When I came to writing for this month’s topic on budgeting, I was at a lost at how I could explain how to do a budget while not being too repetitive of what is already out there. It is difficult because the steps of doing a budget may seem like common sense: list your income, expenses and savings for the year (where you income = expenses + savings). After you have prepared your budget for the year, you can break it down by month to track it better. The monthly budget it is usually the annual amount / 12 (except for items like annual insurance premiums and utilities that are higher in certain months). Pretty simple wouldn’t you say.

Then why do so many people struggle with a budget? Part of it is that a budget is full of pitfalls that sabotage our success. When we feel like we are not meeting our budget or spinning our wheels (taking too much time to do it or not saving any more money), we feel like giving up. The trick is not in how you do a budget, rather how to avoid the pitfalls of budgeting so you do not want to give up as soon as we start.

Some tricks that I use are:

1. Keep it simple

Unless you are totally engrossed in money, you probably do not want to spend more than an hour or two tracking your budget from month to month. In reality, it is probably closer to ½ hour max if you could do it.

That is why I use a simple Excel Spreadsheet to create an annual budget. Others use more sophisticated programs like Quicken or MS Money. What ever you feel comfortable with is the best tool for you to use.

The largest part of my budget process is setting it up for the year. This is where we make the general decisions on what we really want and on we set our financial path for the year.

On a monthly or quarterly basis, I usually just reconcile the amount actually saved (or borrowed) to the amount I projected to save to determine if there is a problem that I need to address. This saves me from having to input all my expenses into a program like Quicken which I am not patient enough to do. I spot check other categories to see if something else that stands out. Be honest, if you had $500 for your clothing allowance for a year, you know if you have spent $100 more or less than the total if you thought about it. At year end, I may do a more detail reconciliation on some of the larger items to see if there should be any adjustments for the upcoming year.

Other budgeting tools are:

CNN/Money website Tool (in Java)
CCH Financial Planning Toolkit

2. See it as a roadmap instead of a path set in stone

The biggest misconception on a budget is that you need to follow it to the letter. If I knew everything that was going to happen to my family during the year, I would use my talents to predict the stock market and be on a beach in the Bahamas instead. Budgeting is similar to a diet plan. Just as you would not plan everything that you eat for the year, you do not need to plan for every purchase. However you know how much meat, vegetables, fruit, grains and/or junk food you should have to stay healthy (per the food pyramid and general calorie counting). You know when you need to cut back, for example if you see your weight increasing (for budget purposes, the target is meeting your savings goal). You know when to say “I am done eating” on your own (for budgeting, you know when to say “no” in the store). Budgeting is more about increasing your awareness of what you are spending and how it affects your financial situation so that you can make better decisions.

For example, if you want that big screen TV, you know that you need to decide to either cut back on something else or work overtime to earn the eating money. It is just like eating a decadent dessert, you need to offset the calories or work it off. If you spend or eat unconsciously (without considering your alternatives), you are only asking for trouble. Yet, it doesn’t mean that you need to set everything in stone at the beginning of the year. Just by setting up budget at the beginning of the year, you become more aware of where your money is going and where to know where you can get into trouble.

Note, if you are in financial distress than you may need to pay more attention to your spending habits than I do. Just like dieting; if you are in trouble, you need to be a bit more regimented to get back on track. Yet, once you have a plan (or budget) that works for you, you can switch more to an automated pilot mode.

3. Don’t go crazy finding every penny when you are bleeding dollars

The saying goes if I can save $5 each day, then I can have $485,000 in 40 years (with 8% investment return)! Yet, do not be fooled. First, the $485,000 is only worth $123,000 after reflecting inflation (at 3.5%) which is still a lot of money yet probably not enough to retire on. Second, a lot of the advice focuses on the small things because that is the easiest place to cut after all the big ticket items are locked in such as car payments, mortgage payments and long-term contracts (such as repayment of credit card debts and cell phone contracts).

Sometimes the best thing to do is look at the bigger picture before getting locked into fixed payments. Even though you can not change everything immediately, you can set yourself up for better long-term success by looking at the larger pieces to your financial puzzle by seeing them on paper with a budget.

As a commenter (Tim) said yesterday, it is important to see the larger picture and plan for it. If you want to have children, set up your budget a few years in advance so that you have a spot for baby expenses instead of trying to cut out every penny to fit in. If your car payment just expired, do not fill it in with a something else putting you in a cost cutting mode a few years later when you need to buy a new car. It may be better to save for a new car when your car payment ends, so that you have a larger down payment when the need arises.

