Another new year is upon us, and as bizarre and surreal as the last two years have been, Jan. 1 always inspires resolutions. Habits related to fitness, finances, and relationships all seem to be on the chopping block once the ball drops.
In terms of finance, finally living within our means or “following a budget” has to be one of the most common New Year’s resolutions. But before you break out the spreadsheets and financial apps, read on to decide if it’s truly the best way forward.
What’s the purpose of creating a budget?
In our experience, too many consumers go through the budgeting ritual simply because “my parents always said it was a good idea” or “I know I should.” But this doesn’t mean it’s necessarily a useful exercise. Before committing to creating a budget for yourself or your household, ask yourself, “Why am I doing this?”
Budgets are made for two reasons:
- To create disciplined rules around spending
- To better predict future spending
Most consumers create budgets to discipline themselves. If this is your goal, a budget has value as a psychological “guard rail” and can curb the tendency to overspend because of either lack of discipline or lack of awareness.
However, one must be sure a budget such as “$250 per month on groceries” is realistic.
Too often, we look at our monthly paycheck and simply work backward. If our net paycheck is $6,000 per month, and we know we want to save $500 of it, we take the remaining $5,500, apply it to all the categories we can think of, and assign a number to each that sounds reasonable. This type of “ballpark budgeting” is virtually always a waste of time and typically leads to frustration and failure.
Why is “ballpark budgeting” doomed to failure?
Budgets need to look forward, but first, they must look backward. If we don’t know what we’ve spent on categories in the past, it’s unfair to expect an accurate prediction for the future.
Your bank account doesn’t care what you spend money on. If you spend more than you put into the account, you’ll eventually run into trouble. So before worrying about categories of spending, figure out how much you spend overall.
How can you figure out what you’ve really been spending?
Luckily, there are only three ways to spend money:
- Credit cards
- Bank withdrawals/checks/debit cards
All three of these categories can be tracked by looking at your credit card and bank statements from previous months. It’s a good idea to look back at least six months to get a fair sample of your spending.
If you pay off your credit cards each month, this process is easier. If not, you’ll want to look at all credit card purchases which are totaled on each monthly statement and add those to the total bank withdrawals made (not including credit card payments from your bank) during the same time period. Statement cutoff dates won’t line up perfectly, so you may need to adjust for this.
If you pay your credit card(s) in full each month, the easiest way to gather all transactions accurately is to look at all bank withdrawals for six consecutive periods. Go through each statement. Subtract credit card payments made from your bank and any transfers to or from other accounts because these represent money movement, not spending.
Cash withdrawals should also be counted as spending unless you’re simply keeping thousands locked up in your home after withdrawing (be sure to budget for a home safe).
This exercise is a great reminder that less is more in terms of the number of accounts you maintain. If you’re using more than one or two credit cards, consider whether the benefits you may be receiving outweigh the hassle of tracking how you’re handling your money.
Check your math.
Once you’ve completed your “spending forensics,” you can average out what you’ve spent monthly during the period in question. You may have spent $13,000 one month and $7,000 another month, but if the average is 10,000, you’re starting to get a clearer picture. The further back you track, the more accurate your spending averages will become.
If you know you’ve spent $10,000 per month, as in the example above, next employ a “double-check” that financial planners use frequently. Take your monthly take-home pay and subtract your monthly spending average ($10,000) from it. If your take-home pay is $11,000 per month, you should notice that your bank account (or some account you use to deposit or withdraw funds) is slowly increasing over time by about $1,000 per month.
Remember, direct deposit isn’t the same as “saving”.” If you direct deposit $1,000 per month into a separate account for emergencies, but there is only $10,000 in it after 10 years, you aren’t actually saving into that account. Don’t count that monthly deposit as savings or extra income.
If you are overspending by $1,000 per month, you will see your account balance diminishing by $1,000 each month or maybe your credit card debt increasing by 1,000 per month. That’s $12,000 a year.
Okay, do you still need a budget?
Now that you’ve figured out your past spending, it’s important to know what you’ve been spending on. There are two reasons for this.
First, you will quickly see where money is being wasted and where the easiest changes can be made. Second, you’ll be in a position to plan when life changes. If you begin working remotely, move to a new city, or have a child, you’ll quickly be able to calculate the financial impact since you already know how much gas, property taxes, and daycare costs.
Don’t forget one-time expenses.
These are infamous budget-killers. After your spending forensics are complete, don’t make the mistake of excluding things like HVAC replacements, big trips, or any other non-monthly expenses.
Instead, figure out what these irregular expenses have averaged each month, and assume a monthly “miscellaneous” category. Too many of us budget only for the “every month” expenses like utilities, gas, groceries, and the like. Without accounting for the “pop-up” expenses, we won’t know what an emergency fund should look like and we won’t get a realistic expectation for the future.
Where To Find Help
Luckily, there are tools that can help you calculate current and past spending without pouring over financial statements like an accountant.
Online aggregators like Mint, or the eMoney software our clients all have access to, will allow you to automatically connect credit cards and bank accounts. The software will categorize your transactions so you know how much things like entertainment, food, kids, or even custom categories are costing you. Feel free to create your own categories such as “Cousin Eddie Living With Us Expenses” so you’ll know what will free up if and when he ever moves out!