Part 2: BUDGET - Financial Independence Series
11 Feb, 2024
In the first blog post in this series of six, I quickly showed you how to calculate your net worth. It will take a little longer today, but I want to explain why you need to keep an eye on how and where you earn and spend your money, i.e., budgeting. When you learn to budget, your net worth will begin to increase.
Budgeting is simply making a plan for your pūtea (money).
Although I meet hundreds of people who are keen, motivated and willing to do better with their money, I meet few who are “Oh yay, let’s track our spending and earning each month”.
I know. I understand your reluctance, but if you want to grow your wealth, you must do what wealthy people do. And they know how much they earn and spend.
So, I’m sorry, there are no shortcuts here; you’ve just got to suck it up and budget anyway.
Most will come to enjoy it as I do, simply because it gives me a feeling of control over my life and removes any anxiety around my pūtea. But for some of you, it will always be a chore. So be it! Do it anyway.
Budgeting takes me where we want to go.
If you have ever logged into your bank account and felt dread or apprehension when you see the balance, and you know you have more expenses coming out soon, so it’s only going to get worse, please know that you can change this situation.
If you can get into the habit of monitoring your earnings and spending, budgeting lets you predict what is coming. My whānau has three big holidays planned for the next 12 months, which would have been impossible to pay cash for had we not budgeted. If we had just booked the holiday without a financial plan, I would have been, you guessed it, looking at our bank balance with a feeling of dread and apprehension.
Via The Happy Saver, I’ve watched countless people move into a more stable position simply because they began to budget.
Start budgeting by hand.
If you have talked yourself into the idea that you want to improve your financial luck in life, I’d first encourage you to budget by hand. Get out a pen and paper or create a simple spreadsheet on your computer. If you are a visual learner, you might find using a mind map easier (one for each month).
#TIP: I don’t advocate rushing to use online budgeting tools in the first instance because you instantly add a layer of complexity to a simple process. Most people have an ah-ha moment when inspiration strikes, so just grab a pen and paper or create a spreadsheet and start immediately before you lose motivation. You can learn how to utilise budgeting software later.
Next, print off the last three months of bank statements for all your accounts. Anywhere where money enters or leaves your accounts, print out a copy.
Once you’ve printed them off, your first thought will likely be just how many financial transactions you complete in a relatively short time. That’s the reality of living a digital life where we often don’t handle physical money; hundreds of transactions are still happening 24/7 online.
Now, with a clear head and no distractions, start methodically working through where you have been spending all of your money. Allow an hour.
Create your categories.
Create some broad “category” headings you will use. Each transaction will be noted under one of these headings. Start with my suggestions, then adjust/add your own so they reflect your situation:
Income - Groceries - Electricity - Transportation - Car Maintenance - Rent -Mortgage Payment - Rates - Insurance - Investing - House Maintenance - Healthcare - Communications - Clothing - Eating Out - Entertainment - Holiday - Subscriptions - Interest Paid and Bank Fees - Gifting - Donations
#TIP: Keep your categories broad. For example, even if you shop at Pak N Save, Woolworths, New World, Fresh Choice and the local farmers market, put each transaction under ‘Groceries’.
Starting with the first day of the three-month period you have chosen, go through your statement line by line:
If you spent $20 at the movies, enter $20 under “Entertainment.”
If you put $90 of petrol in your car, enter $90 under “Transportation.”
If your Rarotongan holiday cost you $6,500, enter it under “Holiday.”
Do this exercise for three separate months.
If you find that you have a transaction that you can’t place, create a category for it - otherwise, you will end up with a giant “Miscellaneous” category (I’m speaking from experience here!) Don’t stress; over time, you will refine your categories.
As you work through the hundreds of transactions, while you should be scrutinising every payment, there is no judgment on the purchase. You are simply working out for the first time where you spent your money, how much you spent in total, and what you earned over three different months.
#TIP: You must include every transaction, even for a “one-off” purchase. Life is full of “one-off” purchases.
You will be eyeballing three separate months of transactions in your chosen categories when you are done. Well done. Take a break.
Example of a simple hand-drawn mind map showing broad “category” headings and every transaction under each category.
Example of a simple spreadsheet showing 3 months of transactions.