In looking at your mortgage, do not look at what the banks say you can afford. Rather look at what you can afford in your budget and retain some flexibility. My wife and I could have bought a house that was significantly more than we actually spent. However, we did not want to strain ourselves especially at a time when I went through a career change and our son was born and thus need to cut the little things that we enjoy.

For more see Don’t Give Up Your Latte.

4. Understand amortization of large expenses

Some people understand this via making their monthly car payments. Yet, we forget long-term that the things in our house need to be replaced that are not financed. For example, my laptop is on its last leg after buying it two years. So, I am about ready purchase a new computer that was not in my budget that I did just two months ago because I thought I could tweak another year out of it. Luckily, I planned for replacing household items (like the refrigerator, television, etc.) every few years to cover such things (which will cover the cost as long as the refrigerator makes it one more year). Do you factor in the cost of new purchases before they happen? For example, a computer every 3 years for laptops or 5 years for desktops, a refrigerator every 8-15 years, a new sofa every …. (you get the picture)? By planning this, you will see that a large replacement fund is needed to maintain your lifestyle. Better to plan for it then be caught mid-year with needing to find the money for a new computer or refrigerator and then being forced to borrow the money at a high interest rate.

5. Avoid being short sighted with repairs and upkeep

Many people do not think of this if they have not experienced a major repair bill on their car for the past two years. The question is how long will your luck hold on for? When will you need new tires? Are you going to need to have someone come out and repair your furnace when it does not start, one cold January morning? We typically underestimate what we need for these items because they either did not happen recently or if they did, we chalk it up to a one-time issue that will not happen this year. If you have a fund for repairs, it is not a crisis every time something happens. And, if you do not use your repair fund in a particular year, just keep it around because the next year (or year after) your luck may turn.

Many people treat repairs such as brakes for cars or new alternator as an emergency. Yet, it should be planned for. An emergency is something that happens out of the blue (e.g., loss of job or trip to the hospital for a heart attack), not for things that we know will happen because appliances, electronics and even furniture break down over time.

6. Have some flexibility with a cushion and/or discretionary fund

I rather have $1,000 extra at the end of the year by building in a cushion into my budget because I know budget is not perfect (for example, needing a new computer). We will forget an item in the budget or something will come up, so leave a little cushion for flexibility. Alternatively, you find yourself having a family sooner than expected or having a child coming back to live with you after college. It is easier to shift money around for new priorities if it is not already accounted for already in the budget.

Note, if you have extra money left over at the end of the year, you can always put it in your vacation fund, emergency fund or appliance fund for the next year. Use it as a treat rather than being $500 behind at year end stressing how to pay the credit card bill for presents bought in December.

You may also want a discretionary fund. Some spouses have $50 or $100 a month to spend as they want without having to go to the other spouse for approval. Again, we do not know everything that we may need or want at the beginning of the year, so allow so flexibility to adapt to how your year goes.

7. Don’t be fooled by thinking a want is a need

We tend to make wants into needs. I need a new car or I need to pay for my child’s activities. Many things that we have are wants which is fine. Yet, when we make wants into needs, we lose our control over the budget because a need is untouchable. And, if all our income is covering needs, we feel like we are struggling to stay afloat. So, look at your budget and see that you have more wants than you realize (e.g., the additional cost to live in a better part of town or a 3 bedroom apartment instead of 2 bedrooms).

8. Understand that arguments with your spouse about the budget have other issues attached with it as well (power, control, etc.).

They say that money is the number one cause of divorce. Yet, it is the issue underlying the arguments about money that is the cause of divorce. It is typical for one spouse to use his/her power and control in the budget process. If the couple is not aware of what is going on, they will fight over money instead of agreeing to share control over the budget. One of the worst things that a spouse can do is make demands on the other spouse in order to control their spending via a budget. If the decision on a budget is not shared, the spouse who is being controlled is just going to resent it and possible take revenge by blowing the budget.

For more see Couples & Money.

A budget is a process. It is never going to be perfect. Thus, rather than beat yourself up over mistakes and give up, learn from your mistakes and try to avoid making the same mistake again and again. The key part of a budget is not that you account for each penny that you spend rather that you change your thinking and your destructive behavior by identifying how you are spending your money.

This entry was posted on Wednesday, February 7th, 2007 at 5:36 pm and is filed under Budgeting. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.