If I had a formula for bypassing trouble, I would not pass it round. Trouble creates a capacity to handle it. I don’t embrace trouble; that’s as bad as treating it as an enemy. But I do say meet it as a friend, for you’ll see a  lot of it and had better be on speaking terms with it.

~ Olliver Wendell Holmes

Update: Thanks to My Dollar Plan for including this article in the Carnival of Personal Finance #256 : Market Crash Edition.

If your income is commission-based or you are self-employed, you may find budgeting to be more of a challenge. We have lived on various types of irregular income for the past 10 years or so. It’s tempting to avoid budgeting altogether since you really don’t know what your income might be from one month or year to the next. How are you supposed to plan anything?

While unpredictable income can be frustratingly difficult to plan for, it’s critical that we take the time to budget. In fact, I’ve found that I’ve gotten a lot better at budgeting since our income became less certain. In many ways, keeping a conservative hand on the controls during some really good years has helped us weather the turbulence of the past 2 years.

Income Statement vs. Cash Flow Statement

Most people who receive a salary or have an otherwise regular income can basically use their income statement (a listing of income vs. expenses) as a basis for their budget. Those with irregular income, however, need to be a lot more concerned with cash flow. The cash flow statement details how and more importantly, when cash flows into and out of a business (in this case your household).

Whether you’re income is 100% commission or self-employment revenue or is based on a salary of some sort plus commission or bonuses, you need to pay strict attention to cash flow and budgeting. In many ways, you’re going to follow the same sound budgeting principles as everyone else, but in a sense, these rules are magnified for you. You still need to know where all of your money is going in order to make sure it’s only going toward the things you value the most. It goes without saying that your budget must balance. Spending more than you take in is unsustainable and will deliver nasty consequences down the road.

10 Strategies for a Variable Income Budget

1. Average Income: This is the most common strategy I’ve read about. Here, you catalogue your expenses as you would for any other budget. To get your income figure, you estimate your net income for the year and divide it by 12. This works fine for people who can come up with a ballpark figure for their income. That’s not always the case for those of us with truly irregular income. It pays to be conservative with your estimates and live well below your estimated means.

2. Issue a Pay Cheque to Yourself: This is a strategy that Lynnae at Being Frugal has written about. When you receive money from your employer or clients, place it in a savings account. Monthly or twice a month, transfer a specified amount to your chequing account (less any money allotted for savings) and use that to pay your bills. This will help you feel a little more “normal” and organized as you manage your finances. It may also keep you from spending every penny that comes your way.

3. Gail’s Budget System: By coincidence, Gail Vaz-Oxlade posted on this very topic yesterday. She had some great advice on what to do When Your Income Fluctuates. Her approach emphasizes breaking your spending into 4 groups: variable and fixed must-haves, and variable and fixed nice-to-haves. (Another great approach is Warren & Tyagi’s Balanced Money Formula.)

4. Keep Your Expenses In Check: Since you have less control over what comes in, it’s even more important to have control over what goes out. Don’t let a few good months (or even years) lull you into thinking that you will continue to earn at that level forever. Bumps in the road can come when we least expect them and they can do a lot more damage if we don’t have really good shock absorbers.

5. Magnify Your Emergency Fund: This is another area where budgeting irregular income means implementing something everyone should have, but kicking it up a notch. Everyone should have an emergency fund of  at least $1000 or so for those unpredictable expenses. For someone with variable income, it should include at least 3- 6 months’ living expenses.

This can be your single best shock absorber and it can relieve the stress of a low- (or no-) income month or two – or more. If you are stressed out about being able to buy groceries and make your mortgage payment, you’re probably not going to be very effective at work. This can lead to a downward spiral and you don’t want to go there.

6. Have an Emergency Plan: This is a plan that should be in writing or stored on your computer with your budget worksheets that details your monthly expenses and denotes the ones that get the axe first if your income took a hit. Perhaps you’ll cancel your newspaper, downgrade your cable or cell phone package, or cut your dining out budget. It’s easier to think about these things when you’re not in crisis mode. If you’re prepared ahead of time, all you have to do is break the glass and put your plan into action. (By the way, making sure you are adequately covered in terms of life and disability insurance is an absolute must.)