You have created a list of where your priorities lay.
We all use money differently. Therefore, it’s not up to me if your spending and earnings are right or wrong. You get to decide.
Did you spend $1,000 a month eating out? Clearly, you prefer other people’s cooking to your own. Do you have six different subscription services for what is effectively watching TV? Well, you clearly like being sat on your sofa watching TV.
There is no judgment here, just a list of how much you spent and on what.
Next comes a little judgment.
You can evaluate if that spending sits well with you. Or not. The fancy name for this is a ‘budget meeting’, but it’s just a chance to discuss what you have learned about your spending habits.
You can adjust your life only once you know where you spend your money (and time). Plus, it helps you see patterns of spending that you can then begin to predict.
If you are single, that’s perfect because you are only about to argue with yourself. But do bring your partner into this conversation early if you are in a relationship. Where you earn and spend your money needs to be a team decision, and everyone has an equal say. I advocate shared finances if you are in a committed relationship, but if you don’t share your money, you can still share with your partner what you are doing with your money.
Now you know. Now what?
Most people start tracking their spending because they sense they are spending too much or money is generally wasted. Hence, you need to calmly and rationally discuss where your money has been going. No finger-pointing is allowed here. That isn’t useful; you will just make the other person resentful. But you can acknowledge what has been going on with past spending and make shared plans to change it going forward.
If you both agree to stop spending in a particular area, but in a month, at your next budget meeting, one of you has continued with that spending, you might have cause to ask, “What gives?” Because doing so really has broken a promise you made to each other and points to broader relationship issues, in my mind.
Two types of change come from that initial budget meeting:
Changing the way you spend has to be your decision and yours alone. There is no point in me telling you to get your act together. I can say all I like, and you won’t hear a word. But I’ve always noticed that once people decide something has to change, they go down one of two paths. Both work, by the way.
Radical
Once some people have noted where they are spending, they take the radical approach of immediately stopping ALL spending that is not essential to survival. They have a “screw this” moment, and they get angry enough to get radical and shake up life as they know it. This is a hard-core reset of what it takes to run your life. No restaurant meals, no clothes being bought, no petrol in the car when you could easily ride your bike to work. I love this approach because there are no grey areas; it’s either “Will this purchase be used to keep me fed and with a roof over my head, or not”? I spoke with a woman recently who learned that on her $95,000 salary, she could live on just $200 a week! And she did! Radical huh!
Methodical
Others take the more methodical approach of assessing each expense and adjusting it over time. The financial pressure on you may not be so great, but you may know you could do better. This type of approach sees you taking a week or two to compare car insurance providers and make a switch to a cheaper supplier. You could halve the restaurant visits. Category by category, you can review and make adjustments to your spending.
You can mix it up. For example, when Covid-19 first hit, and with our jobs uncertain, Jonny and I got radical. All unnecessary spending stopped overnight! We maintained this minimum spending for a few months until life settled down. Now that life is back to normal, we still methodically check and review our monthly expenditures, making tweaks where necessary.
You get to choose your approach.
#TIP: If you have consumer debt, the radical approach will get you out of debt faster. A short, sharp, intense period of cutting costs and increasing income works wonders on resetting your brain and spending behaviours.
Lasting behavioural change.
When I sat down for the first time and collated this information, we spent a lot of money on a few glaring areas. Spending at the supermarket was number one. I worked out what percentage of our monthly pay was spent on food, and it ‘felt’ high to me, given our household income. I simply showed Jonny my math and explained, “We earned this much and spent this much at the supermarket. I don’t know about you, but this feels high; what are your thoughts?” We talked about it.
Collectively, we decided that instead of stopping at the supermarket almost every day, we would do one single weekly shop. We would commit to a monthly period where we wrote down what meals we would eat for the coming week, shopped using a list to get the right ingredients, and committed to making do if we forgot something. We agreed to try to reduce our grocery spend by $50 a week. We tried it for a month, and what do you know, it worked. We still shop this way today. But still, our spending and number of store visits creep back up. So, we relook at our numbers, look each other in the eye and commit to reigning ourselves back in. Again.
