prepared a budget before, I recommend starting with an analysis of what you spent last year. If you use spreadsheet software, that is a good tool for analyzing costs and preparing budgets, but a blank sheet of paper and a calculator is good enough. Take your credit card statements and check book from last year and break down what you spent over a whole year into the type of expenditure: rent (or mortgage payments and property taxes etc. if you own a home), utilities (electricity, heating, telephone, internet etc.), servicing student loans, insurance, medical costs, groceries and other day-to-day living expenses, clothes, running a car or other transport costs, meals out and other entertainment, vacations and so on. You will probably have to use guess work to figure how you spent cash you drew out of your bank account. If you can't figure where all the cash you drew went, include a category called “cash expenses” but this should be a modest amount or there is a problem!
Most people are surprised at what they learn about their spending patterns doing an exercise like this.
Then the next step is to split the types of expenditure between non-discretionary and discretionary. Discretionary is money you don’t have to spend if you don’t have it. We all know what these are: more fancy clothes than we need, expensive vacations, money we spend in bars and restaurants, etc. For now, include housing, transportation, and utilities in the non-discretionary category, though we can make cuts in this area as well if we have to - by moving to a smaller place or a cheaper neighborhood, giving up cable TV, shopping around for insurance, and so on.
This exercise will give you a good idea of what your current spending level is over the course of a year, and how it could be lowered if you cut discretionary spending. You should, however, figure on most costs going up 2% - 3% every year with inflation.
Figure your income for the current year
The next step is to estimate your gross income for the current year. For most people that is in the form of salary; for others it may be income from one’s own business. Some are fortunate enough to have income from investments, or other sources of income, as well. If you are in retirement, you are probably drawing social security as well as income from an IRA or 401k, and perhaps a pension. Make your best estimate of your current gross income for the year. From that deduct the taxes you pay – federal and state income tax, plus social security and Medicare tax. If you are self-employed and don’t know how to do this, there are tables to be found on the internet to help with the calculations. If you use a local tax preparer to prepare your returns, they could help you. (Or send me an email.) Deducting all your taxes will give you income after tax.
Then you need to deduct amounts you pay for medical and dental insurance, life and accident insurance, contributions to a 401k or similar plan and an IRA (a must – I discuss this subject in the Pensions tab on this website) and perhaps things like union dues. The balance is your disposable income.
Compare that with last year’s spending that you analyzed in step one. Does it look like you are you able to save part of your income? Are you spending more that you earn?
Remember I asked you to analyze last year’s spending, so you will have a complete twelve months, and then compare it with this year’s income. I mentioned you should figure on most costs rising at least 2% from year to year for inflation. Make sure you do that. I also like to add a “contingency” of 10% on top of expected spending, to allow for unexpected medical costs, repairs and the like - major expenses that are hard to foresee. If these don’t arise, great, but try to set aside that money as savings.
Prepare a budget for the current year
The next step is to prepare a budget for the current year. If we are part way through a calendar year, actual spending for the year to date gives you a start. The goal is to limit discretionary spending so that total spending, including the 10% contingency, does not exceed your disposable income.
Take your analysis of last year’s spending by category, separating discretionary from non-discretionary spending, and enter alongside last year’s number what you expect to spend this year, allowing for inflation. Some spending will change: if you bought a car last year, you probably won’t this year; your vacation plans may be different from last year; your rent will probably go up. For many items you will simply have to make an estimate based on what you spent last year.
When you are done, add the numbers and then add that 10% contingency I mentioned as the last item. Then you should compare the total with your disposable income calculated in the previous step. If the disposable income is higher than your budget, good news! It looks like you will be able to live within your means for the next twelve months without making any adjustments to your spending patterns, and hopefully save some money as well.
If the budget is higher than your disposable income, you need to see where you can make cuts to get it down to a point where they are equal, and ideally a bit more than that. Start with discretionary spending; take a hard look at where you can reduce or, if necessary, eliminate items. Hopefully you can get your income and spending into balance by doing this. If not, you may have to make painful changes to what I have called non-discretionary spending such as moving to a smaller home, using public transport rather than driving, getting a cheaper phone plan and the like. An alternative is to try to increase income: look for a new higher-paying job or find additional part-time work. As I said at the beginning, the last thing you should do is run up credit card debt! That is not going to solve the problem and is not a good idea.
Monitor spending every month through the year
At the end of every month take your check book and credit card statements and analyze your spending into the various categories in your budget. Add each month’s spending to arrive at a year-to-date total and compare that with the budget to see how you are doing. Then you can lower your spending in certain categories if necessary, to get back on track. Just make sure to do this at the end of every month. I wish you luck!
Key Point:
Budget your spending at the beginning of every year at a level you can afford, and do all you can to stick to that budget.
Unless you are really wealthy, I believe all of us should prepare an annual spending budget, and then try to stick to it. Whether one is entering the workplace, starting a family, saving to send children to college or for one’s retirement, or has left the workplace, the best way to be sure of living within one’s means is to carefully budget expenditure and then track one’s monthly spending against that budget.