7. Avoid Debt: Again, this is good advice for everyone, but it’s even more important for the income-challenged. Debt (contrary to what some seem to believe) constitutes a binding contract between a borrower and a lender. You don’t want to make commitments that you’re not sure you can keep. Keep your mortgage principle manageable, pay for your cars in cash, and never carry a credit card balance.

8. Establish an Alternate Income Stream: One way to offset the uncertainty of irregular income is to have a side income, even a very small one, from another source like a part time job, small business, or investment.

9. Keep Saving: This is an area where I have admittedly fallen down over the past year. When our income was reduced, I cut back on savings along with a lot of other expenses, telling myself that we had put a lot away recently and could afford to take a year off. Wrong, wrong, wrong 2 Cents.

Starting today, I’m going to set up a monthly transfer from our chequing to our savings account. It’s going to be a very small amount, but that doesn’t matter. It’s just there as a placeholder for a larger savings contribution in the future when things (hopefully) improve. The key is to establish a habit of saving and make sure that’s one of the categories into which you place some money when cash flow is heavier.

10. Frequent Budget Check-Ups: Make a point of re-evaluating your situation at least monthly, or whenever your income or expenses change materially. If you have the potential to make a very profitable sale, start thinking about how you will allocate that income – and please remember that some of it should go to savings. That way, when the cheque arrives, you’ll know exactly what to do with it and you’ll hopefully avoid using it as a slush fund. (But don’t be tempted to spend it before you actually have the cash on hand! )

Keep Your Balance Sheet Off Life Support

I don’t want to imply that you’re ill if you have a variable income, but it is sort of like having a manageable medical condition. If you follow the rules and take your budget’s pulse often, you should be able to live a very comfortable, healthy life. If, however, you cheat by over-estimating your income, under-estimating your expenses, piling up debt, or failing to save, you may find your balance sheet on life support.

Do you have any other tips for people living on irregular income?

Related posts:

1. Your Budget: 5 Factors That Will Determine What It Looks Like
2. How to Make a Budget: My 2 Cents
3. How to Make a Budget: Your One-Stop Shop

One half of knowing what you want is knowing what you must give up before you get it.

~ Sidney Howard

Update: This article was featured in the Carnival of Money Stories posted at Buxr as well as the Festival of Frugality #226 posted at Beating Broke. Thanks!

I’ve written often about the importance of tracking your income and spending. Whether you want to call that a budget or something else is up to you. Whether you want to track every penny or just have a really good set of spending boundaries is up to you too.

In fact, your whole life is up to you, and you have a choice and a lot of say in how it turns out. Suppose you’ve finally had it with living pay cheque to pay cheque. You’re tired of being out with friends and wondering whether that entrée you just ordered is going to cut into your rent or mortgage payment for the month. That new spring wardrobe you bought last month is still riding on your credit card at 19.75% interest. Ouch!

You’ve finally capitulated and decided it’s time to sit down and piece together your budget. Yes, now that you’ve gotten over the shock becoming your parents or your geriatric aunt or whatever other conformist, unhip stereotype you want to apply, you’re going to set up a spreadsheet or invest in some softwareor just get out your pencil and calculator. Now what?

Well, you could start by hitting the BJ category archives and reading about budgets. Or you could look at some of the great posts that Squawkfox has recently had on financial planning and budgeting. Lynnae at Being Frugal has some good budgeting posts in her archives as well. Either way, it comes down to a need to know how much money is coming in and how much is going out.

Doh!! . . . Our Budget Doesn’t Balance!

So you’ve done the math and . . . uh-oh. Your out number is bigger than your in number. I’m going to go out on a limb here and say that you’ve probably got some debt in there too that’s weighing you down. Given that you’re spending more than you’re earning, that number is certainly going to get bigger.

Now I’m not here to point fingers or scold anyone. The truth is, we’re in the same (sinking) boat right now. We’re spending more than we’re earning due to a recent (and rather dramatic) drop in our income level. We don’t have any debt other than our mortgage, but if we continue on our present course, we’ll need take some major evasive actions to avoid the debt trap.

What to Do If Income – Expenses = Negative Number

For us, this is a relatively recent development, so we have a savings cushion and we don’t have the pile of debt that would normally go along with a protracted budget deficit. But we are fully aware that we’re living on borrowed time. If we don’t do something to change the situation, we’ll soon be living on borrowed money too. While we would have plenty of company, that’s not a destination we’re prepared to visit – ever.

