Knowledge Logging: Personal Finance – Budgeting

(This post is a comprehensive view on budgeting, so it is designed to explain introductory information of budgeting for those with no experience, but also to progress into finer details for experienced users to obtain new strategies as well. It’s not going to answer the question of how should you individually use a budget, but it will show you how to think while using a budget.)

Happy New Year! 2018 is finally here, and if you’re like many people, one of the resolutions you may have is to get control over your finances. Good for you! But now that we’re a couple weeks in, you may have felt the weight of the reality that we were never taught the fundamentals of personal finance. Beyond looking at a Checking account balance to see if there’s enough to pay for this month’s credit card bill, budgeting has seemed to be an overly complicated and restrictive concept. If you haven’t set up a budget before, I’ll assure you that once you get past the first hurdle of setting up a budget, the lens that you look at your finances change and each step forward gets exponentially easier to take. But just for starters, let’s explain what is a personal budget.

Budgets: what it is and what it isn’t.

I don’t know about you, but even after all these years of budgeting my own finances, the mental picture that comes to my mind when I hear budget (especially when it’s said with a tone of disgust), is writing in an old checkbook the debit and credit transaction at the grocery store. Or maybe you think it’s this form of financial fasting where you never get to eat out and have to buy Safeway brand cereal to appease this evil oppressor called “The Budget.” If you have a mental picture similar to one of those, I just want to assure you that it is never that dull of an operation or that depressing.

If I could summarize what a budget truly is, I would say that a budget is simply the framework to orient your resources towards your greatest benefit; It shows you who are and how to better yourself.

All a budget does is take your income and break it up into smaller boxes for you to properly handle and understand. You are in control and you tell the budget what you want it to report back. Over time, you can start identifying trends in your spending and make adjustments to better suit you, or you find alternative means of accomplishing your goal that costs less.

What I’m trying to say is this: budgeting is not synonymous with dieting. Which speaking of dieting, both of these things have bad reputations and it’s because of similar reasons: we treat them as restrictive programs to curb consumption, but that is not what a healthy diet is supposed to do and neither is a budget. A healthy diet and budget may involve cutting back, but for the most part it is transferring energy from unproductive means to productive means.

Introduction On How Budgets Work:

Ok that was pretty abstract, so let’s go into some of the parameters of how a budget functions.

If we want to get to bare bones version of how to do a budget, all you need is:

– A cycle period (weekly, monthly, etc)

– A starting balance

– And categories to divide up that starting balance into.

During the cycle period, you just enter your expenses, and determine which category they all go into. At the beginning of the new cycle, you calculate the remaining balance of each of your categories and roll them over into the new cycle period.

Again that is just an example of a bare bones version of it; there are many different programs that present this function in many different forms of automation to cater to your specific needs that I’ll talk about later.

Simplified Budget Demo:

Let’s add a little more context to the budget function but with simplified numbers. (these numbers are not realistic amounts to base your own spending on, so don’t caught up in the specific details here)

Here we are going to create a budget that has a cycle period of 1 month, and a starting balance of $1,000. We have $1,000 to spend over one month, now we need to divide that $1,000 into categories. So let’s use simple major categories: Food $300, Rent $400, Transportation $100, Saving $100, & Entertainment $100 (everything that doesn’t fit into any of the previous categories goes in here as well).

Month: Jan. 2018
Balance: $1,000

Food: $300
Rent: $400
Transportation: $100
Saving: $100
Entertainment: $100

Now let’s say over the month, your expenses totaling like this:

Food: $326
Rent: $400
Transportation: $75
Saving: $100
Entertainment: $90

Which means the budget would ended up looking like this:

Category: Budget amount – Expenses = end total

Food: $300 – 326 = (-$26)
Rent: $400 – 400 = $0
Transportation: $100 – $75 = $25
Saving: $100 – 100 = $0
Entertainment: $100 – 90 = $10

Ending balance: $1000 – $991 = $9

So overall, you did a great job! your budget had $9 left over. But without making any adjustments to the budget, let’s look just at what the February budget looks like if we have another $1000 to work with plus what has rolled over from last month:

Month: Feb. 2018
Balance: $1000 + $9 = 1009

Category: Budget amount +/- rollover = available balance

Food: $300 + (-26) = $274
Rent: $400 + 0 = $400
Transportation: $100 + 25 = $125
Saving: $100 + 0 = $100
Entertainment $100 + 10 = $110