Let me also say this up front: paying the minimum balance due on credit cards every month is not living within one’s means. The interest rate one pays on credit card debt is very high and should be avoided at all costs. Large amounts of credit card debt are also bad for one’s credit rating. Pay the credit card balance in full every month, preferably by having the funds taken automatically from a bank account. If you don’t have the self-discipline to settle the balance in full every month, my suggestion is to cut up the credit card and use a bank (debit) card so you don’t run up debts.
So how does one prepare a budget for the first time?
Start with last year’s spending
If you have not prepared a budget before, I recommend starting with an analysis of what you spent last year. If you use spreadsheet software, that is a good tool for analyzing costs and preparing budgets, but a blank sheet of paper and a calculator is good enough. Take your credit card statements and check book from last year and break down what you spent over a whole year into the type of expenditure: rent (or mortgage payments and property taxes etc. if you own a home), utilities (electricity, heating, telephone, internet etc.), servicing student loans, insurance, medical costs, groceries and other day-to-day living expenses, clothes, running a car or other transport costs, meals out and other entertainment, vacations and so on. You will probably have to use guess work to figure how you spent cash you drew out of your bank account. If you can't figure where all the cash you drew went, include a category called “cash expenses” but this should be a modest amount or there is a problem!
Most people are surprised at what they learn about their spending patterns doing an exercise like this.
Then the next step is to split the types of expenditure between non-discretionary and discretionary. Discretionary is money you don’t have to spend if you don’t have it. We all know what these are: more fancy clothes than we need, expensive vacations, money we spend in bars and restaurants, etc. For now, include housing, transportation, and utilities in the non-discretionary category, though we can make cuts in this area as well if we have to - by moving to a smaller place or a cheaper neighborhood, giving up cable TV, shopping around for insurance, and so on.
This exercise will give you a good idea of what your current spending level is over the course of a year, and how it could be lowered if you cut discretionary spending. You should, however, figure on most costs going up 2% - 3% every year with inflation.
Figure your income for the current year
The next step is to estimate your gross income for the current year. For most people that is in the form of salary; for others it may be income from one’s own business. Some are fortunate enough to have income from investments, or other sources of income, as well. If you are in retirement, you are probably drawing social security as well as income from an IRA or 401k, and perhaps a pension. Make your best estimate of your current gross income for the year. From that deduct the taxes you pay – federal and state income tax, plus social security and Medicare tax. If you are self-employed and don’t know how to do this, there are tables to be found on the internet to help with the calculations. If you use a local tax preparer to prepare your returns, they could help you. (Or send me an email.) Deducting all your taxes will give you income after tax.
Then you need to deduct amounts you pay for medical and dental insurance, life and accident insurance, contributions to a 401k or similar plan and an IRA (a must – I discuss this subject in the Pensions tab on this website) and perhaps things like union dues. The balance is your disposable income.
Compare that with last year’s spending that you analyzed in step one. Does it look like you are you able to save part of your income? Are you spending more that you earn?
Remember I asked you to analyze last year’s spending, so you will have a complete twelve months, and then compare it with this year’s income. I mentioned you should figure on most costs rising at least 2% from year to year for inflation. Make sure you do that. I also like to add a “contingency” of 10% on top of expected spending, to allow for unexpected medical costs, repairs and the like - major expenses that are hard to foresee. If these don’t arise, great, but try to set aside that money as savings.
Prepare a budget for the current year
The next step is to prepare a budget for the current year. If we are part way through a calendar year, actual spending for the year to date gives you a start. The goal is to limit discretionary spending so that total spending, including the 10% contingency, does not exceed your disposable income.
Take your analysis of last year’s spending by category, separating discretionary from non-discretionary spending, and enter alongside last year’s number what you expect to spend this year, allowing for inflation. Some spending will change: if you bought a car last year, you probably won’t this year; your vacation plans may be different from last year; your rent will probably go up. For many items you will simply have to make an estimate based on what you spent last year.
When you are done, add the numbers and then add that 10% contingency I mentioned as the last item. Then you should compare the total with your disposable income calculated in the previous step. If the disposable income is higher than your budget, good news! It looks like you will be able to live within your means for the next twelve months without making any adjustments to your spending patterns, and hopefully save some money as well.
If the budget is higher than your disposable income, you need to see where you can make cuts to get it down to a point where they are equal, and ideally a bit more than that. Start with discretionary spending; take a hard look at where you can reduce or, if necessary, eliminate items. Hopefully you can get your income and spending into balance by doing this. If not, you may have to make painful changes to what I have called non-discretionary spending such as moving to a smaller home, using public transport rather than driving, getting a cheaper phone plan and the like. An alternative is to try to increase income: look for a new higher-paying job or find additional part-time work. As I said at the beginning, the last thing you should do is run up credit card debt! That is not going to solve the problem and is not a good idea.
Monitor spending every month through the year
At the end of every month take your check book and credit card statements and analyze your spending into the various categories in your budget. Add each month’s spending to arrive at a year-to-date total and compare that with the budget to see how you are doing. Then you can lower your spending in certain categories if necessary, to get back on track. Just make sure to do this at the end of every month. I wish you luck!
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