I would love to give you some clever post on 20 ways to balance your budget and still live like royalty, but that’s not realistic. In the real world, there are only 2 ways to balance any budget:

1. Decrease Spending: This is so much easier said than done. Do you mean I need to let my gym membership expire? Do I really have to cancel my magazine and newspaper subscriptions, stop eating at restaurants, pack a lunch and . . . gulp . . . give up my daily Timmie’s? Should I cut my cable bill and downgrade my cell phone package?

Well, not necessarily. But if any of the above are the only way to bring your spending in line with (and preferably below) your income, then yeah. You really need to think about what you are willing to give up in order to balance your budget.

We’ve recently made a few more budget cuts at my house, and while it’s not fun, it’s not the end of the world either. We once lived without these things quite comfortably and we can do it again. It’s still better than the alternative.

2. Increase Income: Again, this can be very difficult to do. But if you’ve made up your mind that change is necessary, then you’ve got to be open to doing what it takes to get where you want to go. Whether you decide to change jobs, take on a second job, start a side business, sell some of your possessions, or maximize your investment returns, increasing your income will definitely help. Just make sure you don’t increase your spending to go along with your new cash flow boost.

Ideally, it would be great to be able to do both. Perhaps increasing your income and cutting out a few budget items will allow you to keep some of those expenditures that you value the most. No one can make that choice for you. But if you are determined to balance your budget, you may need to make some pretty painful decisions.

A budget that doesn’t balance is not sustainable. That’s a mathematical fact. You can ignore it for a while, but the piper will eventually get paid. We would rather pay on our own terms rather than those that will inevitably be forced upon us at some point in the future.

I’m going to leave you with one more quote. It’s one of my all time favourites, so you’ll probably see it here again sometime.  I’ve seen it attributed to a Chinese proverb, Professor Irwin Corey, or “author unknown” in various forms. Given our current budget shortfall, it’s been much on our minds lately:

“If we don’t change direction soon, we’ll end up where we’re going.”

You are in charge of your life. If you’re headed in a direction you don’t care for, only you can change it. What are you willing to give up in order to get what you want or need?

Have you ever had to make tough choices? How did they turn out for you?

Related posts:

1. Your Budget: 5 Factors That Will Determine What It Looks Like
2. How to Make a Budget: My 2 Cents
3. Do You Need a Budget?

There is no one giant step that does it.  It’s a lot of little steps.

~ Peter A. Cohen

Update:  6 Remedies for a Debt Hangover is mentioned in today’s Money Hacks Carnival #100 @ The Ultimate Money Blog. Thanks Mrs. Money!

Over the past 2 years, I have had to rework our budget a half a dozen times or so, in addition to running various budget scenarios for potential job changes. So this stuff is pretty fresh for me. For what it’s worth, this post describes how I handle our budget. I don’t decide on percentage allocations up front. This might work for someone just starting out, but most of us have spending commitments that are well-entrenched. Rather, I start by looking at our net income and all of our expenses in detail.

Tools of the Trade

• Quicken: I use Quicken categories to track our income and expenses now, but I used to do it with a coil notebook, a pencil, and a calculator. The software also allows you to create a budget, track bank accounts, and plan savings.
• Paper, Pencils, & Calculator: I still use these tools a lot when I’m looking at various tax, savings or spending scenarios. I tend to organize my thoughts best on paper and with a pencil in my hand.
• Computer Spreadsheets: Even though Quicken provides numerous reporting options which I do use, I still use a computer spreadsheet to compose an overall annual look at our income and expenses. I just think it’s a bit more streamlined and it works for me.

What to Do With the Numbers

Once I get a picture of how our income and expenses compare, I go to work figuring out ways to:

A.  Make Sure We Are Spending Less Than We Earn

This is the whole point of budgeting. If our income minus expenses yield a negative number, something’s got to change. Debt is not an option. Spending is going to be cut somewhere.