For each category, we calmly discussed what we had been spending and agreed on a way forward. If there was obvious wasteful spending, we decided to stop it right now - radical immediately. For other expenditures, we were more methodical in reducing them, researching alternatives before deciding.
Your time is money.
Work out your after-tax hourly rate. Let’s say it’s $30. If you have calculated that you spent $1,000 eating out in one month, that equates to 33 hours of work to pay the restaurant or takeaway bills. Therefore, during the month, you worked a full eight-hour day on Monday, Tuesday, Wednesday, and Thursday and one hour on Friday just to pay that expense. Almost one whole week out of a four-week month, or a quarter of your time at work, was spent earning money to feed your face. Was it worth it? You get to decide.
What if your income fluctuates?
Not everyone, my household included, has the luxury of a fixed income. Every month is different in my whare, often by thousands of dollars. So, how can you budget if that’s you? By tracking our weekly and monthly expenses, we have worked out the minimum income we need to run our lives. We break every payment we make into a shorter time frame to reduce the shock of a large bill. For example, we pay our rates weekly, at $62 per week. Wherever we can, we make a weekly payment to a supplier or, as I’ll explain shortly, a weekly transfer of money into another bank account in readiness for paying a bigger bill. This way we know how much it costs to run our whare weekly and monthly. Any income above these basic expenses can then go towards extras, such as restaurant meals.
Once you have looked back, now you can plan.
Using three months of historical data and agreement on what you will cut spending on, you can plan ahead as to how much you expect to spend in the coming months.
For example, Jonny and I had been spending $1,250 monthly on groceries, and we agreed to cut that back to $1,000.
Although a good place to start, predicting the coming year for things like electricity is more challenging based on only three months of transactions. Find out the total yearly amount. It’s not unreasonable to expect that the following year you would spend a similar amount. So, if there is a category where you need a little more detail, go back and find it.
Sinking funds are magic money-saving machines.
Monthly budgeting is tricky if you have fluctuating bills. Our highest winter power bill was $300. In summer, our lowest was $110. We spent a total of $2,300 over one year. We can prepare for this fluctuating expense using Sinking Funds.
$2,300 divided by 52 weeks = $44 per week.
I opened a bank account, named it “Power”, and set up a rule that $44 is automatically transferred from my chequing account every Monday into this “Power” bank account. It quietly builds up. When my power account arrives, I set up a transfer of that amount into my chequing account for the day the bill is paid. Everything else is automated, besides transferring that monthly bill total back to my chequing account in readiness for payment.
These accounts iron out variable spending; you can use as many sinking funds as you like. And if your bank charges you fees for each account, it might be time to find a better bank.
WHY so many accounts? Doesn’t that just complicate things?
Having different bank accounts with names that give them an obvious purpose, such as power, school, car repairs, holidays, tax, etc, eliminates the need to constantly do math in your head. If you have one ‘catch-all’ bank account for bills, it’s easy to overlook one and come up short. I know because people tell me they do this all the time, and having one large pool of dosh means they don’t feel they have a clear purpose for any of it.
Think about it this way. If you were running a big company with multiple divisions, you would have specific amounts of money allocated to each division. It’s the same with your personal finances.
I say that budgeting gives me peace of mind and control of my pūtea. When I see a bank account specifically called “Holidays”, it gives me a mental boost to watch that account grow, bringing my much-anticipated break even closer. And the increasing balance lets me dream about the things we will get to do on holiday because I can see we have the money to do them. Similarly, if we’ve had a hectic week and fancy a night away somewhere, a quick look at this account tells me if we can afford to go or not.
#TIP: Don’t run your bank accounts too lean. A common phrase is that “your money needs to be working for you”, and people are keen to push more towards debt or investments to do this. Money sitting in your bank is NOT wasted. Having a decent amount of money in each of your bank accounts is ‘working for you’ because it reduces anxiety around running out. I advocate having a healthy buffer in your accounts, particularly your daily cheque account. As your wealth grows, the amount of money you have in your bank represents a smaller and smaller percentage of your overall net worth.
Planning ahead on where you will spend your money.
