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?