B.  Make Sure That Income Is Going to the Places That Are Most Important to Us

• Look At the Big Stuff First: I usually try to organize the spreadsheet so that the largest annual expenses are at the top. I double check to make sure these expenses are as lean as I can make them. For example, I may go over our insurance coverage to make sure we are not paying for things we don’t need, that we are not paying finance charges for our payment frequency, and that our deductibles are maxed out. Groceries are always one of our largest expenses. I make sure to track (in Quicken) our spending habits, as our grocery expense trend has gone a bit parabolic (straight up) over the past couple of years. Those of you with sons in the 10 plus age range know what I’m talking about!
• Look At the Mortgage Payment: Can I increase the payment or payment frequency? We already pay weekly, so the latter is not an issue anymore. If you have read some of my previous posts, you know that I actually reduced our previously accelerated payments in order to balance the budget with our new income situation. If the mortgage is up for renewal in the coming year, I will start looking at various interest rate scenarios and their effects on our payment and budget. We hope to have the mortgage paid off before we need to renew it again in 2013.
• Look at Discretionary Spending: If I need to cut expenses, this is probably the first area on the chopping block. Our 3 largest discretionary expenses are probably dining out, music lessons & supplies, and “beverages”. For us, dining out rarely means going out. We usually order pizza or some finer food from a good restaurant for take-out. This way, we enjoy some nice food, I get a break from cooking, and we don’t pay for things like drinks that are marked up a ton in restaurants. Speaking of beverages, Mr. Cents and I enjoy sharing a bottle of red wine on the weekends. Rather than European or Southern Hemisphere vacations, this is how we splurge. Recently, we have been buying $10 rather than $16-$20 dollar bottles. (There really are some pretty good ones!) Our 2 older boys are very talented musicians (not that I’m biased ), so I would have to say that if cuts were made, beverages and dining out would get chopped before we ever touched the music lessons. (Incidentally, Mr. Cents gave up his music lessons so that the boys could continue theirs when the waters got rough last year.)
• How Much Are We Saving? To be honest, we may not save much of anything this year, depending on where our income is. In The Balanced Money Formula from All Your Worth, accelerated debt payments count as savings. We probably won’t be paying too much extra on the mortgage unless our income allows it. But we have no other debt, and we have saved quite a bit over the past couple of years, so we can afford to go lighter on the savings for this year until our income picture clears up. I recently wrote about Our 2010 Financial Plan, so I won’t repeat the details here.

How to Handle Cash?

We do tend to pay for most of our purchases with a single credit card to collect the points. We never carry a balance. We used to budget a certain amount each month for cash, and I usually wouldn’t track that money. Cash really can be difficult to track. But when things got tight last year, I decided to find a way to do it. I set up a “Cash Account” in Quicken where I track cash spent. It is a bit of a pain to enter every expense, but I was already entering most of them in Quicken anyway, and this really gives me a better picture of where we are spending our money.

We have begun to take out less cash lately and only use it for purchases that are really too small for credit or debit cards. So far it’s working out OK. It just makes a little extra work, but it’s worth it for the peace of mind it gives me.

Revisit & Adjust as Needed

Depending on how our cash flow is proceeding, I will usually look at the budget monthly and/or quarterly. I have a monthly budget report that I can review in Quicken. I also have a report that lets me know how we are doing on an annual basis. For example, I can tell whether the clothing I bought for the boys this month has put a serious ding in their annual budget, or just a scratch. We do put a lot of our expenses on our credit card, so if I’m noticing that cash is getting tight when it comes time to pay the bill, I know I need to look at the budget more closely.

It’s also important to update your budget whenever something in your financial picture changes. If you begin or cancel a subscription, change jobs, switch internet, insurance, or phone providers, or if your property taxes are adjusted, you’ll need to revise your budget. Similarly, if you needed to tap your emergency fund, you’ll need to budget in some savings to top it up again.

This is just one person’s approach to budgeting. It’s not for everyone. Do you have any good budgeting tips or tricks to share?

Related posts:

1. Your Budget: 5 Factors That Will Determine What It Looks Like
2. How to Make a Budget: Your One-Stop Shop
3. Do You Need a Budget?

The first step towards getting somewhere is to decide that you are not going to stay where you are.

~ John Pierpont Morgan (Yep, it’s that J.P. Morgan)

Update: This post is included in the Money Hacks Carnival #102 at Passive Income Now. It’s also in the carnival Personal Finance: Third Edition. Thanks!

