I hope you’re feeling good and motivated to conquer the next step. As I mentioned last week, you’ve gotten the hardest part out of the way. You’ve found your pain and established some solid goals. You’ve also taken the critical steps of identifying your available cash flow and your net worth.
This week we start bringing everything together to help you create a spending plan to achieve your financial goals.
Keep in mind that this plan is just the beginning. As you take action steps and get more involved in your process, you’ll gain more clarity on your goals, desires and wishes. With the foundation that we’ve already created, you will have the information and tools that you need to make smart and principled changes.
Enough of this week’s pep talk. Shall we?
Analyzing Your Information
Last week you calculated your figures and let them sit. Now it’s time to analyze the info.
We’ll start with the cash-flow statement. What do you see? Are you currently meeting your expenses or are you in the negative every month?
Ironically, what I hear most often is, “there’s no way that I have that much left over each month.” If this is your response, you should do a couple of things.
First, go back over your expenses to make sure that you included everything. You may need to expand your analysis to six or 12 months in order to capture annual or semi-annual expenses like insurance premiums or tax payments, or sporadic costs like gifts, vacations or doctor’s visits that might not have shown up in your three-month analysis.
If you feel that everything is accurate, the second thing that you can do is find all of your cash withdrawals. You may find a lot cash that wasn’t accounted for. Keep that as its own category for now when creating your spending plan. In the future, you may want to spend less in cash to get more accurate information or figure out a way to keep track of what you spend the cash on.
Whatever gap that exists between what you see on the page and what you feel, try to narrow it and fill in the blanks the best that you can. In the end, you may just have more money than you thought you did.
Repeat this same process with your balance sheet. What do you see? Are you better or worse off than you thought? Again, this is just a starting point. This information provides the foundation of what you will need to move forward.
Creating Your Spending Plan
You now know what you have to work with. You also established that you have specific expenditures that you want to prioritize (e.g., alleviating your acute pain, saving for your goals, etc.) Now it’s time to create your plan.
I know what you’re thinking. Here comes the “B” word. People hate the word “budget” because of its negative connotations of restriction and sacrifice.
To me, budgets actually provide the opposite. They give you the freedom to do what you want with your money and help you make smart, conscious money choices that align with the goals and priorities that you laid out in Step 1.
In that sense, budgets are really spending plans, which seems to be a term easier on the ears for most people. So I like to use that. Additionally, you can create a plan in a variety of ways that works best with your money personality. Below are three options that I’ve found useful.
1) Tracking Every Penny
My preferred method involves tracking every penny that I spend and monitoring to make sure my priorities are being met. I track in both Excel and Mint in order to create a check and balance system for myself and our joint spending. Plenty of online sources such as Mint, Quicken and You Need a Budget (YNAB) can do the tracking for you. (You just need to make sure items are categorized correctly.)
I don’t use this approach for restricting myself. In other words, I don’t say “I’ve hit my eating out dollar limit for the month, so I have to stop eating out.” That’s not how costs work. Some months you spend more on certain items and in other months less.
The point is to keep you aware of the averages and make sure that they are in line with your priorities and goals. If not, it may be time to adjust what you want to achieve and shift your spending in a way that matches those priorities. For instance, if you find yourself enjoying eating out, continue to do that and reduce your clothing spending.
2) The Balanced Money Formula
If tracking every penny (or close to every penny) doesn’t strike your fancy, and you’d like more concrete percentages, I recommend using Elizabeth Warren and Amelia Warren Tyagi’s Balanced Money Formula, also known as the 50-30-20 budget. This approach divides your net income into the following categories:
- 50 percent for needs: These include expenses you have to pay every month – rent/mortgage, groceries, utilities, insurance, minimum payments on credit cards, etc.
- 30 percent for wants: These types of expenses are what you treat yourself to – dinning out, bars, movies, etc. Sometimes expenses in the same category may fall on separate sides of the need/want continuum. For example, you need milk, but you want Oreos. While both are groceries, one provides much less of a benefit than the other (and yes I’m talking about the Oreos).
- 20 percent for savings and debt: Lastly you have to save and pay your debt, like your student loans or credit cards.
I like that this approach provides prescriptive percentages but still allows you the flexibility to determine what you spend within each category. I can’t say this enough: your spending should focus on YOUR goals and priorities, not prescribed amounts.
My only reservation for this plan is that people with serious amounts of debt, like many of my lawyer and doctor friends with massive student loans, may need to allot more than 20% their income to service that debt and still save for retirement. If that’s the case, you will have to adjust the percentages of the other categories to meet your goals.
3) The Bucket Budget
If complete tracking or even general spending plans aren’t for you, I suggest using The Bucket Budget. This approach is similar the Balanced Money Formula, although once your necessary expenses and savings buckets are full, you can spend the rest on whatever you want, without keeping track. This is Ben’s favorite budget, and I wrote about it in detail here. You can base the necessary and savings buckets on the information you found in your cash-flow analysis.
Whichever method you choose, make sure to take an approach that best fits your lifestyle and temperament. The best spending plan is one that you can stick to.
Start with The Major Priorities
As you develop your spending plan, I want you to keep a few fundamental priorities in mind before you resolve your pain or start working on your goals.
- Save for Emergencies – You’ve likely heard the importance of having 3-6 months of your net income in an emergency fund. Emergency funds are critical so unexpected expenses don’t throw off your spending strategy. You may not have that amount of cash set aside (you’ll be able to tell by your balance sheet), so I suggest keeping a month of your net salary in your checking account as an initial buffer. Then build up your emergency fund to three to six months in an online savings account, as a part of your preferred spending plan.
- Pay Off High-Interest Debt – High-interest debt can easily derail a spending plan. Pay off this debt as soon as possible. It’s likely part of your acute pain that you’re trying to get rid of anyway. Make sure any unused portion of your income gets put there.
- Start Saving for Retirement, Especially With a Company Retirement Match –We are all becoming more responsible for our financial well being in retirement. As such, you need to get started saving for those years as early as possible to give you the best chance at success. Although I’m not a huge fan of prescribed percentages, I do believe in saving 10-20% of your net income (i.e., take-home pay). You should also take advantage of any employer retirement match, as that’s free money.
That’s it for this week. Only two more lessons and you’ll have a strong financial foundation to build your future success. Next week, I’ll provide a checklist on fundamental information and documents that you need to have to complete your foundation in specific financial planning areas. See you then!