This is what we would have to work with if we decided not to change anything to our budget, but what if we look at our expenses and saw that our normal commute to work was actually less expensive than we had thought (maybe gas prices were lower than you remembered, or maybe you’ve been carpooling and haven’t been using your car as often, etc.) so you decide that you actually don’t need as much in your transportation budget, you decide to transfer over $25 to your food budget. Your budget would now look like this for February:

Month: Feb. 2018
Balance: $1000 + $9 = 1009

Food: $325 + (-26)= $299
Rent: $400 + 0 = $400
Transportation: $75 + 25 = $100
Saving: $100 + 0 = $100
Entertainment $100 + 10 = $110

Now let’s look at what happens in the month of February:

Month: Feb. 2018
Balance: $1,009

Food: $299 – 315 = (-$16)
Rent: $400 – 400 = 0
Transportation: $100 – $125 = (-$25)

Saving: $100 – 100 = 0
Entertainment $110 – 85 = $25

Ending Balance: $1,009 – $1,025 = (-$16)

So a few interesting things happened in this month that we can quickly observe. Food has been over budget both months, transportation jumped up $50 over last month’s expense, and we went over budget overall for the month by $16. Last month we just did simple patch work and thought that transportation could be cut and cover food, but food was still too high and not only that, transportation was way up, so we need to dive deeper to see what’s going on with the actual expenses.

First let’s try to figure out what happened with transportation: Let’s say we look at expenses in the transportation budget and saw this (listed in format of date, vendor, price):

2/11/18 Shell. $35
2/20/18 Firestone $54
2/23/18 Shell. $36

We realize that our normal gas costs were just the two Shell transactions, which when totaled would have fit our normal budget, and actually would have been under budget with a total of $71. But while the Firestone transaction was for your car, it was for an oil change, which you now recall that you do that about every 4 months and you had forgotten that was coming up. Since this is something you’re going to have to account for and since it’s messing up your Transportation budget, what you could do to organize yourself is by breaking up the Transportation budget into two categories: Gas & Maintenance. So moving forward you’re going keep the gas budget at $75 per month, but you’ll add a new budget of Maintenance at $15 per month, and you’ll pull that from the $100 Entertainment budget, which now will be $85 per month. This way we can let that $15 rollover a few months so that in 4 months, when we’ll spend around $54 again for an oil change, there should be $60 in the maintenance budget to pay for it (15+15+15+15=60). But that’s without the $54 we already spent that we didn’t plan for, so maybe we should actually be pulling $20 from Entertainment to make up for the negative balance, so it’ll now be $80.

But we’re not done yet with adjustments. We were still over budget overall and if our monthly budget was all our money, then we’ve either overdrawn our checking account that comes with fees, or if these expenses were with a credit card, that means we will be paying interest on some of the balance. But even if we have more money than our budget lists, this is still a red flag that we need to adjust. Something is wrong with our spending, and there are a couple different routes we can take. One quick fix that will help the short term but could harm our long term is we could just cut savings by $25 or $50, and put that towards our food budget. That would stop the bleeding, but savings is a buffer for when we hit hard times and will come in handy down the road, especially when we decide to look into long-term investing strategies.

So let’s look at a different place: food. Why is it so high? Let’s take a look at the expenses:

2/4/18 Safeway $45
2/5/18 Panda Express $13
2/7/18 Red Robin $32
2/9/18 Subway $9
2/12/18 Teriyaki Madness $10
2/14/18 The Matador $39
2/15/18 Five Guys $12
2/17/18 MOD Pizza $15
2/18/18 Safeway $49
2/20/18 Shiro’s Sushi $41
2/22/18 Taco Bell $7
2/24/18 Uneedaburger $10
2/27/18 Zeek’s Pizza $24
2/28/18 Chipotle $9

Now when we look at all these expenses, we can see there’s a few trends that appear here: it appears as those we’ve been going to a fast food restaurant about twice per week, and eating out a more expensive restaurant once per week. Also it appears groceries were only bought every other week. Again this is just a simplified budget concept, and your own tendencies will vary, but what else can we learn about this trend and what opportunities can we take advantage of with further insight? First off: why do you get fast food at least twice per week? look at the particular days and imagine what prompted you to do that. It doesn’t mean it was the wrong choice, but do you remember why you did that on those days and not others? Do you realize you’re spending over $30 on a single meal at least once per week? What are you doing then? Is it date night? Hangout with friends? What happens if we just break this expense report into two categories: Groceries and Restaurants.

