Part 3 - Budgeting

"A budget tells us what we can't afford, but it doesn't keep us from buying it." ~William Feather

Welcome to Part 3 of Investing For Young Adults. If you haven't read Parts 1 & 2, you may find it helpful to do so before tackling this topic. Please leave any comments or suggestions at the bottom of each post or send me an email via the contact form. Thanks!

In this post, we're going to talk about budgeting as a young adult. We'll cover what it can do for you, what the different methods of budgeting are, and some tips and tricks to get you started in the right direction.

What a budget can do for you
I would be lying if I said that this is going to be fun. Budgeting is a necessary evil. A very necessary evil. It's really the only way to get (and keep) your spending under control. Even if you become a millionaire, you should still stick to a budget.

For years I avoided setting up a budget and sticking to it. I usually had a rough idea of how much money was in my account and I made decisions on whether to buy something or not based on that rough figure. The problem was that I often wasn't thinking about all the upcoming expenses, nor was I aware of how much I spent on different categories. After several years of paying ridiculous overdraft fees, I finally decided that I was going to solve this problem once and for all and I started budgeting. I tried a few methods until I found the one that works for me. The difference in my financial peace and control is striking. More than anything else, including making more money, budgeting has completely revolutionized my financial life.

Before I started budgeting, I hated seeing bills come in the mail, because I never was sure if I'd have the money to pay them on time. Every single purchase I made carried a little bit of guilt, because I never knew if I was overspending and if this money should be earmarked for rent or the electric bill. When multiple overdraft fees of $30 each would hit my account, I would be overwhelmed with frustration and anger.

Now that I budget, I hardly even notice when bills arrive. Paying bills doesn't bother me, and spending $20 for a book doesn't worry me at all if I know that I have the money left in that category. I haven't had a single overdraft charge since I started budgeting. I feel more in control and at peace about my finances. And best of all, I now have money to save and invest for the future. I no longer plan on just saving whatever is left at the end of the month, usually nothing. I now include savings and investments as a part of my budget and pay it each month just as if it were another bill.

You will find it difficult or impossible to reach your financial goals if you do not implement some kind of budget. Saving for retirement, kids college funds, vacation, a down-payment on a house, etc. just can't be managed well without a budget, in 99% of cases. If you're one of those 1% out there who doesn't have a budget and thinks you're doing just fine, I encourage you to give budgeting a try for a few months. You may indeed be doing ok without a budget, but you'll likely do far better with one.

What a budget is not
It's not helpful to think of a budget as a financial diet. It's simply a tracking tool that lets you measure your monthly spending against your planned spending for that month to ensure that you don't spend more than you should in a certain category. If you plan on spending $200 for groceries this month, a budget helps you make sure that you don't spend more than that $200.

Methods of budgeting
There are several methods of budgeting that different people find works best for them. You should evaluate each one and determine what might work best in your particular case. Budgeting can be split into two different activities: building your spending plan and tracking your income and expenses. All three of the methods utilize these activities; only their implementation differs.

Paper budgeting
This is the bare-bones version of budgeting: just you and a piece of paper. The first thing you'll need to do is setup your spending plan. In the simplest variation, you write your income at the top of a sheet of paper and list your expense categories (groceries, insurance, savings, food, etc) below that. Next to each expense category, you write the monthly amount that you plan to spend in that category. Then you add all the expense amounts together and ensure that they match the income at the top of the page (meaning that the budget is balanced).

The difficult part with this budgeting method is tracking your expenses on a daily basis, since you'll need to record each transaction under the appropriate category and add it to the running total for that category to ensure that you're not overspending in that category. Depending on your volume of transactions each month, this can be difficult to keep up with.

Advantages

• Dead simple
• Free
• Portable

Disadvantages

• Can be a lot of work
• More room for calculation errors
• Difficult to track changes in spending month-to-month or year-to-year
• No way to export for tax purposes

Envelope budgeting
This method of budgeting starts with the paper spending plan, just like the paper budget above, but for tracking, you use cash in actual envelopes for each spending category. At the beginning of the month, you put cash in the envelopes to correspond with the spending plan for that category. For example, you have an envelope for groceries. On the first of the month, you put $250 into that envelope, or whatever your spending plan calls for. When you buy groceries, you take the money out of the grocery envelope. When the envelope is empty, that's it. It's very simple, but very effective, and you don't need to write down each transaction.

Advantages

• Simple
• Free
• Portable
• No calculations needed
• Physical separation of cash into categories

Disadvantages

• Carrying a lot of cash isn't advisable
• Paying for everything with cash is inconvenient
• Difficult to track changes in spending month-to-month or year-to-year
• No way to export for tax purposes

Software budgeting
Technology has improved many areas of our life, and budgeting is no exception. Budgeting software typically walks you through the creation of your spending plan and helps automate the tracking process. Most budgeting programs download your transactions daily from your bank and other financial institutions. Then you'll just need to assign those transactions to the appropriate categories. Budgeting with software can have a slightly steeper learning curve, but offers greater convenience and tracking capabilities.

Some of the most popular budgeting programs include:

• Mvelopes (very highly recommended)
• Microsoft Money
• Quicken
• You Need A Budget

Advantages

• Loads of features and functionality
• Track your income and spending in a variety of ways
• Automatically download transactions from your bank
• No manual calculations reduces chance for error
• Export information for tax purposes

Disadvantages

• Not free (pricing varies)
• Can be difficult to get started with
• Greater comfort with technology is required
• Not portable

Tips and tricks for getting started

Include your spouse in the process, if applicable
Adjusting to a budget can be difficult, especially at first. If you're married, you'll need the full cooperation of your spouse to make it work. The best way to minimize argument and tension over your budget is to make your spouse a part of the planning process, giving each person a voice in the decisions that are made.

Customize your categories
Part of the art of budgeting is determining what categories to include in your spending plan. You shouldn't necessarily use the default categories provided in any sample budgets or software packages. Determine the best categories for your particular situation. Also, you want to make your categories specific enough to be useful, but not so detailed that categorization becomes too tedious and cumbersome. As a general rule of thumb, if you have more than 20-25 spending categories, you may want to consider combining a few into more general categories.

Record your expenses for at least a couple days before starting
Get a notebook and write down every penny you spend for at least a few days to get an idea of where you spend your money now. This will give you a good baseline from which to construct your first spending plan.

Expect changes for the first couple months
When you first start budgeting, you probably will need to do it for a couple months to get a handle for where you actually spend money and what kinds of things you under-budgeted or over-budgeted for. This is natural and you shouldn't be discouraged by it. Just make sure that your budget still balances after each adjustment to your spending plan.

Be realistic
It may be tempting to put down $50 / month for food, but try and be realistic. It's probably a good idea to not stray too far from the numbers you came up while recording your spending, at least for the first spending plan. After the first month or two, you can look at ways to trim your budget and put more towards savings and investment.

Don't forget savings
Don't forget to budget for savings, just as if it were another bill you had to pay. If you're still paying off debts, that money will go towards your debt snowball until your debt is eliminated. By setting that money aside each month in your budget, you'll be more likely to follow through and meet your goals. Just as a rough guide, although everyone's situation is different, most people should budget to save at least 10% of their income. We'll cover investment targets in more detail in Part 4.
Task: setup a budget
If you don't have a budget, start by creating a spending plan on paper using the method described above. Then pick a budgeting method and get started with it right away. Don't get frustrated if things are difficult at first. Stick with it and you'll soon reap the benefits of greater financial control and peace in your life.

Don't forget to check back on Monday for Part 4: Investment Targets

Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.