Budgeting has negative connotations, but it can do wonders for your overall financial picture and it takes very little effort to create and maintain a budget. Think of a budget as simply a tool for organizing cash flows. You are, in essence, a CEO on a smaller scale who is taking steps to ensure your company's (or family's) cash flow is monitored each month. In this article, we'll cover five of the most commonly asked questions with regards to budgeting, and show you how it really is possible to save money, pay off debt and still enjoy life.
How Much Should I Set Aside for Investments?
- Your age will help determine not only your asset allocation (younger investors should have higher equity allocations than older ones) but also how much money should be put toward future goals like buying a home or retirement. Because younger individuals have lower wages, investors in their 20s or 30s can generally afford to put away smaller amounts than investors in their 50s with few retirement assets.
- Disposable income is independent of all your costs that need to be paid out in order to survive. You can spend it on toys or stash it away in savings. The amount of disposable income you have will determine how much fun you can have now, and how much fun you can plan for later in life.
- Liquidity means how fast you can convert your assets to cash. Your level of liquidity will generally determine what kind of interest rates you will receive or how fast you will be able to access your money. If you place your money in accounts that tax you for withdrawing money, or only let you make withdrawals after many years, then you have a very illiquid financial stance. How much personal liquidity you maintain is up to you, and should be decided before you invest.
Some good ways to begin saving for your future include employer-sponsored retirement accounts (e.g. 401(k)s) that allow you to use pre-tax dollars to fund your account. Many employers even offer to match up to a certain percentage of your annual income. If possible, you should always look to pay the maximum that is matched by the company. The employer match is basically free money, and the ability to fund with pre-tax income earns you a free return even before considering any investment returns.
Once an employer-sponsored plan has been maximized, any extra money that you can afford to put toward investments should go into fully funding an individual retirement account (IRA) for the current year. Retirement accounts for you or a spouse provide tax-free appreciation of your invested assets, a crucial component of long-term growth found in these funds.
While there is no magic dollar amount that defines how much should be saved or invested, 10% of your net income is a desirable target (but starting at 5% is still admirable). It is essential that any money set aside for investing should be free of any monthly or annual expenses. This should also only be considered if you have a "cushion account" or emergency fund that can be accessed quickly, like a savings account or Treasury bill.
How Much Should I Allocate to Debts Like Credit Cards or Car Loans?
Some of our debt, such as car financing, comes with specific repayment schedules; but rolling debt instruments like credit cards can generally be paid off according to one's ability to pay. The ruling maxim here is – don't allocate money to taxable investment accounts if you have existing credit card balances. Most credit cards charge between 5% and 30% interest annually, which often outpaces what the average investor can expect to earn from stocks, bonds or funds. It's much better to pay the credit cards off first and then begin budgeting some money for taxable investment accounts. Doing so will allow you to save on escalating interest expenses.
Some fixed-period loans will allow for overpayment, while others will not. You should evaluate the interest rate being paid to determine if paying a fixed debt off early is the right path. If you have existing credit card debt, chances are that this is costing you more in interest than an auto loan for example. In this case, you should still target paying off the credit card debt first.
Some creditors will give you different payment options if you simply contact them. You may find that you can have your monthly payment increased or otherwise adjusted to fit your budget. First make sure there are no prepayment penalties for retiring a specific debt early, as these could negate any savings you get on interest costs. If you have too many cards, or don't know which to pay off first, consider getting a consolidation loan to pay off all your cards and debts and make one manageable payment each month. If you go this route, remember – you must stop using your credit cards and stop attaining new loans until after you've paid off this consolidation loan.
Should I Overpay on My Mortgage?
Your mortgage is often the cheapest source of debt you have (assuming that it is a conventional mortgage and not subprime), but it could still make sense to overpay on your monthly payments. First and foremost, all of the higher interest debt that can be settled should be done so first, before considering this option. It's also good to have an emergency fund of two to three months of net income before deciding to overpay. Basically, any money that is considered for overpayment should be money that would otherwise go into a savings or investment account, meaning that all other budget categories are fully funded for the time being.
While it is possible to earn more on an investment than would be saved in mortgage interest, it does expose you to the increased risk of market fluctuations. Many people would rather pay a couple hundred extra dollars per month towards their (typically) largest source of debt than subject a small investment account to possible losses in the markets. The more favorable your interest rate is on your mortgage, the more the scales tip in the favor of keeping the extra money to invest instead. On the other hand, mortgage payments are generally tax-deductible; depending on your overall tax picture the extra deductions could save you more money year to year, making it worthwhile to overpay. You should consult an accountant or Certified Financial Planner® if your tax picture has a lot of moving parts each year.
How Should I Maintain and Update My Budget?
In the first few months, it's essential to review account statements regularly and see exactly how much you're spending and on what. These figures should be compared to the amount set up in your budget and any adjustments should be made to reflect the reality of your life. This is the best and easiest way for your budget to remain relevant in your financial life.
Inevitably you will come across "one time" expenses that you may wish to add up over the course of a year rather than per month. For example, let's say your refrigerator goes on the fritz and it costs $400 to make repairs. While this is a legitimate household maintenance expense, it wouldn't be accurate to add $400 to a section of your budget for household expenses or upkeep. It would be better to add these sporadic expenses to arrive at an annual figure for "home maintenance" or a similar category in your budget.
Remember, however, if you find that you've budgeted too harshly and have left little room for fun, you will not stick to this budget. If you find that you are covering bills, decreasing debt, filling your emergency fund and savings accounts, but just can't stand missing out on the latest movies or parties with friends, then you should re-evaluate your budget to reflect your new goals. If you don't keep your budget current to your needs, wants and future goals, you simply will abandon it for present pleasures. It's not rocket science, and you can have both.
Why Do I Always Have Expenses That Don't Fit into My Budget?
One reason why some people stop using a budget is because there are many expenses that don't seem to have a place in their budget. This is partly to be expected, and is easy to fix. Any good budget will have a "miscellaneous" category for all disparate expenses that come up in a given month or year. A target budget for miscellaneous expenses can be made by simply looking over purchases made over a few months time and calculating a simple average. What came up that had to be fixed, bought or borrowed? Would you be able to include those surprises in any of your other categories? If not, then add these miscellaneous costs to your budget to cover for the rest of the year.
The point is to decide which costs are fixed (not negotiable and must be paid each month) versus variable (which fluctuate depending on the month or your mood). Your rent, for example is fixed. Your gym membership, however fixed the rate is, can still be cut if you choose to quit, and is therefore variable. Once you figure out if the cost is fixed or variable, you've won half the battle to budgeting.
Sometimes the answer is a simple as re-evaluating your original budget for any missing categories or places where you might have underestimated how much should be budgeted. Gifts and travel should have their place in your budget, and entertainment expenses should include eating out and small impulse buys like magazines and snacks. Otherwise you'll always find yourself with expenses that don't have a home in your budget, and this could discourage you from sticking with the process. Over time you'll find that your budget more closely reflects your spending patterns, so long as you are honest with yourself about where the money goes.
The Bottom Line
Good budgeting may seem like a humbling or constricting endeavor, but it can actually be very freeing if approached with an open mind and with future goals in place. After all, the goal of any budget should be to maximize what can safely be spent on the things we want and need, while at the same time planning for a solid financial future. Following a good budget can lower debt, increase funding for investment accounts and reduce the overall stress that comes from not knowing how much money is needed from month to month.