Ten Steps to Personal Budgets
Personal Budgets - Pill or a Piece of Cake?
“I don’t make enough to worry about budgeting!”
“Making a budget and sticking to it – how boring!”
“I’m doing ok financially without budgeting. Why complicate things?”
"Budgets are for self-disciplined people, wouldn't work for me..."
Sounds familiar? Most of us get into our careers, earn salaries, take on debt, go on holidays – in essence, live our lives ignoring what we see as the ugly nitty-gritties of personal financial planning. The word “budget” has in itself attained a negative connotation that indicates constrained spend – have you bought a “budget smart-phone” or gone on a “budget holiday”?
The truth is that most of us are not born with the mythical silver-spoon – we are not fabulously rich by birth. So, there will come a point where we realize that we have made some bad financial decisions, there may also be points where we acquire definite financial goals. Parenthood is often times a game-changer for most individuals – one is suddenly beset with additional expenses for child-care, which is usually far beyond what was envisaged. There are also the fond plans for a rosy future for your offspring, full of the best opportunities, which may crystallize into a college fund.
Even without a moment of epiphany (with or without parenthood), considering some form of budgeting goes a long way towards improving financial health.
Some of us may be happy with "going with the flow" on our finances, letting our financial goals materialize "if and when" they happen or strongly believe in financial destiny. Like the fabulously rich, these people require no insight into budgeting, but for the rest of us - here is one way forward.
Why map out a Budget?
Have you taken a trip recently? Was it a “grab the opportunity” at the last minute where you booked the first flight available, chose a hotel at random and went with the hotel concierge's suggestions on what to do? Or, was it a planned trip where you did hours of internet research, talked to friends who had visited the same place, shopped around for the best deals on flights and hotels? Maybe, you outsourced the plan to your friendly travel agent who used his professional contacts and came up with options for you to choose from – albeit, for a fee.
Alternately, in keeping with our times, have you take a road trip from point A to point B, when you know nothing of the route without using GPS and your favorite mapping tools?
A budgeting exercise is similar: it helps us gain control on the unknown (our spend) and helps plan to help reach our goals. It also brings to light unrealistic goals – thereby bringing in the need to alter our income to help achieve the goals or to tweak the goals to make them more achievable.
Have you Successfully run a Personal Budget?
How do I Start?
If you have a fear of numbers, a budgeting exercise can seem like a nightmare. However, you can choose an approach that works for you. You can choose to go the old-fashioned way, with pen and paper. You can choose to build excel spreadsheets. You can choose to use any of the multitude of apps available on the internet. Whatever the tool, there are certain steps that can be followed.
The following sections provide a broad guideline on the steps, but it is just a guideline that has to be customized to individual requirements.
Step 1: Define a Period
A budget makes sense when it is created for and monitored over a finite period of time. In most cases, a year is a good period to work with, simply because it is one of the most common financial periods – tax computations, interest computations are usually done annually.
Step 2: Identify all your Income Sources
Your salary may be your primary source of income, so this may be very simple. But there could be other sources:
Investment returns – even the small interest amounts that you get in your bank account
Moonlighting income – maybe you have something going on the side
Inheritance – that rich aunt who left you what was left of her savings (wishful thinking, I know)
In most cases, you have to do this computation annually when you file your tax returns, so it should not present as something new to be done.
Step 3: Identify your Major Expense Heads
For a first budget, this is possibly one of the most difficult tasks. However, you can control the level of detail and bucket expenses into categories that make sense to you - a sample follows:
At this point, you are making no judgment calls, you are just looking at your last year’s data impersonally and classifying the heads of expense.
Step 4: Map Previous Year’s Expenses into These Heads on a Monthly Basis
This is arguably one of the most time-consuming steps. You have to pick data out of your bank statements/credit card statements – and if you use cash a lot, you have to figure out how to track it. Some of the items would be straightforward – they would be once a month items. For the rest, you can make a call on how granular you want the computation to be – if you see a recurring pattern, you could define a month-wise total. My grocery shopping invariably happens on fixed days of the week at specific stores – picking these items for two months from my credit card bill allows me to extrapolate for other months, without too much error. Some additions have to be made in specific months, that go out of pattern.
At the end of the step, a sanity check should be done to ensure that your map totals to something similar to the actual outflow from your bank account for last year.
Step 5: Review the Expense Data
Build a view of your spend pattern – order the categories in terms of percentage spend from highest to lowest. Then, check if your top 3 items are indeed the ones you should be spending the maximum on.
As an example, rent, transportation and loans could have good reason to be in the top 3 list, food can also be considered acceptable, in some circumstances.
If maintenance is in the top 3, a little more analysis may be required – did you have any unusual maintenance costs last year? Maybe you had major car repairs or some other household appliance breakdown. Was it one-off, or would you have to carry it forward into the next year?
Medical getting into the top 3 list may also have significance – if there is a major family illness being handled beyond what insurance covers, your view on budgeting and finances may need to change drastically.
If clothes, hobbies or entertainment make the top 3 list, there is soul searching required – maybe you have an expensive hobby that really has to be nurtured as there are massive payoffs expected, down the line. Or maybe, these areas can be consciously trimmed down in the following year.
Having investments in the top 3 is an ideal situation – an eventual goal can be to bring it into the top 3.
Step 6: Plan your Budget
Define your potential income for the coming year. This can be based on previous year’s data, you can factor in increments or any other expected windfalls, if you feel certain about them. Or you can keep them out, and end up with nice positive balance at the end of the year if the windfall materializes.
