Personal Finance Basics, Part 2
Budgeting and spending
This is an ongoing series on personal finance and, if you haven’t done so, I’d recommend starting with the basic overview.
So we had the overview, then we had part 1 about how to track your spending. Hurray, now you know where your money’s going and you have a tool to monitor it. Congrats, that’s a big step.
Now it’s time to figure out what to do with this information.
The first basic principle is spend lass than you earn. Sounds simple enough, but for most people their money just sort of flows out without a lot of thought or intention behind it. The next step is making sure your spending is both A) reasonable based on your income and B) aligned with what you value in life. I’m not here to tell you that you can’t buy a latte if you want one, or that driving a nice car is inherently a bad decision - the point is that we all live in a world of finite financial resources and we want to make sure those resources are being used in a way that brings us the most happiness and satisfaction.
The first step here is figuring out your mandatory spending versus what you choose to spend on. Everyone has a fixed “floor” of money they need to spend in order to survive. You need somewhere to live, you need to eat, you need to pay utilities, etc. Now that you’re tracking your spending, you have an idea of how much you spend in each of these categories. You probably want at least 3 months worth of spending to have a good idea of how things normalize over time, and you can revisit every so often to see how those trends are changing. Let’s say that you add up your mandatory spending on things you absolutely need to purchase (housing, utilities, food, vehicle, whatever is mandatory to you) and it’s, I don’t know, $3,000/month and your income is $5,000/month.
That means you have $2,000 month of discretionary income. This is what you get to spend on what you want versus on what you need, and this is where you want to think about spending being in line with what you value and find important. Want to drive a fancy car? Want a latte every morning? You can do those things even though traditional personal finance advice might say that’s “not responsible.” Nobody should be able to tell you exactly what to buy or not to buy - as long as you’re living within your means, what you value is a personal choice.
However, there’s one catch. That $2,000 isn’t just “buy whatever you want” money. Or at least it shouldn’t be, because then you’ll still be broke and living paycheck to paycheck. That $2,000 is your money to spend on things that bring you joy but ALSO to save and invest for the future. So, you don’t just want to budget right up to $2k, spend it all, and think “hurray I’m doing so well with my finances,” because at some point some unexpected expense will pop up. The car will break down. You’ll have medical bills. Or maybe you’ll just want to take a vacation or splurge on a big gift for your significant other (extra expenses don’t always have to be something bad!).
So, how much should you save/invest? That’s a personal decision and it depends on your life circumstances and your goals. If you’re just out of college in your first job, you probably don’t have the income to invest a ton. If you’re planning to buy a house in the next couple of years, maybe you want to boost the savings to get your down payment together. I’m going to set aside the subject of longer-term investing for now and come back to it as it deserves its own article and just focus on shorter-term savings. What you want to have is some kind of emergency fund. This is what’s meant to handle the “oh no” situations - an unexpected expense or job loss.
Common wisdom is that you want to have somewhere from 6-12 months worth of expenses in your emergency fund. Exactly how much depends on your life. If you have a partner who works and you can get by on just their income for a while if needed, you need less. If you’re the sole provider for your household and you have children, you probably want more. The idea here is that you want to have savings on hand so that when life throws you a curveball, you can deal with it without going into debt. If you find yourself stressed out over money, this is one thing you can do to significantly relieve that stress - I promise. Just knowing “hey, if something happens it sucks, but I’ll be ok” is tremendously empowering. Stick that money in a high-yield savings account so it’s at least earning a bit of interest (you can use Bankrate to check for which banks are offering good yields, or just use Everbank - it’s easy and their yields are generally pretty competitive).
Ok, let’s see where we’re at. You’ve tracked your spending and you know where your money is going. You’ve separated it into needs (mandatory spending), wants (discretionary spending), and some amount for saving/investing. Congratulations, you’re now ahead of probably 80-90% of people. There’s just one more little detail.
You need to review this from time to time. Generally I like to do it once a month, and since I’ve been doing this for a while, it probably takes me about 5 minutes per month. In the beginning it might take you a bit longer, but I promise it gets super simple and easy after just a few cycles. The first part of the review is just to see how you’re doing. You planned on spending $800 on food - did you? Or did you spend more, or less? If you see a pattern here, you may need to either adjust the amount you plan to spend, or, make changes to the spending. Fortunately, your spending tracker makes it super easy to see this since it shows you how much you’re spending in each category each month.
The other thing to review is your intentions. Let’s say you’re spending $800 on food…but how do you feel about that decision? Remember, we’re trying to be more intentional with our money and not just let it bleed out by accident. Do you like how you’ve been eating on that budget? Do you feel like you really wish you had a bit of extra money to put somewhere else, and think you could cut back the food budget without it feeling like a big sacrifice? Cool, try it out and see how it feels. Or maybe you really enjoy high-quality food and want to increase the food budget so you can buy more avocado toast and steak. That’s cool too - go for it, bump it up and see how that feels.
All of this is a bit of work to set up. You’ll need to commit to it. But once you’ve been doing it for a couple of iterations, it shouldn’t take more than just a few minutes per month. Like I keep saying: the point of this is to be easy. It’s to make money and finances less stressful and empower you by giving you more information and helping you make decisions with knowledge and intention.
Now go forth and budget.