Most people avoid creating a budget and fewer still stick to one. But it doesn't have to be painful.
If you're the type of person who always has plenty of cash, knows exactly where every penny goes, and never has trouble paying bills, skip this chapter. You're either too rich or too smart to need it.
For the rest of us, unfortunately, making - and sticking to - a budget is the essential tool for ensuring that our money gets used the way we need it to. Even if you're in the happy situation of having plenty of income, the homework involved in drawing up a budget can be instructive, since you may find that you are spending more than you wish on items like DVD's, electronic gadgetry, or restaurant meals.
Drawing up a budget is usually pure drudgery enlivened only by the reality of staring your foolish spending habits in the face. Why do you have a luxury sound system if neither you nor your spouse listens to it? In fact, one of the chief impediments to budgeting is that most people would rather not know how they really use their money.
It's bad enough to learn this kind of information on your own. It's even worse when a spouse or significant other finds out, since it usually confirms his or her worst fears - and provides new ammunition for future "discussions."
Take heart. Any spending mistakes you're making are probably common and not impossible to kick. Moreover, the bulk of budgeting's pains are at the beginning.
After you have a budget in place - and you've fine-tuned it with a couple of months of actual spending - tracking your expenditures becomes almost automatic.
If your boss at work were to ask you for an analysis of the department's spending, you'd figure it out quickly enough. Budgeting your household should be approached in the same businesslike fashion. A variety of electronic tools can make the process easier.
Showing posts with label Finances. Show all posts
Showing posts with label Finances. Show all posts
Small Ways to Save
1. Use cash. Instead of charging things to credit cards or debit cards, use cash for non-bill spending such as eating out, gas, groceries. Spending cash makes the spending more real, and there’s an added advantage of knowing when you’re out of cash, instead of spending more than you have.
2. Small weekly savings transfers. I decided that I could live with $40/week without really feeling it — it’s a relatively small transfer that I barely notice, and I save about $2,000 a year on top of my larger bi-weekly savings transfers.
3. Stay home. Going out makes you more likely to spend unnecessarily. You eat at restaurants, go to the mall, stop at the gas station for snacks. It’s hard to avoid spending when you’re on the road. Instead, stay home, and find free entertainment. It’s also a great way to bond with your family.
4. Don’t get catalogs. Or emailed announcements from companies trying to sell you stuff. Their announcements of sales or cool new products make it very tempting to buy something you don’t need. Instead, stop the catalogs and emails from ever getting to you in the first place, and you’ll spend less.
5. Keep a 30-day list. If you have an impulse to buy something you don’t absolutely need, put it on a 30-day list. You can’t buy anything but necessities — everything else goes on the list, with the date that it’s added to the list. When the 30 days are up, you can buy it — but most likely, the strong urge to buy it will be gone, and you can evaluate it more calmly.
6. Cook at home. I know, it seems more difficult than eating out. But it doesn’t have to be hard. Throw together a quick stir-fry with frozen veggies and either boneless chicken or (my favorite) tofu with soy sauce or tamari. Make home-made pizza with a ready-made crust, some sauce, cheese and veggies. Put some spices on something and throw it in the oven while you cook some brown rice. Not only is this much cheaper than eating out, but it’s healthier.
7. Exercise. Staying healthy is the best way to avoid costly medical bills later.
Use the envelope system. It’s the same idea as using cash for spending, but in addition you use envelopes to split your spending cash into categories. My non-bills categories are groceries, gas and miscellaneous spending. Three envelopes, and when they’re empty, I’ve spent my allotment.
8. Talk with your SO weekly. It’s important that you and your significant other be on the same page. You should have the same financial goals, and from there you should agree on a general spending plan and a policy for impulse buying that won’t have either of you wanting to choke the other. Make sure you both know what bills have been paid, what your balances are, etc. A weekly meeting of just 20 minutes accomplishes that. Communication is key.
9. The spreadsheet tracker hack. There are expensive programs like MS Money, Quicken, and the like that will do amazing things with your financial information. There are even free ones, on your desktop or online, that can do all kinds of things. Trouble is, I don’t need all that. All I want is a way to track my money easily, with no other bells and whistles, and a way to access that online so that I can view it from anywhere. The best way I found to do that is through Google Docs and Spreadsheets. I created a simple spreadsheet to track my bank accounts, that does everything I used to do with MS Money. It has the date of each transaction, the title and amount, a little field for memos, and a running balance. What more do I need? Keep it simple. Update: View a sample I put online here.
10. Pay savings and debt first. When you sit down to pay your bills (I do them all online), make the first bills you pay be your savings transfer and your debt payments. If not, if you pay them last … you’ll often end up shortchanging them. But if you pay them first, you’ll make sure you still pay your rent or mortgage, utilities, groceries and gas … so you’ll just cut back on other spending.
Exercise at home. Some of you will disagree with me on this, which is OK — everyone should do what works for them. But I’ve saved a lot of money that I used to spend on gyms by just running at the local track or on the roads in my neighborhood, and buying some simple weights and a chin-up bar. I do a lot of body-weight exercises (pushups, Hindu squats, lunges, pullups, dips, etc.) and I don’t need a gym for those things.
11. Cut out cable TV. I’m not saying I don’t watch TV — I watch DVDs, so that I’m sure that what I’m watching is something great, rather than the useless stuff you find on TV most of the time. And there’s a lot of it online for free if you look. Not a huge savings, but it adds up.
Declutter. By getting rid of all the excess stuff in your home, you not only make your life much simpler and more peaceful, but you make it harder to buy stuff that will just clutter things up again. Once you’ve simplified your home, you won’t want to go back.
12. Lend and borrow. Give books and clothes and toys you don’t need anymore to your friends and family. If you need something, send out an email asking if anyone has it. Chances are, they’ll give it to you for free if they don’t use it anymore.
Barter. It’s a lost art, but lots of people will take your services or goods instead of money, especially if you’re friends or at least know each other. Get into the habit of offering to barter, and you’ll find yourself saving a lot of money. My website design was done through the barter system, so I saved well over $1,000 there, for example.