A lot of people hate the idea of budgeting. They say it’s too constraining. They need more flexibility. I’m not going to lie to you and say I love working on the budget. But I do love it when it’s done. And I love it when an expense pops up and I don’t have to get stressed out about it because our emergency fund covers it. I love it when my kids ask for something and I can tell them definitively whether or not we can afford it and provide the figures to back it up. Setting up a budget gives you more flexibility, not less.

Gordon Pape, as many of you know, is a venerable and well-respected Canadian investment writer. We usually think of him doling out advice about mutual funds, asset allocation, and retirement planning. But in his book 6 Steps to 1 Million Dollars, he says that “everyone needs a budget”.  As we pointed out in Your Financial Hierarchy of Needs, it’s important to master the basics before you move on to higher goals. Mr. Pape offers a downloadable budget spreadsheet in Excel format on his website.

So how do you go about setting up a budget? I thought that rather than prescribing one no-fail budget method (there isn’t one), I would give you a tour of some of the different methods out there. You can choose one that’s right for you and your unique situation. Give yourself some options.

Starting any budget requires that you research yourself a little bit first. You need to know how much money is coming in and how much is going out on a monthly basis. I prefer to look at these items on a yearly basis as well, as it gives me a better sense of the big picture. For expense categories like clothing, dining out and even groceries, expenses may fluctuate quite a bit from month to month. I like to know that if I overspent on groceries because I stocked up on some good sale items, it will likely balance out with lower expenditures in other months. If it doesn’t, I need to look at the numbers again.

Budget by Percentages

Many budget plans will have you break down your net (after tax) income into various piles and allocate a fixed percentage to one area or another. Here are a few examples:

3-Step Budget by Andrew Tobias

I came across this one via Get Rich Slowly. It goes like this:

1. Destroy Your Credit Cards
2. Invest 20% of Your Earnings
3. Live On the Remaining 80%

This budget, while simple, is not for me. I like to use my credit cards for the convenience and the reward points, so I have no intention of destroying them. I pay the balance in full every month and I am able to control my spending, so overspending and spiraling into debt hasn’t been a problem. What I do like about the Tobias plan is that he follows the pay yourself first doctrine by cutting 20% of earnings off the top and telling us that we simply must find a way to live on the remaining 80%.

Warren & Tyagi’s Balanced Money Formula

I wrote about this in detail last week in my book review of All Your Worth. To recap, the formula is as follows:

1. 50% Must-Haves
2. 30% Wants
3. 20% Savings

This remains my personal favourite out of all of the budget plans presented here. I’m giving it a spin with our own finances this year. We’re not in balance yet, but I’ll keep you updated as the year goes on.

The 60% Solution by Richard Jenson

This budgeting method was originally presented by Mr. Jenson on MSN Money, but I found it (again) via Get Rich Slowly. It’s sort of similar to the other plans, but it breaks down spending further:

1. 60% Committed Expenses: regular bills, basic food and clothing, insurance premiums, charitable contributions, all taxes
2. 10% Retirement Savings: automatically deducted from pay
3. 10% Long Term Savings: discounted purchase of Microsoft stock (as an MSN employee), which can be converted to cash within days – He uses this as an emergency fund.
4. 10% Short Term Savings: He has this directly deposited into a savings account and uses it for irregular expenses like new appliances, repairs, vacations and gifts.
5. 10% Fun Money: This can be spent on anything your heart desires.

I like the fact that this budget works well for Mr. Jenson and his family, but the 10% divisions wouldn’t work that well for everyone. Further, most of us will obviously not be able to participate in the particular stock purchase plan to which he has access. Still, I think his point was simply to allocate some money for longer term savings or to an emergency fund. That could work for all of us. This is a great example of how, in money or in life, one size does not fit all.

Envelopes & Jars

There are a couple of systems out there that advocate a cash budgeting plan whereby you decide how much you will spend in a certain category and place that amount of cash into a jar or envelope that is labelled accordingly. Once the cash is gone, that’s it – no whipping out the credit card, no writing out just one more cheque, and no visiting the ATM. Gone is gone.