On the expense side, define the month-wise expenses based on the analysis in step 6. In most cases you can fill it out for one month and then copy it over to other months with alterations, where necessary. The difference is that you now have a target top 3 list, with some planned changes in specific areas.
Check if the total expenses are within the total income – if not, you have to either figure out alternate sources of income, or in most cases, tweak the planned expenses to fit the income.
Maybe you cannot attend too many live rock shows (or any other favorite entertainment event), for instance, if it breaks your budget.
While doing these tweaks, demonstrate practicality – you cannot plan to reduce your food bills by 50% overnight, for instance.
Also, do not consider the budgeting exercise as a cure-all - if you are battling an addiction (expensive coffee or maybe substance abuse), you cannot expect to overcome the addiction by simply cutting the item out of your budget, there will be more will-power and hard work required.
Step 7: Monitor for a Quarter
Make a note of the actual spend amount against each category month-wise. Some people find it easier to do this on an ongoing basis, some people do this at specific intervals. Figure out what works for you. Bear in mind, it is at this point that most budgeting exercises breakdown for lack of follow-up and the work you have done upfront goes waste.
Step 8: Review after a quarter
Check the spend patterns against the budgeted spend. Are you more-or-less on track? It is not necessary for every category to come out under budget, if you exceed on one, but go under budget on another with no harm to the total, it is perfectly fine. If you go over budget one month, but are able to cover it up the next month, that is fine, as well. Only, do not fall into the trap of assuming that next month will be better, every month. If you can think of some simple tweaks to the budget for improvement, now is the time to implement them.
On the other hand, if you are way off track, you have to go back to Step 5 to review the data and then re-plan your budget. Maybe you would like to seek help from a trusted friend to get a fresh pair of eyes on the data.
Step 9: Monitor/Review Through the Rest of the Year
You now have a working budget cycle in place, you have to continue monitoring and reviewing. If the monthly monitoring and quarterly review cycle works, use it. Else, define a monitoring and review cycle that works for you. By the end of the year, you should be comfortably coming within budget, unless you were hit by unplanned events.
Step 10: Rinse and Repeat
You can continue the annual cycle ad-infinitum. Once you get into a way of working, you will find it easy to continue and optimize. And over time, you can start considering strategies for paying off loans or owning a property and most importantly, improving your investments.
Simple? This Sounds like a lot of Work!
It is our perceptions that assign complexity to tasks. Tax returns are a necessary evil, so we either have to educate ourselves enough on basic finances to be able to file our returns ourselves, or get a professional accountant to do it for us. Similarly, there are many personal finance specialists who are available for a fee.
Personally, I am a “do-it-yourself” person – I do not feel comfortable giving out my personal finance details to someone else, so I choose to work it out. However, it is not easy to fall into the rhythm of budgeting cycles. I have initiated such cycles two or three times, but each time, I fell through in step 7 with the view that things seem to be okay, why bother monitoring. The one thing that changed my view and made me continue with the full annual cycle is when I defined personal financial goals and discovered the need to work towards them.
At some point we build up some aspirational financial goals – sometimes these are dreams that are good to fantasize about for a short while, but oftentimes these are clear goals that we can attain by strategizing our budget.
The goal could be building a house, buying a major asset or simply targeting savings towards a fund (retirement or education or travel etc). Usually, these goals are not something that can be achieved within a single annual budget, some of them may require years or decades.
The first task is to put a number to the financial goal and then to figure out how your investments and budget can be rearranged to achieve the goals in the lowest possible time, with little impact to your spend pattern. If you are not working to annual budgets, you are left without a starting point to your financial goals. This is also where having your investment bucket in the top 3 spend categories helps – if you are already maintaining a regular investment stream with decent returns, you probably have a good corpus for your financial goals. If not, you may want to consider ways to improve investments – maybe re-look at some of the expense categories for trimming and redirect funds to investments.
"Needs" and "Wants"
It is also worth-while noting the differences between “needs” and “wants”. “Needs” are the bread-and-butter of your life, “wants” are the cakes.
Anyone who says that they will eliminate all “wants” is barking up the wrong tree – we have to include some of our “wants” for the “feel good” effects. An oft-quoted percentage in personal finance circles is to spend 50% of your budget on “needs”, 30% on “wants” and 20% on investments. There are some people who advocate pushing up the investments to up-to 50%, but this may not be feasible on an ongoing basis.
Also, the same item may be a “need” at one point, and a “want” at another point – you may really need one good business suit for official meetings, but would you buy five of them in a year because you got a good deal?
When you are looking at trimming expense categories to reduce the expense budget, it would be worth-while doing a bit of a deep-dive: check on what are the "needs" and "wants" within each category and see if some of the "wants" can be eliminated or reduced, at least, temporarily, while working towards the goal.
What else is there to Personal Budgets?
Actually, that’s it. Once you get into the groove of budgets and working towards financial goals, you get in control of your finances. You start gaining knowledge of investments, and figure out how to make your investments work for you. You look for ways to automate some payments, making tasks easier for you. You understand that one of your investments has to be an emergency fund – for the unhappy eventuality of losing a job, or illness. Maybe you even start making enough to hire a professional investment advisor to help you improve your investment strategy.
At its core, budgeting is an intensely personal exercise, specific to an individual or a family and can work best when there is a true desire to make it work, even accepting some of the associated difficult actions while working towards goals. Once you approach it with integrity, the power of control that it gives you over finances, and the pleasure of achieving major financial goals over time, give you all the benefits that you ever wanted.
© 2018 Saisree Subramanian