13. Use online savings. I use Emigrant Direct, but IMG Online is also popular, as are a bunch of other online banks. Not only do you earn like twice the interest of a normal bank savings account, but if you don’t get the ATM account it’s not as easy to withdraw money … making it less likely that you’ll get money out on an impulse. Read more at Get Rich Slowly.
14. Try frugal gift-giving. Giving people gifts is one of the most wonderful traditions, as it shows generosity and caring. Until it becomes commercialized. Then it’s just really really expensive. Instead, try giving the gift of spending time with someone. Try giving them something you baked or made yourself. Try giving them services they’d appreciate. It doesn’t have to cost a lot to be generous.
Teach your kids about advertising, saving, earning, and gift-giving. If you have kids, educating them about money will save you a lot of money in the long run. If they know about how advertising influences them in tricky ways, they’ll be less likely to demand (OK, beg and plead for) the latest fad toys. If they know about saving and earning money, they’ll respect the money that you earn, and that you are trying to save. If they know that gift-giving doesn’t have to be about spending a lot of money (see above), they won’t necessarily want expensive stuff.
15. Find happiness in life, not spending. Many times people buy stuff because they think (subconsciously perhaps) that it will bring them happiness. They just HAVE to have the latest gadget or shoes or cars. It’s so fun! And yet, you buy that stuff, and you’re only happy for a day or two at most. Then you just need to buy more. It’s a never-ending cycle. Instead, learn to love life. Find joy in nature! In the people around you! In doing something you love! In exercise and meditation! There’s so much in life to make us happy, there’s no need to find it in spending.
2. Small weekly savings transfers. I decided that I could live with $40/week without really feeling it — it’s a relatively small transfer that I barely notice, and I save about $2,000 a year on top of my larger bi-weekly savings transfers.
3. Stay home. Going out makes you more likely to spend unnecessarily. You eat at restaurants, go to the mall, stop at the gas station for snacks. It’s hard to avoid spending when you’re on the road. Instead, stay home, and find free entertainment. It’s also a great way to bond with your family.
4. Don’t get catalogs. Or emailed announcements from companies trying to sell you stuff. Their announcements of sales or cool new products make it very tempting to buy something you don’t need. Instead, stop the catalogs and emails from ever getting to you in the first place, and you’ll spend less.
5. Keep a 30-day list. If you have an impulse to buy something you don’t absolutely need, put it on a 30-day list. You can’t buy anything but necessities — everything else goes on the list, with the date that it’s added to the list. When the 30 days are up, you can buy it — but most likely, the strong urge to buy it will be gone, and you can evaluate it more calmly.
6. Cook at home. I know, it seems more difficult than eating out. But it doesn’t have to be hard. Throw together a quick stir-fry with frozen veggies and either boneless chicken or (my favorite) tofu with soy sauce or tamari. Make home-made pizza with a ready-made crust, some sauce, cheese and veggies. Put some spices on something and throw it in the oven while you cook some brown rice. Not only is this much cheaper than eating out, but it’s healthier.
7. Exercise. Staying healthy is the best way to avoid costly medical bills later.
Use the envelope system. It’s the same idea as using cash for spending, but in addition you use envelopes to split your spending cash into categories. My non-bills categories are groceries, gas and miscellaneous spending. Three envelopes, and when they’re empty, I’ve spent my allotment.
8. Talk with your SO weekly. It’s important that you and your significant other be on the same page. You should have the same financial goals, and from there you should agree on a general spending plan and a policy for impulse buying that won’t have either of you wanting to choke the other. Make sure you both know what bills have been paid, what your balances are, etc. A weekly meeting of just 20 minutes accomplishes that. Communication is key.
9. The spreadsheet tracker hack. There are expensive programs like MS Money, Quicken, and the like that will do amazing things with your financial information. There are even free ones, on your desktop or online, that can do all kinds of things. Trouble is, I don’t need all that. All I want is a way to track my money easily, with no other bells and whistles, and a way to access that online so that I can view it from anywhere. The best way I found to do that is through Google Docs and Spreadsheets. I created a simple spreadsheet to track my bank accounts, that does everything I used to do with MS Money. It has the date of each transaction, the title and amount, a little field for memos, and a running balance. What more do I need? Keep it simple. Update: View a sample I put online here.
10. Pay savings and debt first. When you sit down to pay your bills (I do them all online), make the first bills you pay be your savings transfer and your debt payments. If not, if you pay them last … you’ll often end up shortchanging them. But if you pay them first, you’ll make sure you still pay your rent or mortgage, utilities, groceries and gas … so you’ll just cut back on other spending.
Exercise at home. Some of you will disagree with me on this, which is OK — everyone should do what works for them. But I’ve saved a lot of money that I used to spend on gyms by just running at the local track or on the roads in my neighborhood, and buying some simple weights and a chin-up bar. I do a lot of body-weight exercises (pushups, Hindu squats, lunges, pullups, dips, etc.) and I don’t need a gym for those things.
11. Cut out cable TV. I’m not saying I don’t watch TV — I watch DVDs, so that I’m sure that what I’m watching is something great, rather than the useless stuff you find on TV most of the time. And there’s a lot of it online for free if you look. Not a huge savings, but it adds up.
Declutter. By getting rid of all the excess stuff in your home, you not only make your life much simpler and more peaceful, but you make it harder to buy stuff that will just clutter things up again. Once you’ve simplified your home, you won’t want to go back.
12. Lend and borrow. Give books and clothes and toys you don’t need anymore to your friends and family. If you need something, send out an email asking if anyone has it. Chances are, they’ll give it to you for free if they don’t use it anymore.
Barter. It’s a lost art, but lots of people will take your services or goods instead of money, especially if you’re friends or at least know each other. Get into the habit of offering to barter, and you’ll find yourself saving a lot of money. My website design was done through the barter system, so I saved well over $1,000 there, for example.