Envelopes

This is probably one of the oldest forms of budgeting and has been endorsed by numerous experts, grandmas and gurus over the ages, including Dave Ramsey. He also advocates a zero sum budget, where every dollar has a name and allocation, whether it’s for food, fun, debt repayment, or regular household expenses. If the budgeted amount goes up in one category, some other category must go down. If you get a raise, make sure you allocate it to the parts of your budget that really need it first.

Jars

This is the system used successfully by Canadian personal finance guru Gail Vaz-Oxlade. It works pretty much like the envelope system, but you use jars instead. Again, if this type of system works for you, use whatever you want for the cash containers. Gail has a great guide to building a budget on her site and she includes a useful interactive budget worksheet as well. I like her worksheet in particular because you can work with it online, play with the numbers, and print it out when you’re ready. You don’t need Excel, but she offers a downloadable Excel version too. I love choices!

Budgeting Software

There are lots of different types of budgeting software out there. Some run on your computer desktop and some are available over the internet. Many are tailored to American consumers and are not all that useful to Canadians. Many people use Microsoft Money, but I understand Microsoft is no longer supporting it. I haven’t tried out any of the online tools and I don’t know a whole lot about them, so I will just direct you to a great review of online budget tools by The Dough Roller.

I personally use Quicken Home and Businessalthough I have a Mac and I needed to get a special program for it to run Windows in order to use the software. Quicken for Mac is not available in Canada. I find this pretty frustrating, but I have used the program for years to track our income, expenses and taxes and it does the job for me. Still, if there is a better program out there for Macs, I would switch in a heartbeat.

Shop Away

Whether you’re a seasoned budgeting veteran or a rookie, I hope you found something you can use here. If you try out one method and you can’t make it work for you, go ahead and try another until you find one that fits. I was going to close by telling you how I go about working on our budget, but the post was getting too long. I’ll tell you about it tomorrow.

Did you find anything here that you hadn’t seen before? Do you have any other good stuff to add to our Budget Shop?

Related posts:

1. How to Make a Budget: My 2 Cents
2. Do You Need a Budget?
3. Your Budget: 5 Factors That Will Determine What It Looks Like

Success consists of going from failure to failure without loss of enthusiasm .

~ Winston Churchill

There is no single right way to make a budget. Like most other aspects of personal finance and life we just need to figure out how to make the one that works best for us. Usually, this will mean trying a bunch of different things before arriving at the one that suits us the most. The only thing that is certain is that we do need some type of budget. The key is not to give up after the first few tries. Persistence pays. Here are 5 factors to think about as you prepare your budget:

1.  Your Income Structure

The way in which money comes into your income statement is critical for planning cash flow. Here are some questions to ask yourself and some ways in which your answers might determine what your budget should look like:

a. Is Your Income Fixed or Variable?

• Fixed Income: Are you paid a fixed annual salary, or an hourly wage where your hours are more or less stable? If your income is fixed and predictable, budgeting will be easier, but a little less exciting. You know what’s coming in, so you know the maximum that can go out. But unless you have the potential to earn a bonus or other income, your budget will be pretty static, and you will need to make sure that any changes in spending don’t push your income statement into negative territory.
• Variable Income: Are you paid an hourly wage where your hours vary quite a bit? Are you self-employed or a commission sales employee? Do you own an incorporated business? Living on a variable income can be both scary and rewarding: you are always wondering what your actual income will be, but you at least have the possibility of earning more.  If you receive a base salary plus commission, try to live on the base salary if possible and save the commission. Alternatively, if your base salary doesn’t quite cover all of your expenses, but you earn a certain minimum amount of commission consistently, base your budget on an average year. To be safe, I usually count on less than average income, but have a plan for what to do with the extra cash if it does materialize. Also, keep in mind the tax consequences (and benefits) of a variable income and plan accordingly.

b.  Do You Operate on a Single Income, or Do You Have Multiple Streams of Income?