Groceries: $86
Restaurants: $229

Do you like that distribution? I’m asking a lot more open-ended questions because now the decisions are going to be subject to your own values and needs & these are the questions you need to answer before moving forward. Do you like spending more than 250% of your groceries on restaurants alone?

I said in my initial description of what a budget is, is the framework to orient you towards your greatest benefit. So now we’ve been provided new insight, and we are trying to reduce cost, how do you want to do it? It could be that this cost breakdown showed you that you in fact do eat out a lot more than you want to believe, and most of those fast food purchases were completely frivolous. So you half your cost of fast food just by being more intentional about your day which also allows you to eat healthier and to cut spending. What if you bought more groceries and brought prepared food to work? Would that curb your need to get fast food? So maybe your Groceries now goes over $100, but now you cut $50 in fast food as well. That would solve your problem. Or what about the more expensive restaurants? Maybe you don’t want to cut down the frequency of either your fast food or the dine in restaurants, but if that’s your Friday night activity with friends, could you choose just one of those weeks to stay at your place and everyone chips in something for a prepared home meal or party supplies? Just that alone could cut $30 from the budget.

All this is is demonstrate how the budget provides you with new insight and doesn’t constrain you, but allows you to be more intentional about your actions and enjoy what will really bring you satisfaction and cutting out the financial waste. So just for demonstration purposes, let’s say you decided you’re having too much fast food unnecessarily, and have decided to only frequent a fast food restaurant once per week on average, which would have decreased spending by $46, and are going to invest more into groceries, which would have increased groceries by $20. But that is just simply seeing how the previous month would have looked and so moving forward we use those changes to make new projections.

With all these changes, we can now construct a new monthly budget for March that would look like this:

Month: Mar. 2018
Balance: $1000 – 16 = 984

Groceries: $125 + 0 = $125
Restaurants: $200 + (-$16) = $184
Rent: $400 + 0 =$400
Gas: $75 + 0 =$75
Maintenance: $20 + (-$25) =($-5)
Saving $100 + 0 =$100
Entertainment $80 + $25 =$105

And that’s how the function of a budget works! Again excuse the simplicity of the demonstration and the unrealistic application of living this out, but I hope this helps you see the incremental development of a system that will adapt to you and your own preferences.

Starting Your Budget:

Now to the important question: how do I start one? Well now that you know how they work it’s time to apply and customize.

1. Determine the budget cycle and balance.

How long do you want the budget cycle to go for? This will be dependent on simply what works best for you, but is typically influenced by your income frequency. If you are on a payroll salary that’s monthly or biweekly, you’ll have a pretty good job of setting a cycle and overall setting up your budget with more consistent projections moving forward. If you get paid weekly, then maybe a weekly budget cycle may be best for you. At the end of the day, you do what makes most sense for you, because even if you get paid biweekly and want a weekly budget, all you’d have to do is half your paycheck to arrive at an average weekly budget; the same is if you wanted a monthly budget in that you could just double to arrive at the month.

But even determining what is the actual number can be complicated, especially if your income fluctuates greatly from paycheck to paycheck as can be in the food service industry. With that, there are a couple options you could do: if you’re trying to do a monthly budget, sum up the total of the past 4 months, then divide it by 4 to get an average monthly income total as the basis for a given month. The one drawback in this is you’re still forecasting into the future how much you intend to make and maybe the past few months were during the holiday rush that brought abnormally higher income and in the following months you will be receiving considerably less that causes you to overspend while still being “on budget.”

Another option and is the one that I do is base the budget upon what I made the previous month. This gives the advantage in that you’re not projecting future income, but rather you are literally spending the money you earned last month. Since my income does vary upon the amount of hours I work, each month does fluctuate notably and my budget changes every month. This method has a couple cons in that it does require mental forecasting so if I know the following month appears to be lower income, then I may need to over-fund an account this month to offset the deficiency next month. Also this method requires a little added financial cushion since if I’m “spending” last month’s income this month, then what I was actually living on last month cannot have been from anything I earned to start this budget.

Personal preference: I love the weekly budget over the monthly budget. For me, a month is too long and even though I’m probably more financially disciplined than the average person, I don’t like looking how much I have to spend on eating out for a whole month. I fear that if I saw something like $200 in my budget, I would just eat out the whole first week and then have to go the whole remaining 3 weeks on $10. So when I make a budget, I take my income from last month, then divide it by how many weeks are in the month. But again, that’s only my preference. Most budgeting apps actually are locked in at a monthly budget.