Using the monthly category totals you have calculated, find the average and plan out your coming months:
Category: Petrol
Oct 2023 - $460, Nov 2023 - $230, Dec 2023 - $550
Jan 2024 - $413, Feb 2024 - $413, Mar 2024 - $413
We spent $1,240 over three months - an average of $413 monthly. We can use this figure to plan the months ahead. The more data you gather, the better you will estimate future spending.
You also take this time to decide if this is excessive, OK, or could be lowered. What can you reduce this expense to if you need to? Could you make fewer trips, walk to work, carpool etc. Equally, if you know you have a road trip planned, you can plan for spending more.
Budgeting is about more than just the numbers on the paper. It’s more about what YOU will do about the numbers you see on the paper.
For each category, once you know what you have spent on average for a month and consider whether it’s too little, too much or perfect, you can plan the month ahead. Once that month has ended, go back and write where you spent all of your money. Now you have FOUR months of data, and this last month should reflect the changes to your spending habits.
Using manual systems to determine where you have previously been spending your money is helpful because you eyeball each transaction. But, in my experience, manual systems don’t work well beyond about the four-month mark. Most of us are simply too busy to come home from work and write down that the electricity bill was paid by direct debit last night. Good intentions soon fizzle out, and the careful eye you were keeping on your money wanders elsewhere.
But as a place to start, heck, yes, manual budgeting works! Simply because you get to feel each transaction as you write it down.
Don’t sweat the cents.
Budgeting down to the last cent is difficult, particularly when you have joint bank accounts with your spouse. There will be unexpected, yet necessary, expenses. Each individual will spend and earn as the weeks go by. That’s life. If you are desperate to track every cent, yet your partner, although careful with money and working towards shared goals, does not, then the more stringent budgeter needs to loosen up a bit. This is why I think having a $1,000 buffer in your chequing account that you try not to go below - but you are relaxed if it briefly does - is vital for taking the stress out of budgeting.
The next logical step is to use budgeting software.
The next step is to move to automated budgeting software that links to your bank accounts, for which you will pay a monthly subscription. Instead of manually entering every transaction, it does it all for you, reading your bank transactions and dropping them into categories that you have chosen. From there, you create budgets where you set spending limits/guidelines and can easily track your progress.
After trying several different apps (both free and paid), I prefer to use PocketSmith, a Dunedin-based but international budgeting software company. I think their “Foundation” plan is a good one to start with. I’ll regularly share images I take from my PocketSmith account on my blog because they convey my financial information so effectively.
Example of my Earning and Spending pinwheel in PocketSmith.
But had I just launched into using PocketSmith when I decided to start budgeting for the very first time, I probably wouldn’t have lasted the distance because it took me a few months to wrap my head around how it works. This is why I’m adamant that starting with pen, paper, mind map, or spreadsheet works best initially. You already know how they work, so no new skills are required, leaving you to concentrate entirely on your numbers.
A final yet crucial point for you to understand about budgeting is that we ALL do it differently; we are ALL looking for our data to tell us a unique story, and it takes us all a bit of time to find our groove.
You must find a system that works for you because budgeting must become a lifelong behaviour, not a chore. I go to PocketSmith every couple of days to check things are ticking along as per my plans.
Because I’d spent time manually categorising our expenses, I developed a plan for what information I was looking for, and I could transfer that into PocketSmith and build upon it. Each person I speak with uses it in a slightly different way, but that’s the beauty of it. I believe you can bend it to your will.
Using a budgeting app gives you a straightforward way to look at your spending and earnings, and it's an incredibly effective tool to help you reach saving and spending goals (of your design). It links to your bank accounts, meaning the information is always accurate, but when you need to move money around, you still need to go to your online banking to do this. PocketSmith can only ‘read’ what's in your bank accounts, not touch your money. Either on my desktop or phone, I can check how our month is tracking and whether we need to tighten our spending, increase our income, or celebrate that we have reached a goal.
Like any new skill, you have to give budgeting time to settle in, but once it does, and once you gain an understanding of where your money comes from and goes to, you stop looking behind you, and you start planning ahead. When you budget, the longer you budget, the more you will feel in control of your money.
The goal is to spend less than you earn every single month. This creates the gap needed to put more money towards debt or investments and is how you grow your net worth over time.
Next time, I’m going to talk about Emergency Funds.