• Single Income: If you live on a single income because one partner is tending to the home front, you have more risk in your budget because a loss of one income means a loss of all income. At the same time, a stay at home parent can act as a human capital contingency plan as that person could get a job if necessary. (I realize that may or may not be feasible depending on your child care requirements, etc..) If you are living on a single income, it’s probably a good idea to concentrate first on building a larger emergency fund rather than plowing all of your savings into a retirement plan. Once you have a good 6 months’ living expenses saved, you can turn your attention to retirement savings.
• Multiple Income Streams: Are you part of a dual income household? Do you run a business or have investment income on the side? If so, you have a built in contingency plan in case one income stream is no longer available due to job or investment losses. This is only the case, however, if you are saving adequately. If you are spending all of your income, the safety buffer disappears. If you have alternate income from real estate or other investments, it’s a good idea to look at the risks associated with that particular income stream. If you have an investment property that is mortgaged, could you afford a spike in interest rates? If it’s a rental property, could you afford a period of months where you might not be able to find tenants? If you own stocks, could you stomach the type of losses that we saw last year? What about the possibility of dividend cuts?

c. How Stable Is Your Income?

Is your job pretty safe, or are you hearing downsizing and restructuring rumblings? Are you a seasonal employee who is laid off for a period of time each year? Are you at risk if the value of your investments goes down? I guess the events of the past 2 years have made all of us ask these questions. The more risk you perceive in your cash flow picture, the more your budget should contain a good cash buffer in the form of a large, liquid emergency fund.

2.  Your Spending Habits

How money exits your income statement is equally critical to your cash flow.

a.  Do You Have a Few Larger Expenses that You Need to Save For Throughout the Year?

For us, property taxes and insurance are 2 of our larger expenses (outside of the mortgage), and we need to save ahead for them in order to avoid a cash crunch. We pay our insurance only twice a year instead of monthly to avoid the financing surcharges that are often included in monthly insurance premiums. Christmas is another thing that we save for throughout the year. Take a look at your expenses and identify the big ones. Make sure your budget includes a savings schedule that will prevent you from taking on debt to cover these.

b.  Are You Spending More Than You Would Like in One or More Categories?

The only way to figure this out is to look at a detailed list of money coming in and money going out. If it doesn’t balance, it doesn’t work. Something will have to change. Maybe you’re not spending too much in general, but you would like to spend less in one area in order to have more to spend somewhere that’s more important to you. Do you want to travel more? Maybe you can cut back on your T.V. package or dining out expenses. It’s your choice.

3.  Your Use (or Not) of Credit & Debt

Whether or not, and to what degree, you are carrying liabilities on your balance sheet will determine how much of your budget will need to go to service that debt.

a.  Do You Use Credit as a Crutch or a Tool?

• Credit as a Crutch: If credit cards are your emergency fund and you are in the habit of tapping them regularly for wants rather than needs, your balance sheet won’t balance and your budget will increasingly incorporate debt service expenses rather than savings. This is a very risky spot to be in. If you find that you cannot resist whipping out the plastic every time you hear the siren call of the mall, leave the plastic at home and do some window shopping. Or stay out of the mall. For more tips, check out 6 Remedies for a Debt Hangover.
• Credit as a Tool: If you use credit cards as a tool for convenience or maybe reward points, and you pay them off every month, interest expenses will not be a part of your budget. But you do need to be extra careful about how much you are spending. I know some people put all of their bills and expenses on a single credit card and pay it in full every month. This almost acts as an expense tracking system on its own. Others find that when they use credit cards, they always spend more than they want to, so they rely on a cash system. Still others use a combination of both. It doesn’t really matter, so long as you are maintaining a balanced budget.

b.  Is Your Housing Liability Too Big for Your Income Assets?

• Have you, like so many others, bought more home than you can really afford? Have you, also like many others, suffered a big drop in income due to a job loss, job change, divorce, or illness? If so, the only real way to balance your budget might be to make the very painful choice to downsize your housing expenses. This might mean buying a smaller home, or temporarily renting while you repair your balance sheet.
• Your Interest Expense: What is the current interest rate and payment amount on your mortgage? When does it come up for renewal? In the current environment, it’s a good idea to look at the effect a rise in interest rates might have on your mortgage payments. (Check out some of the calculators on the bottom of the sidebar to play with the numbers.)
• If you rent, is your monthly payment manageable? If the rent on your beautiful new condo is causing your budget to get out of whack, you have 2 choices: you can cut expenses elsewhere, or you can move to a smaller beautiful condo or apartment.

4.  Your Tech Savvy

The actual physical incarnation of your personal budget will also depend on the degree to which you are comfortable with technology.