2. Determine categories

This one was actually pretty much explained in the demo, but my recommendation is start with a few generic categories and then work your way to expanding into more sub-categories. This is for a couple of reasons, one being that if this is your first time, it may seem like a very daunting task you’re taking on and with so many calculations and decisions may feel to intimidating to sustain. A second reason is by incrementally adding more categories allows you to make more educated decisions based upon your own insights of what you want to track.

Psychological tip: Budgeting isn’t just about controlling and limiting your spending, but it’s also a tool to invest further into your values. If you want to invest more into self care, you can open up a budget category to set aside funds into massages, day trips, chiropractic, etc. Want to be able to shower people with random acts of kindness? Create a small budget account for it.

I recommend just starting with the essentials: Food, Shelter, Transportation, Bills, and Saving. Everything else goes into a miscellaneous category that I just label as Entertainment, which then once I’ve identified a trend in my spending here, I then pull it out and create a new budget category for it. An example of this was I have an Audible subscription where I pay $16 per month and I get a new audiobook every month. It came just out of my entertainment account but I used this to buy nonfictional audiobooks to help me learn. So I decided to create a new account and I called it “Learning” which I put the Audible subscription into along with a few extra dollars. I then started using those extra dollars and started going to Value Village and picking up books for $3 per book with that account. Then I got a membership at the Seattle Town Hall, which regularly hosts authors to lecture on their upcoming books, for which now I’ve met over 10 different authors.

So just start with a few categories and then work your way up. I’ve been doing this for 10 years and I’m still adding new budget categories to mine.

3. Determine budget amounts.

There isn’t going to be a set rule for this one. You’re pretty much just going to have to throw some numbers together and watch it play out and adjust. Sure there are some metrics you want to keep an eye out for so that 50% of your income is going towards avocado toast (sorry had to go there since we’re talking about budgets. Don’t understand the context? click here: http://money.cnn.com/2017/05/15/news/millennials-home-buying-avocado-toast/index.html ).

While that does sound messy and chaotic, there’s an added benefit to this and that’s to just loosen up. Budgeting isn’t absolute and perfect; it’s constantly in adjustment as you continue to learn more about yourself and your tendencies. You don’t have to have the perfect budget to start (if you have no financial cushion then the margin is noticeably smaller though), so just put something together and see how it goes.

I’ll be writing about investing next, but for now it’s often recommended to save 15-20% of your income into emergency funds and long-term investing, but don’t worry if you can’t hit that immediately. Maybe just start with saving 10% to start off if you have to, but saving and investing is going to be one of the most powerful tools you’ll have at your disposal that will impact your financial wellbeing.

But to finalize this, just take your budget total, then fill in the categories until you use up your budget total.

Favorite hack: My absolute favorite budget hack is to intentionally leave off savings from the budget allocation. I determine how much I want to feed back into my bank account, to add to my financial cushion and then I actually deduct it from my budget total. So if in simplified numbers, if I had a budget of $1000 to work with, and I wanted to save $50, I would just make my budget now start at $950 and then allocate that $950 into all my accounts with that $50 just magically disappeared. What this does is allow me to save without even thinking about it. When I look at my budget, I’m not tempted to see the growing balance in my savings and spend it on something frivolous.

4. Track and evaluate.

This is going to be the most difficult part; not because it’s complex, but that it requires diligence and commitment. You can craft the perfect budget, but if you fail to keep using it and monitoring your expenses, then it just keeps building up more and more until eventually you just give up on it. So you need to turn this into a habitual routine. If you just wait until you feel motivated, then this whole thing will be short lived, because it is hard work and I still have to keep pushing myself sometimes to keep up with my finances.

Psychological tip: One of the best ways to keep up on your finances (and pretty much any kind of New Years Resolution) is to turn it into a habit, with the development of mental queues that make the work almost automatic. Just like how most people brush their teeth everyday without thinking about it, we can use the same concepts to develop other healthy habits. Fun fact, America used to have a dental hygiene problem and it wasn’t until the introduction of Pepsodent toothpaste that provided that tinging sensation that turned teeth brushing into a daily routine that you wouldn’t feel clean until you started your day with sparkling fresh teeth (read: “The Power of Habit” by Charles Duhigg for more on this).