13. Use online savings. I use Emigrant Direct, but IMG Online is also popular, as are a bunch of other online banks. Not only do you earn like twice the interest of a normal bank savings account, but if you don’t get the ATM account it’s not as easy to withdraw money … making it less likely that you’ll get money out on an impulse. Read more at Get Rich Slowly.
14. Try frugal gift-giving. Giving people gifts is one of the most wonderful traditions, as it shows generosity and caring. Until it becomes commercialized. Then it’s just really really expensive. Instead, try giving the gift of spending time with someone. Try giving them something you baked or made yourself. Try giving them services they’d appreciate. It doesn’t have to cost a lot to be generous.
Teach your kids about advertising, saving, earning, and gift-giving. If you have kids, educating them about money will save you a lot of money in the long run. If they know about how advertising influences them in tricky ways, they’ll be less likely to demand (OK, beg and plead for) the latest fad toys. If they know about saving and earning money, they’ll respect the money that you earn, and that you are trying to save. If they know that gift-giving doesn’t have to be about spending a lot of money (see above), they won’t necessarily want expensive stuff.
15. Find happiness in life, not spending. Many times people buy stuff because they think (subconsciously perhaps) that it will bring them happiness. They just HAVE to have the latest gadget or shoes or cars. It’s so fun! And yet, you buy that stuff, and you’re only happy for a day or two at most. Then you just need to buy more. It’s a never-ending cycle. Instead, learn to love life. Find joy in nature! In the people around you! In doing something you love! In exercise and meditation! There’s so much in life to make us happy, there’s no need to find it in spending.
Creating a Budget
Assess your monthly expenses.
Make a list of all of your regular monthly expenses, including any money that you spend on fun things like eating out, entertainment and hobbies; and any minimum payments that you have to make towards your debts. You can use a budget form for this purpose if it makes the job easier.
Total your earnings.
Calculate how much you make per month, including any money that you receive from investments and other forms of residual income.
Subtract expenses from earnings.
Test out the effectiveness of your budget by subtracting your monthly expenses from your earnings. This will show you how much you can expect to have left at the end of the month.
Rework your budget.
If your budget comes out on the negative side, rework it until your numbers crunch. To do this, go back over each expense, and look for places to make cuts.
Build in money for debt reduction.
If you have debts, your budget should already include the minimum payments that you have to make each month. Now you need to find the money to pay down those debts. Look at your numbers again, and determine where you are willing to make sacrifices to get out of debt.
Build in your savings and investments.
Now it’s time to budget money for your financial goals. Do you want to have an emergency fund? Retirement investments? Vacation savings? Make a list of what you hope to achieve, and then survey your budget once more to find the money that you need to reach those goals. If you have a lot of debt, you may need to skip this step for a while, and that’s okay—debt reduction should be priority one.
Put your budget to work.
Once you’ve created a budget that covers all of your monthly expenses and financial goals, it’s time to put your budget to the test. Try to live within your budget, and see how it feels.
Assess your budget.
At the end of each month, look over your expenditures to see if they are matching up to your budget. If they aren’t, determine if you need to work harder to stick to your spending plan; or if you need to rework your budget to reflect your actual spending.
Assess and assess again.
A frugal budget is never finished. Continue to look over your budget every month to catch areas of overspending. Then, crunch the numbers again until you’ve made it right.
Tips:
Be honest about your spending habits, and you’ll end up with a much more realistic budget.
Don’t forget to budget for fun; budgeting isn’t about total deprivation.
Don’t be afraid to change your budget; a good budget is always evolving.
Make a list of all of your regular monthly expenses, including any money that you spend on fun things like eating out, entertainment and hobbies; and any minimum payments that you have to make towards your debts. You can use a budget form for this purpose if it makes the job easier.
Total your earnings.
Calculate how much you make per month, including any money that you receive from investments and other forms of residual income.
Subtract expenses from earnings.
Test out the effectiveness of your budget by subtracting your monthly expenses from your earnings. This will show you how much you can expect to have left at the end of the month.
Rework your budget.
If your budget comes out on the negative side, rework it until your numbers crunch. To do this, go back over each expense, and look for places to make cuts.
Build in money for debt reduction.
If you have debts, your budget should already include the minimum payments that you have to make each month. Now you need to find the money to pay down those debts. Look at your numbers again, and determine where you are willing to make sacrifices to get out of debt.
Build in your savings and investments.
Now it’s time to budget money for your financial goals. Do you want to have an emergency fund? Retirement investments? Vacation savings? Make a list of what you hope to achieve, and then survey your budget once more to find the money that you need to reach those goals. If you have a lot of debt, you may need to skip this step for a while, and that’s okay—debt reduction should be priority one.
Put your budget to work.
Once you’ve created a budget that covers all of your monthly expenses and financial goals, it’s time to put your budget to the test. Try to live within your budget, and see how it feels.
Assess your budget.
At the end of each month, look over your expenditures to see if they are matching up to your budget. If they aren’t, determine if you need to work harder to stick to your spending plan; or if you need to rework your budget to reflect your actual spending.
Assess and assess again.
A frugal budget is never finished. Continue to look over your budget every month to catch areas of overspending. Then, crunch the numbers again until you’ve made it right.
Tips:
Be honest about your spending habits, and you’ll end up with a much more realistic budget.
Don’t forget to budget for fun; budgeting isn’t about total deprivation.
Don’t be afraid to change your budget; a good budget is always evolving.
Setting Priorities
Top things to know
1. Narrow your objectives.
You probably won't be able to achieve every financial goal you've ever dreamed of. So identify your goals clearly and why they matter to you, and decide which are most important. By concentrating your efforts, you have a better chance of achieving what matters most.
2. Focus first on the goals that matter.
To accomplish primary goals, you will often need to put desirable but less important ones on the back burner.
3. Be prepared for conflicts.
Even worthy goals often conflict with one another. When faced with such a conflict, you should ask yourself questions like: Will one of the conflicting goals benefit more people than the other? Which goal will cause the greater harm if it is deferred?
4. Put time on your side.
The most important ally you have in reaching your goals is time. Money stashed in interest-earning savings accounts or invested in stocks and bonds grows and compounds. The more time you have, the more chance you have of success. Your age is a big factor -- younger people (who have more time to build their nest egg) can invest differently than older ones.
