CESI Personal Finance Guide - Chapter 4: Building a Budget
Get Debt Consolidation Options
Call Now! (866) 484-5373
Chapter 4: Building a Budget
A budget is an account of your anticipated income and expenses for a given period. It helps you to set up a system that will make your money work for you and is your ally in times of financial stress. Your personal spending plan, if designed correctly, will guide you to financial security and peace of mind. A well-constructed budget also provides you with an opportunity to do a test run on the distribution of your resources.
For some, the mere mention of creating a budget brings on an anxiety attack. They confuse guidelines with restrictions. In actuality, a spending plan is your pathway to financial success. It keeps you focused and moving forward rather than standing still, or worse, backpedaling. By sticking to the guidelines you set, you will reach your goals in record time.
The advantages of budgeting your income and expenses cannot be overstated. A recent poll of people who have filed bankruptcy revealed that most did not develop a budget, or they developed one but failed to stick to it. (The absence of a savings plan was another common thread among people who fall victim to bankruptcy.)
A budget can cover any length of time. Most government agencies and corporations establish an annual budget to track income and allocate funds for the fiscal year. A budget can be developed to manage resources for a specific item, such as wardrobe expenses or purchasing a new car. This discussion will focus on creating an outline to effectively manage your monthly financial activity.
Why Is a Budget Important?
Examining how you spend money helps you to discover critical aspects about who you are. Exploring your goals and writing down your preferences helps you to identify your financial personality. When completed, your spending plan gives you a clear picture of your fiscal position. With thorough knowledge of your resources, obligations, and use of discretionary cash, you can set realistic goals. A well-written budget also inspires the most reluctant to acknowledge the benefits of saving money.
Many people have trouble saving the recommended 10% of their monthly income on a consistent basis. Studies have shown that people who keep a record of their financial activity are more successful at establishing and maintaining a savings account.
Assessment Leads To Prudent Choices
A friend recently decided to buy a home. Nicole is the epitome of frugality. She is a single woman with an annual income of $65,000. She has minimal credit card debt, a vehicle that is paid for, and below-average expenses. Her expertise is finding bargains. She routinely tours thrift stores and garage sales for giveaways. She truly has a gift for getting the best price on everything from A to Z. So it was no surprise when Nicole announced that she was hunting for a bargain when she decided to buy a home. She found one. She purchased a two-bedroom, one-bath bungalow on the outskirts of town.
Nicole’s friends questioned her selection. Knowing her general financial position, we advised her to look for a home that would more adequately meet her needs and still be affordable. Nicole was hooked on the $650 monthly payment that her housing “find” offered. This included interest, taxes, and insurance. She moved in, elated to have a snagged what appeared to be the ultimate deal.
Four months after moving in, Nicole was miserable. She mournfully admitted that the home was a major disappointment. The rooms were too small. There were not enough closets. Her microwave claimed most of the counter space in the kitchen. The windows did not allow for adequate light during the day. The patio was not big enough for her plants. The one-car garage did not have room for extra storage. The list went on and on.
Unfortunately, Nicole did not evaluate her personality and preferences before shopping for a home. She also failed to analyze her resources effectively. Her monthly income is about $5000. When Nicole realized that she was able to allocate up to 30% of her monthly income for housing, she broadened her scope. She settled on a monthly payment between $1000 and $1300. Armed with a more realistic price range, Nicole went on the hunt again. She found a home that met all of her needs, not just affordability. The experience taught her the importance of selecting quality as well as value. She also discovered the advantages of completing a comprehensive financial assessment before making a major purchase.
Assemble the Data
To prepare your budget, you will need a record of all of your income. This includes pay stubs, retirement checks, investment income, and an accounting of all cash that is received on a regular basis. You will also need to gather records of all of your regular expenses. Once the data has been collected, you can begin to construct your spending plan. It is best to take on this task when you are relaxed and have plenty of time. Do not be concerned if you go through several rough drafts before constructing a budget that meets your needs.
Calculate Your Income
The second element of an effective personal budget is to have an accurate account of your resources. If you have standard pay stubs, you will see an amount for gross income and net income. The gross income is the amount of your pay before deductions. Your net income is the amount of your pay after deductions, the amount of money you actually receive, sometimes called “take-home pay.” This discussion will refer to your net income. If you decide to use your gross income, remember to enter the deductions as expenses on your budget sheet.
Record your actual take-home pay for a month. If you are paid once a month, use that total as your net monthly income. If your income fluctuates from month to month, calculate your income from the previous year and divide that amount by 12 to get a monthly average. If you are paid twice a month, multiply the net figure times two. If you are paid every other week, multiply the net figure times 26. Divide this amount by 12 to get your average monthly income. If you have retirement income or investment income, list the actual amounts received. Include any funds received from self-employment. Remember to list gifts, such as financial assistance from family or friends, if received on a regular basis.
Where Does the Money Go?
Next, review your expenses. Regular expenses reflect what we need to spend to support our daily activities. Expenses can be fixed or variable. Fixed expenses usually do not fluctuate from month to month. A car payment, rent, or mortgage payment are typically fixed amounts. The electricity bill, the amount you spend at the gas pump, and your purchases at the grocery store usually vary depending on the season and your specific activities. As you begin to put together this snapshot of your expenditures, you will find that a lot of your preferences and habits are revealed as well. Most of us are aware of what we spend on major items like housing, food, and transportation. However, there may be some spending that is not so easily tracked.
Not sure where your money is going? Save your receipts for a month or two and then analyze the results. Collect receipts and carry a daily spending journal with you. If you are not able to get a receipt for a purchase, make a note in your journal. Include the date and the reason for the expense. This is important research because you are getting a realistic view of your spending habits. At the end of your review period, organize your receipts and journal entries into categories. Start with the typical groups; food, housing, transportation, utilities, clothing, entertainment.