This is again something that can be customized to your own liking, but find a consistent environment to que you into tracking your finances. It could be part of your morning routine (after you brush your teeth maybe?) or before you go to bed, or maybe during your lunch break you could quickly be entering in expenses. Or maybe a daily update is too much, and maybe you just do it on Saturday mornings; it would mean you’d have to set aside more time to do it then, but it’s also when you have more time.

Once your budget cycle is through, make sure all your expenses of have been accounted for then its time to evaluate. Look at your individual budget accounts and see which ones are doing great and which ones are doing poorly. Is the discrepancy a fluke due to unforeseen circumstances, or is there a trend that forces you to adjust?

If it’s a short term discrepancy, then you could just take some of the left over balance from one account and apply it to the overexpensed one, but I think it’s better to look at why one was over budget and see what you can do moving forward to better fund the account so it’s not prone to going over budget later.

The Negative Balance Dilemma:

I’m not sure if this is going to be beneficial for you or if it reveals one of my own weaknesses in my own budget planning, but I don’t fear going over budget. For how much I’m seen as a financially disciplined and conservative consumer, I actually love buying things. With that, I run most of my daily budgets to near zero, or even rollover a negative balance. I’m actually not really that good at short-term saving up for a bigger purchase, like going to a Seahawks game or something like that. I am doing better at putting money aside for meaningful things that are costly, like I have a vacation budget account that I’m regularly contributing to so that when I take time off, I have money put aside to blow without it causing any damage to my finances.

While I sometimes see it as a limitation to my budget, there are some useful benefits to this form of operation. The first is that I can treat my budget like a credit card, but I don’t get hit with any interest since I’m technically owing myself money (this requires a cushion in your bank account of at least $1000 to operate this way). The other benefit is the psychological relief that can come from having flexibility in your finances. For those who need more discipline, then this may end up being a crutch, but if you’re overcome with anxiety when it comes to finances, then having the freedom to carry a negative balance in a budget cycle that you can compensate for in the following cycle without penalty may prove to solidify a budget as a form of emotional security rather than a form of confinement.

Budget Applications:

Now that you understand the function of a budget and what you need to set up one, let’s now look at a couple different options on which application should you use. I’m only going to highlight a couple because there are now so many that all have their own unique advantages and disadvantages to them, and it doesn’t hurt to sampling a few of them to see which works best for your needs.

Mint: The Biggest and Easiest.

Mint.com is owned by Intuit Inc. The software company that owns TurboTax & Quickbooks, so it’s a pretty reliable system. One of the great perks of the Mint software is for the most part, you just plug in your bank account info, and Mint pulls all your transactions and puts it into an expense log that all you have to do is designate which budget category it’s coming out of. So if you want as much automation as possible, then Mint is probably going to be your best bet.
I really wanted to use Mint for years, but there was this one issue that I couldn’t ever get around, and it’s that Mint doesn’t allow for a weekly budget format, it’s only monthly.

Dave Ramsey’s EveryDollar & YNAB (You Need A Budget):

EveryDollar’s premium service allows for automatic bank input data into the app while YNAB is all manual entry, and I believe both use the zero balance method of planning, where you input a beginning balance and you allocate funds to budget accounts until you hit zero. YNAB has a more detailed web program that you actually install onto a desktop computer which then also works with a mobile app.

HomeBudget: My personal favorite.

I used an app called iReconcile for about 8 years until the app developer closed down, and I went searching for a new budgeting app about 2 years ago. I tried out probably 10- 15 different budgeting apps and nothing provided me with the freedom of control over my budget (most notably to have a weekly budget and have rollover editing), until I came across HomeBudget. What is great is not only to have full customizing options at my disposal, but I can track trends in my spending history and see how much over time I’ve spent at individual vendors. Not only that, but it syncs with other devices so couples can share the app and contribute individually to it.

Moving Forward:

I know this will in no way answer all your questions, because your situation is going to be uniquely your own, but I hope this at least provides a mental framework of understanding how you can use a budget to maximize your income’s potential. Being in control of your spending is an essential skill, and once you’ve overcome that hurdle, you can then start to control your savings and investing to multiply the power of your earnings. The investing post should be more entertaining since that is where I’ll be able to show how even a prudent low wage earner has the potential to set themselves up to being a multimillionaire without having to win the lotto, but none of that is possible if you first don’t know how to properly budget your resources.

All these years we were taught that budgeting is stressful and scary, but it is budgeting that takes the stress and fear out of finances.