Budgeting is not a word that is looked upon fondly. It implies restrictions, cutbacks and frugality (not that frugality is a bad thing). What many people don’t understand is that budgeting doesn’t have to mean these things. In reality, budgeting is just a tool we use to manage our money.
What is a Budget?
As we do with many things, we will start with a definition. The Oxford English Dictionary defines a budget as “an estimate of income and expenditure over a set period of time”. When we talk about a budget in terms of personal finance, we usually talk about a monthly budget. As most of us have monthly bills and get paid monthly, it makes sense to budget on a monthly basis.
As we can see from the above definition, a budget is comprised of two parts, income and expenditure. Anyone who is employed knows their income (more or less). It is the expenditure side most people struggle with. When creating a budget there are only three outcomes. As most people reading this will have a set salary, it makes sense to concentrate on the expenditure side of things.
- Your expenditure can be greater than your income resulting in a deficit.
- Your expenditure can be the same as your income resulting in no gain or loss.
- Your expenditure can be less than your income resulting in a surplus.
It’s not rocket science, you should be aiming to be in the third bracket.
In order to get a handle on your expenditure, I’ll give you my thoughts on what I count as an expenditure.
Expenditure is any expense incurred that isn’t savings or investments. This includes but is not limited to:
- Rent / mortgage
Expenditure can be paid for in one of two ways, cash or credit. Cash payments are made with money you currently have (actual cash, debit card etc.). Credit payments are made with borrowed money (credit card, loan etc.).
Cash or Credit
So should you cover your expenditure with cash or credit? As with most things in personal finance, it depends. I avoid credit as much as possible and try to stay debt-free. I don’t have a credit card and the only credit I have is a mortgage and a car payment (working on eliminating the car payment, it was a necessary evil). This approach won’t suit everyone.
Credit cards can be a useful tool in your personal finance toolbox, but only if you are paying off the bill in full every month. Carrying a balance on a credit card is a sure-fire way to hinder your financial progress. We will cover credit cards in a separate post.
A lot of personal finance blogs will outline a huge plan for you to create a budget and stick to it. I’m going to try and keep things a bit simpler and provide some guidelines rather than hard rules. As I keep saying, personal finance is deeply personal. Find something that works for you and stick to it.
- Quantify: The first step to creating a budget is to get a handle on what you currently spend money on. This can be done manually in an excel spreadsheet, or you can track it using an app. The debit card I use (Revolut) automatically tracks my expenditure and allows me to view it on a monthly or weekly basis. Without knowing how much you spend on a monthly basis, it will be difficult to make any meaningful changes to your spending habits.
- Analyse: Now that you have a report of what you spend your money on, it’s time to analyse it to see if there is anywhere money is being wasted. At this point, it is a good idea to separate your expenditure out into “needs” and “wants”. Ultimately, it will be up to you to decide what is a need versus a want, but by categorising them you should be able to cut down on the wants column if needed. (Helpful hint, you should class savings or investments as a need).
- Plan: This is the point where you take note of your planned incomings (salary, dividends etc.) and outgoings (bills, rent, savings etc.). Once you have noted your “needs” you can allocate the remainder to your “want” spending section. If you feel like you can cut this section down, it’s a good idea to automatically allocate that excess money to savings or investments.
- Monitor: As you progress with your budgeting, certain things will become apparent. At the outset, you may have deemed those three coffees a “need”, but when you see the amount you spend on it each month you may change your priorities. Alternatively, you may notice that you are struggling to afford things at the end of the month. Perhaps you have been a bit aggressive when allocating money to investments and you need to reconsider. The point is, your budget should be fluid and should respond to your situation.
Do not budget to within an inch of your life. It is important to ensure you have enough free cash to cover unforeseen expenses. It would be counter-productive to allocate 100% of your incomings for the month, any surprise bill will leave you in the hole. What I like to do, is to allocate a certain amount to the non-negotiable “needs” (including savings/investments) that I am comfortable with. If, at the end of the month, I have money left over that wasn’t used by “wants”, I’ll deposit this into the savings or investment account.
If I have excess money left over for a few months in a row, I’ll allocate a portion of that to next months automatic savings. For example, if at the end of June, July and August I have €200 left over, for September I will increase my automatic savings or investments by €100. Notice I’m not allocating the full amount for the reasons outlined above.
Do not be discouraged if you fail with your first few attempts at creating s budget and sticking to it. As with anything worthwhile, it takes practice and repetition to become proficient. As you become comfortable, try to cut down your “wants” and put the extra money to work through investments.
I will leave you with a quote from the Stoic philosopher Epictetus.
“Wealth consists not in having great possessions, but in having few wants.”
The more you can cut down on your “wants”, the wealthier you will be.
The Stoic Trader