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by Trent Hamm
August 16, 2017
by Trent Hamm
August 16, 2017
Budgets are often presented as being some kind of magical tool that people can use that will transform their day-to-day life from an ongoing slow-motion financial disaster into a debt eliminating and wealth building machine.
Quite often, personal finance books and websites buy into this picture, too. They immediately suggest creating a budget for your spending, setting caps on all kinds of spending areas, and then showing that this budget somehow "transforms" your income into covering all of your needs and leaving you with lots of money to pay down debts and build a great financial future.
It's exciting. It's motivating. And it's wrong.
A strong budget is much like a 1,200-calorie-a-day diet. If you actually manage to stick to it, it's going to produce great results fairly quickly. If you can't, it falls apart and becomes useless.
Part of the problem is willpower, of course, but another big part of the problem is that life is simply not fully predictable. You don't know what tomorrow will bring, and if your budget is so tight that you have little breathing room for the unexpected, your budget will break. Just like a very tight diet sometimes dies when you have unexpected travel or a friend shares a treat with you, a very tight budget sometimes dies when you have to travel for a funeral or your car breaks down.
A super tight, super optimistic budget is doomed to failure, by definition. The simple unexpected nature of daily life is going to force you into very difficult decisions and you will eventually – and surprisingly quickly – find yourself trampling over a tight budget, much like a person quickly finds themselves shoving aside a diet that's too restrictive.
Why do people have restrictive budgets, then? The simple reason is wishful thinking. If you envision a future where everything goes well and there are no problems whatsoever, then a strict budget will work and it will get you to your financial goals as fast as possible. Thus, the wishful thinking is twofold: Your life will go perfectly with perfect discipline and your financial goals are achievable in absolute minimum time.
The problem with that wishful thinking, as noted above, is that it begs for your budget to fail and quickly become meaningless. Wishful thinking turns budgeting into a flight of fancy rather than a really useful financial tool.
Instead, a good budget is a picture of your real spending with a few good choices thrown in. Think of it as a financial version of a diet that's going to cause you to lose a pound a week or something realistic rather than a "beach body in 30 days" diet.
The first step in building a good budget isn't to sit down and start writing down ideal numbers; instead, you should start by simply tracking your spending. If you have receipts and statements for the last month, that's a brilliant starting point, as you can use that to make a baseline "budget" for the last month… in reality, it's just a picture of how you spent your money.
In fact, your best move is to make several of these "budgets" over the course of several months. Where did your money actually go each month? This helps with figuring out things like irregular bills, like quarterly insurance payments or annual property taxes or vehicle registration, something that is often overlooked in a tight budget. It also helps you get a grip on irregular expenses, like buying gifts or traveling – these things aren't strictly bills per se, but they are expenses that don't pop up like clockwork every single month. Some months have minimal travel costs, while others have significant travel costs. Ideally, you'll take several of these "spending pictures" and average them to get a picture of a true "average month" of spending.
One area many people struggle with is "categorization." How does one organize one's expenses in a sensible way? There are thousands of budget templates out there – here's my own guide to a simple first budget – but you shouldn't treat the categories they provide as written in stone. Treat them as a starting point. You can make up new ones, or divide the ones they have into pieces, or even combine pieces. Turn it into something that makes sense for you, so that you intuitively know what category each expense in your life belongs in with minimal effort or thought.
For example, rather than having a catch-all "entertainment/hobby" category, I actually split our family's budget up into several sub-categories so that I can keep careful track of various flavors of spending there. This allows me to budget my own personal hobby spending and put some light but reasonable caps on the overall hobby and entertainment spending for our family (we'll get to this in a second). This may make sense for some, while it may not really click for others.
Find categories that work for you. Over a few months, chop up each month's spending into those categories. It's then, and only then, that you can make a sensible budget going forward, one that isn't reliant on wishful thinking.
What do you do when you have those things? Make an "average" picture of your spending. Just average out each of those categories across all of the months.
Let's say that, in January, you spent $50 on books, and books was a line item on your budget. February had $70 in book spending, while March had $50 again, while April had only $30. You add all of those up – $200 – and divide by the number of months – 4. This gives you an average of $50 a month you spent on books. You do this exact thing for each spending category you have, and what you'll produce is a true picture of what an average financial month looks like for you.
Now, all you need to do is put some light caps on a few of the flexible categories. In the example above, that person is "budgeting" $50 a month for books – that's their average spending over several months. That person then creates a budget for the coming month and puts in $40 for books.
Do the same thing for every category that's actually flexible – in other words, ones where your choice has an impact. Cut it by 10% or so. If you spend $200 a month eating out, make that target number $180 or $175 for the coming month. You get the idea.
Now, what about those less flexible numbers? Just start going through them and see if there's anything you can trim that won't really affect your quality of life. Maybe you realize that you almost never watch cable any more and instead you just watch Netflix. In that case, perhaps you can simply cut out your cable service and save $50 a month. Maybe you can call your cell phone provider and switch to a smarter plan. Maybe you can shop around for insurance. Maybe you realize that you'll start saving $10 a month by buying an annual bus pass instead of a monthly one. When you permanently reduce a bill, you can reduce that matching number in your overall budget.
There are still a few things to do to really make this a worthwhile budget.
First, it's a good idea to account for emergencies, so include a line in your budget for putting money into your savings account for an "emergency fund" and treat it like a bill. The more you put aside here, the easier it is to handle unexpected disasters. Leave that line alone and continually transfer that much money each month – in fact, automate it if you can. Then, only tap that emergency money if you need to.
Second, it's also a good idea to add a little bit of "inflation" to irregular bills. Although you calculated an average of many of your bills, it's a good idea to add a little bit to each of those averages to make sure you come in below budget in those categories most months. For example, if your electric bill averages $200 a month, but your bill varies a lot, it's a good idea to budget $225 for it. There's no need to budget the maximum amount, but budgeting a bit above average gives you breathing room.
Continuing on with that thought, when you come in under a budget category, don't just spend that money freely. Instead, use it to cover other areas of your budget where you may have gone over this month, then bank the remaining amount for overruns in future months. Let this be an addendum to your emergency fund, in other words.
It's important to note that this isn't a crutch to allow yourself to consistently go over budget in your flexible spending areas. Rather, you should be making smart choices about your flexible spending areas in your budget so that you don't go over budget during the course of a month. For example, just because you came in under budget with your electric bill doesn't mean that it's okay to choose to go way over budget on your entertainment spending. You should be shooting for your target in every category, regardless of the performance of other categories, and ideally coming in a bit under budget in as many categories as possible.
As you can see, a budget isn't a place for wishful thinking; it's a place for realistic thinking. It's a place where you can get a meaningful picture of your spending for the coming month, see where your money is going, set some reasonable goals for your own money behavior, and plan out your steady march toward your big financial goals!
It all starts with a little realistic thinking!
The post Your Budget Is No Place for Wishful Thinking appeared first on The Simple Dollar.
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