5. Choose carefully.
In drawing up your list of goals, you should look for things that will help you feel financially secure, happy or fulfilled. Some of the items that wind up on such lists include building an emergency fund, getting out of debt, and paying kids' tuitions. Once you have your list together, you need to rank the items in order of importance.
6. Include family members.
If you have a spouse or significant other, make sure that person is part of the goal-setting process. Children, too, should have some say in goals that affect them.
7. Start now.
The longer you wait to identify and begin working toward your goals, the more difficulty you'll have reaching them.
8. Sweat the big stuff.
Once you have prioritized your list of goals, keep your spending on course. Whenever you make a large payment for anything ask yourself: "Is this taking me nearer to my primary goals -- or leading me further away from them?" If a big expense doesn't get you closer to your goals, try to defer or reduce it.
9. Don't sweat the small stuff.
Although this lesson encourages you to focus on big-ticket, long-range plans, most of life is lived in the here-and-now and most of what you spend will continue to be for daily expenses - including many that are simply for fun. That's okay - so long as your long-range needs are taken into consideration.
10. Be prepared for change.
Your needs and desires will change as you age, so you should probably reexamine your priorities at least every five years.
Identifying goals
You probably won't achieve every financial goal. But you can go farther than you think.
What are your top three financial objectives?
Most people, when asked that question, answer with general goals, such as achieving financial security.
The fact is, many of us haven't thought much about which financial objectives really matter most. Instead, we muddle through our financial lives, spending to meet the day-to-day expenses that dominate our attention.
That approach risks leaving your most important objectives unfulfilled.
That's what this lesson is all about: helping you identify the financial goals that matter most to you and making sure they happen.
That's not as easy as it sounds, since financial goals continually collide with one another. Paying for a child's braces may rob money that would otherwise go into his college fund, for example. And saving effectively for your kids' college can wipe out any hope of putting aside adequate money for your own retirement.
That's why to get what you want most you must 1) decide which goals will take priority and 2) work toward the lesser goals only after the really important ones are well provided for.
Fortunately, you have at least one ally in meeting your long-range goals: time. That's an advantage because of the power of compounding - the fact that even a small amount of money can earn interest, and that each year that interest gets applied to a growing sum of money.
Suppose, for example, you put aside only the cost of a single candy bar - about 65 cents - each day. Invested in a tax-deferred account paying 5 percent a year compounded monthly, that string of savings would grow to $3,073 in just 10 years and to $16,470 in 30 years.
For other examples of the way that money can grow over time, try CNNMoney.com's Savings Calculator.
To put the power of compounding on your side, you have to start early. Suppose there are two siblings who both invest in Individual Retirement Accounts earning 8 percent a year.
The sister starts at age 20, and for the next 10 years she stuffs $3,000 a year into her IRA. At age 30, though, she stops and never adds another penny.
Her brother waits until age 30 to get started, but then dutifully salts away $3,000 a year for the rest of his life. Which sibling do you think will be better off?
In this case, the early bird will always be ahead. The sister reaches age 65 with over $642,000, while her brother will have a little under $518,000 - about 20 percent less.
Of course, it's far better, to start early AND keep it up. If both siblings started saving $3,000 a year in an IRA at 20, and kept it up until retirement, each would end up with nearly $1.2 million.
The point is that to put time on your side, you need to decide early which of the many possible financial goals are really worth pursuing -- and start working toward them.
To get started, make a list of all the things that you'd need to feel secure, happy or fulfilled. These can range from the weighty (getting out of debt) to the luxurious (a Lamborghini). You don't need to prioritize them yet.
But you should try to put down all of the money-related things that will really get your motor started. And if you have a spouse or significant other, do this exercise together! Here are some common goals you may want to consider:
- Accumulating enough savings to handle an emergency situation
- Buying a house
- Getting out of debt -- and staying out
- Ensuring that your parents are comfortable and well taken care of in their old age
- Paying for your children's college education
- Amassing enough wealth to retire comfortably
Once you have your list in hand, push on to the next section where you'll determine which of these goals are most important to you.
Resolving conflicts
After you've clarified your priorities, what do you do with your new insight?
Each time you spend more than pocket change on a purchase that doesn't help you attain one of your chief goals, ask yourself whether the outlay is really necessary.
For example, let's say your highest priority is achieving financial independence. And let's say you've saved $4,000 to take the family on a vacation. If you take the trip, you'll be an additional $4,000 from kissing the time clock good-bye.
Of course, if your family has been expecting the trip for months, you'd be unfair to tell them that it's off. Instead, from the beginning you should have earmarked the cash for your investment portfolio and either planned a low-ticket vacation or worked a deal with family members to take the trip later.
Okay, you say, but that choice isn't terribly difficult. You're more concerned about tougher decisions -- choosing, for instance, among such priorities as health care, education, and savings.
All are important. How do you resolve conflicts among them? No single approach will work for everyone -- but here are some guidelines that help.
Is someone's health involved? If you believe that the ultimate purpose of money is to make life better, then you might decide that saving cash at the cost of your well being -- or of a relative's -- is a poor choice. For most people, someone's illness is the rainy day for which they've been saving.
How many people will be affected by my choice? Will one of your goals make your own life better while another will give equivalent help to two of your children? You could decide that when more people derive roughly equal benefit from a goal, its priority rises.
If two goals offer similar rewards, which causes the least harm? This method of selection is typically a last resort, but it can be useful when no other analysis helps you decide among options.
Most people, for example, have to decide between the kids' tuition and their own retirement savings. Well, if you know that you won't be able to live adequately on the money you expect from your pension and Social Security, then retirement savings should be paramount. As for the child in college, he can take out a tuition loan.
You can't put every nickel toward top priorities, of course -- nor should you. Instead, you need to set aside part of your income for current pleasures, so long as you have enough cash left over to put toward your long-range goals.
Also, remember that as the years go by, your priorities will change. You'll need to reexamine and rank your needs regularly in order to use your money most effectively.