Beware of the “miscellaneous” pitfall. If you find that you have a lot of expenses that defy classification, you probably need to do a more thorough examination. A stack of miscellaneous purchases is an indication that you are spending money needlessly. Take the time to inspect each purchase individually. Did your hard-earned cash go for something that was necessary or was it wasted on an impulse purchase? You may be surprised to find that a lot more of your discretionary cash is siphoned off by unnecessary expenditures than you imagined. This is money that could be used to get out of debt ahead of schedule or start a vacation fund.
If you are not sure about a prospective purchase, stop and ask yourself if you can do without it. Question each transaction in advance. You may already have an acceptable alternative. This will help you avoid excessive spending and get in the habit of living within your means. Reflecting on long-term financial goals also helps to curb the itch to overspend. You will be able to afford that exciting excursion to foreign lands a lot faster if you resist the urge to buy a new pair of shoes today.
Once you have an accurate record of the money you receive and of your monthly expenses, you can establish the parameters that will help you successfully manage your finances. Recommended guidelines for distributing monthly income are as follows:
When reviewing your entertainment costs, be sure to factor in movies, sporting events, travel, video games, concerts, reading material, music, and pastime pursuits. Pet owners should consider vet bills, medication, food, and general supplies.
If you have annual or semi-annual charges, convert the total amount to a monthly figure so that the money will be available to cover the payment when it is due.
These are general rules. Your specific circumstances may require some modifications. You should customize any proposed system to fit your specific obligations and lifestyle. Keep it fluid. If your needs change, make adjustments to reflect current circumstances. However, try not to stray too far from your guidelines. When tempted to overspend, they can ensure good money management.
Let’s say you are considering buying a new sofa and the payment will require 7% of your monthly income. Your records show that 4% of your income is already going toward credit card payments. If you use an 8% cap, you only have 4% left to apply to new debt. With that knowledge, you can now make an informed decision. You can shop for a less expensive sofa or you can wait and make the purchase when more funds are available for debt repayment.
Once you have tallied everything, you will have an idea of your current financial status. Ideally, of course, you want to have more income than expenses. Do you have a surplus? Fantastic! You can use the extra cash to reduce outstanding debts more quickly. Your overflow can also be used to set up an emergency account. Putting money aside for a specific goal like a vacation is another possibility.
If you find you have more bills than bucks, it is time to make changes. You can either increase your income or decrease your expenditures. You may opt for a two-pronged approach and attack the problem from both sides. Consider a second job or a higher paying job. Some people take in a roommate to boost their income. Cutting off credit cards, joining a carpool, clipping coupons, taking the bus/train, packing your lunch, limiting shopping trips – even small adjustments add up to significant changes in the bottom line over time.
Perhaps you are just coming up short in one category. For example, you allocate $250 for gas and vehicle maintenance, but you find you usually need $325. In this case, you could increase the vehicle allotment and decrease unused cash earmarked for another area. Evaluating your spending habits before setting up a budget prevents surprises and enables you to conduct your financial activity appropriately.
The Emergency Account
It is not possible to plan for an emergency. By definition, an emergency is an unplanned, unforeseen event. However, you can be financially prepared to handle an emergency. That is the purpose of an emergency account. It protects your standard of living during a crisis. An emergency fund is a separate stash that will cover several months of living expenses.
A job loss, illness or major car repair are events that place a demand on your finances. If you have extra funds at your disposal, these events take less of a toll and enable you to weather the crisis without interrupting your ability to pay your regular bills.
If you find yourself between jobs for a few weeks, you won’t get slapped with late fees or risk losing your car if you have money in an emergency account to keep up your payments. You will also avoid the additional stress of having to borrow money to make ends meet.
Your account should be large enough to cover three to six months of living expenses. Emergency cash is only to be used if you have an interruption in your income or a critical need. The funds are not to be tapped to purchase a big-screen TV or a set of golf clubs.
To set your goal, multiply your total monthly expenses by the number of months you want to be prepared to cover. Some have found it helpful to open a money market account to facilitate the process. You would make payments into this account until you have satisfied your saving requirement. Make an effort to continue to save 10% of your monthly income while setting up your emergency account. It may be a stretch initially, but the extra effort will serve you well in the long run. If you must access your emergency account, be sure to replace the money you used. Think of the deficit as a bill that must be repaid and implement a plan to restock it as quickly as possible.
Your net worth, like a monthly budget, is another indispensable assessment tool. Calculate the value of your assets then subtract the value of your liabilities. The result is your net worth.
Assets include stocks, bonds, the value of any real estate that you own, annuities, cash, certificates of deposit, money market accounts, retirement funds, valuable collections, artwork, furnishings, and jewelry.
Your liabilities include the amount owed on all real estate, credit card debts, the outstanding balances on all loans (including vehicle loans and student loans), and back taxes.
If you own more than you owe, you have a positive net worth. Your financial strategy is working. If you owe more than you own, you have a negative net worth. This is a warning signal. You must take action. You must shift the scales in your favor. Review your financial activity. Set goals to reduce overall indebtedness and manage assets wisely. Take the time to calculate your net worth at least yearly to track your progress. A net worth worksheet follows this chapter. Your net worth is a valuable indicator of financial solidity.
Assets of $165,000 – Liabilities of $179,000 = Negative Net Worth of $14,000
In This Chapter You Learned:
- A budget is an essential part of good money management.
- Recording your income is a great place to start.
- Tracking your spending habits is essential.
- Guidelines for distributing monthly income.
- How to adjust your plan.
- The value of establishing an emergency fund.
- What is net worth and how to calculate it?