• Do you bank online, by telephone, or only at the branch? If you bank online, you can download, print, or view your transactions 24/7 and usually link them to a budgeting software like Quicken. If you don’t trust the security of the internet, you will likely need to set up a system for yourself where you regularly monitor and evaluate income and expenditures.
• Are you comfortable using a computer? If so, you can use budgeting software and/or spreadsheet programs to help you draw up your budget. Some websites even offer free budget software. If you’re not comfortable using a computer, all you need is a pencil, a calculator and some paper. It doesn’t really matter how you do it, just that you do it.

5.  Your Personality

This factor sort of intermingles with some of those mentioned above. You may be a hardwired spender or saver. You may embrace or shun technology. The key is to know yourself and play to your strengths. If the thought of figuring out how to use a computer gives you a rash, forget about it. Budget in a way that fits who you are.

Are You Organized and Detail-Oriented or Do You Prefer to Fly By the Seat of Your Pants?

The truth is, most of us will land somewhere in the middle of these 2 extremes.

• If you are more detail-oriented, your budget will likely include line items with the cents included. You may carry a notepad (spending diary) with you and track every penny you spend. You may look at your budget and spending patterns weekly rather than monthly or quarterly.
• If you like to go with the flow, you may have a basic idea of what’s coming in and going out and a pretty good idea of whether or not you can afford a given purchase. You may go ahead and buy that item, only to discover later that it puts your budget a bit out of balance. You make the necessary adjustments to pay for the item without incurring debt. Hard core budgeters may gasp, but I think this is OK – so long as you don’t go overboard and you have the discipline to take the pain in another category in order to afford your purchase.

Your budget will be as unique as you are. As long as you keep it balanced and allow for enough savings to enable you to eventually become financially independent, you really don’t need to worry too much about exact details. A budget is simply a tool you need to accomplish your short and longer term goals and manage your cash flow. Cash flow simply refers to the timing of income and expenses.

I hope this has given you some food for thought. Tomorrow, we’ll look at a some of the budgeting options and methodologies out there.

Do you use a budget? What do you find useful or frustrating about the process?

Related posts:

1. How to Make a Budget: My 2 Cents
2. How to Make a Budget: Your One-Stop Shop
3. Do You Need a Budget?

If you don’t know where you are going, you will probably end up somewhere else.

~ Lawrence J. Peter

Budget.  Just uttering the word can make people cringe, squirm, and head for the hills.  Even noted personal finance expert David Bachclaims that budgets don’t work.  Rather, he says that we should “toss out the budget and make it automatic” using his (I think originally David Chilton’s) pay yourself first principle. The idea is that you would decide to save, say 10% of your pay and just live on whatever is left over.

I have 2 issues here.  First, everybody needs some kind of budget. Second, even if you only pay yourself first, you are still practicing a form of budgeting, albeit a weak one.  Mr. Bach has some good ideas, but I have to disagree with him on this point.  Here are a few ways a budget – any kind of budget – can help you.

5 Reasons You Need a Budget

1. Knowing where you are is half way to getting where you want to be. If you have no idea how you’re currently spending your income, you can’t possibly improve your balance sheet.
2. Budgets are the “how” part of achieving financial goals. Knowing how much money is coming in and going out is key, not only to determining what our goals are, but to achieving them. A budget is a tool, a method, a means to an end.
3. Budgeting reduces stress. I know. Budgeting itself can be stressful, but that’s usually because we’re afraid of what we might find out when we look at our financial details. Once you know where you stand, you can spend money on dining out, travel, or whatever is important to you with the knowledge that you can afford it.
4. You control your money rather than your money controlling you. Knowing how we spend our hard-earned dollars allows us to cut back on things that are less important to us and redirect those funds to things that are more important to us.
5. A budget can be an early warning system. Having a budget keeps us on track by letting us know when we might be headed for financial trouble, large or small.  When I look at my budget, I sometimes notice bills I have forgotten to pay or financial priorities I have not yet included.  More importantly, it can help you avoid bigger problems like excessive debt and damage to your credit rating.

Does budgeting help you?  Can you add any more good reasons to budget?

Related posts:

1. How to Make a Budget: Your One-Stop Shop
2. Your Budget: 5 Factors That Will Determine What It Looks Like
3. How to Make a Budget: My 2 Cents