When you can save a dollar, you need to decide why you're putting it away. In addition, if you acquire the habit of quickly rating the urgency of every big purchase against the primary financial goals you've set for yourself, you'll eventually find that your spending is under control.
Making Plans
Here are examples of plans you might draw up to meet three of the most common objectives: getting out of debt, paying for college, or financing your retirement:
Getting out of debt
If you struggle to meet credit-card payments every month, then face it: You probably need to shed or consolidate some of that debt.
For example, suppose you owe $3,000 in outstanding credit-card debt at a 16 percent interest rate and a $10,000 car loan at 9 percent. To pay off both these obligations in a year, you'd need to pony up $1,147 a month.
But if you are a home owner with equity in your property, you could borrow $13,000 on a home-equity loan at the same 9 percent and retire those other bills. Then your cost to pay off the home-equity loan in a year would be slightly lower - $1,137 a month - because you're no longer paying high credit-card rates of interest.
Moreover, because you can deduct the interest on most home-equity loans, you'd reduce your taxable income by $642 that year - a $212 saving for someone in the 33 percent federal tax bracket. In effect, the government would help pay off your expenses.
Of course, this kind of strategy works only if you also stop charging new items on your credit cards.
Paying for college
Tuition, room and board at a private college can cost upward of $30,000 a year, and that bill is projected to reach about $80,000 by the time this year's crop of newborns enter college.
Your children may qualify for financial aid either in the form of a scholarship or a loan, and many students work their way through college.
But if you want to spare your kids the burden of graduating in debt, there are a couple of good savings vehicles available to you. Most states now offer so-called 529 Plans - contributions go into in pre-selected mutual funds, grow tax-free each year, and withdrawals to pay tuition are also tax free.
You could also open a Coverdell Education Savings Account (previously called an Education IRA) that lets you put $2,000 a year, after taxes, into a bank account or other investments; earnings on that type of account are totally tax-free, provided the money is used for tuition when it's withdrawn.
It's amazing how far these plans will get you. For example, if you started putting $2,000 a year today into a Coverdell account earning 8 percent, after 18 years you'd have more than $80,000.
Financing a retirement
A popular rule of thumb says that retirees need only 70 percent of their pre-retirement income to maintain their lifestyle, since they no longer have to pay for such costs as commuting or for work clothes.
However, other costs go up in retirement, such as utility bills (if you're home all day), the price of hobbies and travel - and, of course, the cost of health care. In fact, some retirees find they need as much income in retirement as they spent while working.
Unfortunately, traditional pensions pay only a fraction of your salary, and Social Security won't make up the difference. In addition, the younger you are, the less certain you can be about how much money you'll receive at age 65 from any of the retirement plans you have today.
Why? Because Social Security benefits may be revised, and employers are free at any time to change their pension-plan formulas. (They can't do so retroactively - every retirement dollar that you've already qualified for is yours to keep.) Of course, Congress can change the laws governing retirement savings plans at any time.
Moreover, the bear market of the past few years has underscored the point that stocks can be extremely volatile in the short term, even if they remain among the most consistent performers over long periods. Thus, the stock portion of any retirement portfolio needs to take into account the possibility of sharp downturns.
To make your retirement finances secure, you need to contribute to as many different plans as possible. If you have a 401(k), 403(b), or 457 program at work, put in as much money as you can.
Most employers will match your contributions, giving you money for retirement that you won't get any other way. If you have no retirement plan at work, contribute to an IRA. Note that contributions to all of these plans are tax-deferred, so that you, Uncle Sam, and your boss together could be adding to your retirement stash.
Then to insure against possible new retirement-plan rules mandated by Congress, you need to have your own taxable savings plan as well -- ideally invested in stocks, bonds, or mutual funds, which can return more than bank accounts. Best of all, as your investing account grows, it can help you finance other goals.
1. Narrow your objectives.
You probably won't be able to achieve every financial goal you've ever dreamed of. So identify your goals clearly and why they matter to you, and decide which are most important. By concentrating your efforts, you have a better chance of achieving what matters most.
2. Focus first on the goals that matter.
To accomplish primary goals, you will often need to put desirable but less important ones on the back burner.
3. Be prepared for conflicts.
Even worthy goals often conflict with one another. When faced with such a conflict, you should ask yourself questions like: Will one of the conflicting goals benefit more people than the other? Which goal will cause the greater harm if it is deferred?
4. Put time on your side.
The most important ally you have in reaching your goals is time. Money stashed in interest-earning savings accounts or invested in stocks and bonds grows and compounds. The more time you have, the more chance you have of success. Your age is a big factor -- younger people (who have more time to build their nest egg) can invest differently than older ones.
5. Choose carefully.
In drawing up your list of goals, you should look for things that will help you feel financially secure, happy or fulfilled. Some of the items that wind up on such lists include building an emergency fund, getting out of debt, and paying kids' tuitions. Once you have your list together, you need to rank the items in order of importance.
6. Include family members.
If you have a spouse or significant other, make sure that person is part of the goal-setting process. Children, too, should have some say in goals that affect them.
7. Start now.
The longer you wait to identify and begin working toward your goals, the more difficulty you'll have reaching them.
8. Sweat the big stuff.
Once you have prioritized your list of goals, keep your spending on course. Whenever you make a large payment for anything ask yourself: "Is this taking me nearer to my primary goals -- or leading me further away from them?" If a big expense doesn't get you closer to your goals, try to defer or reduce it.
9. Don't sweat the small stuff.
Although this lesson encourages you to focus on big-ticket, long-range plans, most of life is lived in the here-and-now and most of what you spend will continue to be for daily expenses - including many that are simply for fun. That's okay - so long as your long-range needs are taken into consideration.
10. Be prepared for change.
Your needs and desires will change as you age, so you should probably reexamine your priorities at least every five years.
Identifying goals
You probably won't achieve every financial goal. But you can go farther than you think.
What are your top three financial objectives?
Most people, when asked that question, answer with general goals, such as achieving financial security.
The fact is, many of us haven't thought much about which financial objectives really matter most. Instead, we muddle through our financial lives, spending to meet the day-to-day expenses that dominate our attention.
That approach risks leaving your most important objectives unfulfilled.
That's what this lesson is all about: helping you identify the financial goals that matter most to you and making sure they happen.
That's not as easy as it sounds, since financial goals continually collide with one another. Paying for a child's braces may rob money that would otherwise go into his college fund, for example. And saving effectively for your kids' college can wipe out any hope of putting aside adequate money for your own retirement.
That's why to get what you want most you must 1) decide which goals will take priority and 2) work toward the lesser goals only after the really important ones are well provided for.
Fortunately, you have at least one ally in meeting your long-range goals: time. That's an advantage because of the power of compounding - the fact that even a small amount of money can earn interest, and that each year that interest gets applied to a growing sum of money.
Suppose, for example, you put aside only the cost of a single candy bar - about 65 cents - each day. Invested in a tax-deferred account paying 5 percent a year compounded monthly, that string of savings would grow to $3,073 in just 10 years and to $16,470 in 30 years.
For other examples of the way that money can grow over time, try CNNMoney.com's Savings Calculator.
To put the power of compounding on your side, you have to start early. Suppose there are two siblings who both invest in Individual Retirement Accounts earning 8 percent a year.
The sister starts at age 20, and for the next 10 years she stuffs $3,000 a year into her IRA. At age 30, though, she stops and never adds another penny.
Her brother waits until age 30 to get started, but then dutifully salts away $3,000 a year for the rest of his life. Which sibling do you think will be better off?
In this case, the early bird will always be ahead. The sister reaches age 65 with over $642,000, while her brother will have a little under $518,000 - about 20 percent less.
Of course, it's far better, to start early AND keep it up. If both siblings started saving $3,000 a year in an IRA at 20, and kept it up until retirement, each would end up with nearly $1.2 million.
The point is that to put time on your side, you need to decide early which of the many possible financial goals are really worth pursuing -- and start working toward them.
To get started, make a list of all the things that you'd need to feel secure, happy or fulfilled. These can range from the weighty (getting out of debt) to the luxurious (a Lamborghini). You don't need to prioritize them yet.
But you should try to put down all of the money-related things that will really get your motor started. And if you have a spouse or significant other, do this exercise together! Here are some common goals you may want to consider:
- Accumulating enough savings to handle an emergency situation
- Buying a house
- Getting out of debt -- and staying out
- Ensuring that your parents are comfortable and well taken care of in their old age
- Paying for your children's college education
- Amassing enough wealth to retire comfortably
Once you have your list in hand, push on to the next section where you'll determine which of these goals are most important to you.
Resolving conflicts
After you've clarified your priorities, what do you do with your new insight?
Each time you spend more than pocket change on a purchase that doesn't help you attain one of your chief goals, ask yourself whether the outlay is really necessary.
For example, let's say your highest priority is achieving financial independence. And let's say you've saved $4,000 to take the family on a vacation. If you take the trip, you'll be an additional $4,000 from kissing the time clock good-bye.
Of course, if your family has been expecting the trip for months, you'd be unfair to tell them that it's off. Instead, from the beginning you should have earmarked the cash for your investment portfolio and either planned a low-ticket vacation or worked a deal with family members to take the trip later.
Okay, you say, but that choice isn't terribly difficult. You're more concerned about tougher decisions -- choosing, for instance, among such priorities as health care, education, and savings.
All are important. How do you resolve conflicts among them? No single approach will work for everyone -- but here are some guidelines that help.
Is someone's health involved? If you believe that the ultimate purpose of money is to make life better, then you might decide that saving cash at the cost of your well being -- or of a relative's -- is a poor choice. For most people, someone's illness is the rainy day for which they've been saving.
How many people will be affected by my choice? Will one of your goals make your own life better while another will give equivalent help to two of your children? You could decide that when more people derive roughly equal benefit from a goal, its priority rises.
If two goals offer similar rewards, which causes the least harm? This method of selection is typically a last resort, but it can be useful when no other analysis helps you decide among options.
Most people, for example, have to decide between the kids' tuition and their own retirement savings. Well, if you know that you won't be able to live adequately on the money you expect from your pension and Social Security, then retirement savings should be paramount. As for the child in college, he can take out a tuition loan.
You can't put every nickel toward top priorities, of course -- nor should you. Instead, you need to set aside part of your income for current pleasures, so long as you have enough cash left over to put toward your long-range goals.
Also, remember that as the years go by, your priorities will change. You'll need to reexamine and rank your needs regularly in order to use your money most effectively.
When you can save a dollar, you need to decide why you're putting it away. In addition, if you acquire the habit of quickly rating the urgency of every big purchase against the primary financial goals you've set for yourself, you'll eventually find that your spending is under control.
Making Plans
Here are examples of plans you might draw up to meet three of the most common objectives: getting out of debt, paying for college, or financing your retirement:
Getting out of debt
If you struggle to meet credit-card payments every month, then face it: You probably need to shed or consolidate some of that debt.
For example, suppose you owe $3,000 in outstanding credit-card debt at a 16 percent interest rate and a $10,000 car loan at 9 percent. To pay off both these obligations in a year, you'd need to pony up $1,147 a month.
But if you are a home owner with equity in your property, you could borrow $13,000 on a home-equity loan at the same 9 percent and retire those other bills. Then your cost to pay off the home-equity loan in a year would be slightly lower - $1,137 a month - because you're no longer paying high credit-card rates of interest.
Moreover, because you can deduct the interest on most home-equity loans, you'd reduce your taxable income by $642 that year - a $212 saving for someone in the 33 percent federal tax bracket. In effect, the government would help pay off your expenses.
Of course, this kind of strategy works only if you also stop charging new items on your credit cards.
Paying for college
Tuition, room and board at a private college can cost upward of $30,000 a year, and that bill is projected to reach about $80,000 by the time this year's crop of newborns enter college.
Your children may qualify for financial aid either in the form of a scholarship or a loan, and many students work their way through college.
But if you want to spare your kids the burden of graduating in debt, there are a couple of good savings vehicles available to you. Most states now offer so-called 529 Plans - contributions go into in pre-selected mutual funds, grow tax-free each year, and withdrawals to pay tuition are also tax free.
You could also open a Coverdell Education Savings Account (previously called an Education IRA) that lets you put $2,000 a year, after taxes, into a bank account or other investments; earnings on that type of account are totally tax-free, provided the money is used for tuition when it's withdrawn.
It's amazing how far these plans will get you. For example, if you started putting $2,000 a year today into a Coverdell account earning 8 percent, after 18 years you'd have more than $80,000.
Financing a retirement
A popular rule of thumb says that retirees need only 70 percent of their pre-retirement income to maintain their lifestyle, since they no longer have to pay for such costs as commuting or for work clothes.
However, other costs go up in retirement, such as utility bills (if you're home all day), the price of hobbies and travel - and, of course, the cost of health care. In fact, some retirees find they need as much income in retirement as they spent while working.
Unfortunately, traditional pensions pay only a fraction of your salary, and Social Security won't make up the difference. In addition, the younger you are, the less certain you can be about how much money you'll receive at age 65 from any of the retirement plans you have today.
Why? Because Social Security benefits may be revised, and employers are free at any time to change their pension-plan formulas. (They can't do so retroactively - every retirement dollar that you've already qualified for is yours to keep.) Of course, Congress can change the laws governing retirement savings plans at any time.
Moreover, the bear market of the past few years has underscored the point that stocks can be extremely volatile in the short term, even if they remain among the most consistent performers over long periods. Thus, the stock portion of any retirement portfolio needs to take into account the possibility of sharp downturns.
To make your retirement finances secure, you need to contribute to as many different plans as possible. If you have a 401(k), 403(b), or 457 program at work, put in as much money as you can.
Most employers will match your contributions, giving you money for retirement that you won't get any other way. If you have no retirement plan at work, contribute to an IRA. Note that contributions to all of these plans are tax-deferred, so that you, Uncle Sam, and your boss together could be adding to your retirement stash.
Then to insure against possible new retirement-plan rules mandated by Congress, you need to have your own taxable savings plan as well -- ideally invested in stocks, bonds, or mutual funds, which can return more than bank accounts. Best of all, as your investing account grows, it can help you finance other goals.
Making a Budget
1. Budgets are a necessary evil.
They're the only practical way to get a grip on your spending -- and to make sure your money is being used the way you want it to be used.
2. Creating a budget generally requires three steps.
- Identify how you're spending money now
- Evaluate your current spending and set goals that take into account your long-term financial objectives
- Track your spending to make sure it stays within those guidelines.
3. Use software to save grief.
If you use a personal-finance program such as Quicken or Microsoft Money, the built-in budget-making tools can create your budget for you.
4. Don't drive yourself nuts.
One drawback of monitoring your spending by computer is that it encourages overzealous attention to detail. Once you determine which categories of spending can and should be cut (or expanded), concentrate on those categories and worry less about other aspects of your spending.
5. Watch out for cash leakage.
If withdrawals from the ATM machine evaporate from your pocket without apparent explanation, it's time to keep better records. In general, if you find yourself returning to the ATM more than once a week or so, you need to examine where that cash is going.
6. Spending beyond your limits is dangerous.
But if you do, you've got plenty of company. Government figures show that many households with total income of $50,000 or less are spending more than they bring in. This doesn't make you an automatic candidate for bankruptcy -- but it's definitely a sign you need to make some serious spending cuts.
7. Beware of luxuries dressed up as necessities.
If your income doesn't cover your costs, then some of your spending is probably for luxuries -- even if you've been considering them to be filling a real need.
8. Tithe yourself.
Aim to spend no more than 90 percent of your income. That way, you'll have the other 10 percent left to save for your big-picture items.
9. Don't count on windfalls.
When projecting the amount of money you can live on, don't include dollars that you can't be sure you'll receive, such as year-end bonuses, tax refunds, or investment gains.
10. Beware of spending creep.
As your annual income climbs from raises, promotions, and smart investing, don't start spending for luxuries until you're sure that you're staying ahead of inflation. It's better to use those income increases as an excuse to save more.
The dubious joy of budgets
If you're the type of person who always has plenty of cash, knows exactly where every penny goes, and never has trouble paying bills, skip this chapter. You're either too rich or too smart to need it.
For the rest of us, unfortunately, making - and sticking to - a budget is the essential tool for ensuring that our money gets used the way we need it to. Even if you're in the happy situation of having plenty of income, the homework involved in drawing up a budget can be instructive, since you may find that you are spending more than you wish on items like DVDs, electronic gadgetry, or restaurant meals.
Drawing up a budget is usually pure drudgery enlivened only by the reality of staring your foolish spending habits in the face. In fact, one of the chief impediments to budgeting is that most people would rather not know how they really use their money.
It's bad enough to learn this kind of information on your own. It's even worse when a spouse or significant other finds out, since it usually confirms his or her worst fears - and provides new ammunition for future "discussions."
Take heart. Any spending mistakes you're making are probably common and not impossible to kick. Moreover, the bulk of budgeting's pains are at the beginning.
After you have a budget in place - and you've fine-tuned it with a couple of months of actual spending - tracking your expenditures becomes almost automatic.
If your boss at work were to ask you for an analysis of the department's spending, you'd figure it out quickly enough. Budgeting your household should be approached in the same businesslike fashion. A variety of electronic tools can make the process easier
Listing Expenses
There are three steps to creating a budget:
1) Identify how your money is currently being spent.
2) Evaluate that spending to see if it meets the financial priorities you specified in Lesson 1.
3) Track your ongoing spending to make sure it stays within those guidelines (or to understand how your budget needs to be revised).
If you happen to use Quicken, Microsoft Money, or other such software, you're in luck. These programs generally make it easy to draw up a budget.
In Quicken, for example, every time you make a deposit, write a check, pay a credit card bill, or dispatch an electronic payment you are asked to assign it to a particular category, such as "salary," "clothing," "groceries," "child care," or "health insurance."
You can also create subcategories, dividing "auto" expenses into "fuel," "insurance," and "service." The program comes with a set of categories that handle most of the basics. You can edit the list to create categories that make better sense for your particular household.
And if you're away from home, you can track expenses at the Quicken Web site and then download the transactions later.
The drawback, of course, is that entering and categorizing all of your income and outflow is a tedious chore.
You can reduce the tedium by judiciously selecting categories. Let's say you are only worried about tracking your spending for recreation and leisure pursuits. You could create categories that cover those types of expenses, and let everything else accumulate under "miscellaneous revenue" or "miscellaneous expense."
The problem with that approach is that you forgo the opportunity to spot problems in other spending areas that you may not even be aware of.
A better solution is to track expenses using electronic banking. That way, you can download your payments and deposits directly from the bank, rather than having to enter them by hand.
The downloaded banking transactions generally show up without any categorization - meaning you'll have to add the categories by hand. But if you use a credit card that is issued by a bank that permits electronic access, then the downloaded charges from your card sometimes do come with categories attached (they aren't always right, so check them).
Either way, once you've got your spending tracked by category, drawing up a report requires only a few clicks of the mouse. Even better, such programs often have an automatic budget-creation feature that scans your spending in the past in order to estimate how much you'll spend going forward.
If your finances aren't wired, you can still get a good handle on your spending the old-fashioned way. Start by getting all your records together from the past 12 months, including pay stubs, loan proceeds, withdrawal slips, canceled checks, and itemized credit-card statements. Then go through them and compile totals for your income and expenses in a set of categories that makes sense for you.
At the end of this exercise, you may still have a sizable lump of spending that's undocumented - typically, the money you withdraw in cash and then spend on day-to-day needs. If this portion of your budget seems to be getting out of hand, keep a journal for the next four weeks in which you record every nickel you spend. You can use those results to extrapolate how your cash is being spent throughout the year.
Now that you've got a good picture of where your money is going, you can proceed to evaluate which parts of that spending should be raised or lowered. You might start with our Ideal Budget calculator, which compares your spending with recommended levels.
Setting Goals
Once you have a budget, it's time to go through your spending and figure out where you need to cut back.
This is especially urgent, obviously, if you spend more than you make - a scary position, for sure, but not uncommon. In fact, Labor Department numbers show that many families making $50,000 or less are spending at least a few percentage points more money each year than they actually bring in.
That doesn't mean that they, or you, are headed for bankruptcy. But it does show that Americans are in the habit of borrowing to cover both short-term expenses, like those on credit cards, and long-term ones, such as buying cars and homes.
Let's just say that if your spending exceeds your income, then your top priority in constructing a budget should be to slash your spending, pronto.
If your household runs in the black, you may still want to reallocate some of your spending. The calculator helps identify trouble spots by highlighting categories where your annual expenses are sharply higher or lower than average for households with similar demographics.
In some cases, a divergence will be perfectly reasonable. The average family spends only a few percent of its income on education, for example. But if you have a child in college or private school, or are taking some courses yourself, your education spending will be a lot higher -- and more power to you.
On the other hand, if the calculator shows that you're spending twice as much as the average family on meals away from home, and there's no obvious reason why that should be so, you may want to consider eating in more often.
When projecting your income, don't include money that you can't be sure to receive, such as highly variable year-end bonuses, tax refunds, or gains on investments. Instead, wait until the extra cash arrives, then save or invest it to produce more revenue for the future.
Your goal should be to reduce your spending to about 90 percent of your income, with the aim of plowing the rest of that money into the financial objectives you deem most important.
Once you've set your budget goals, you need to develop the habit of tracking your expenses on an ongoing basis - something that's most easily accomplished using personal-finance software. The aim here is to make sure the spending stays within the limits you've set.
But there's a second aim: Very likely you will discover that some of the goals you set were unrealistic. If so, ease them slightly. No point in giving yourself an unreachable hurdle, but neither should it be too easy.
Often it takes two or three revisions before you achieve a budget that you can really stick to. If juggling the numbers leaves you wishing you could free up some extra cash, push on to the next section of this lesson for suggestions.
Cutting Costs
The most common spending problems are caused by a house that's too large, a car that's too luxurious, or a credit-card lifestyle that's too lavish for your income.
Whatever your situation, here are some common ways that people can reduce monthly bills.
Eliminate trivial but needless costs
Look first for small savings - not because they'll end your budget problems, but simply because they're easy to find and take advantage of. For example, swear off that mid-afternoon Danish or expensive premium latte. Shop for clothes and household furnishings only during sales. Keep your house warmer in summer and cooler in winter. Take on chores that you usually pay someone else to perform, such as mowing the lawn or shoveling snow.
Seemingly inconsequential savings do, in fact, add up.
Reduce larger expenses
These recommendations are decidedly more painful. If you smoke, for instance, take steps to quit. Don't buy season tickets to anything. Trade in your luxury car or sport utility vehicle for something a lot cheaper to buy, fuel, and maintain (we did say this was painful).
On the assumption that those kinds of changes may be too wrenching, here are some other specific areas where many people can find savings:
Refinance your mortgage
If new mortgages are costing at least two percentage points less than the rate you're paying, refinancing may save you significant dollars; check our refinancing calculator to be sure.
Cut your taxes
Usually this means taking better advantage of itemized deductions, and it's a lot easier to do if you are either self-employed or have some income from work you do outside of a regular job. That opens up a range of new deductions -- from expenses for work-related items to a home office -- that are much harder to claim if you're an ordinary working stiff.
On the investment side, you can save some money by selling, and then writing off, investments that have lost money. You can use such losses to offset any gains you may have in a given year. If your losses outweigh your gains, you can deduct as much as $3,000 of investment losses from your ordinary income each year. Those with higher incomes may also be able to save some money by shifting money out of taxable bonds into tax-free municipal bonds.
Appeal your home assessment
If you're a homeowner, you may even be able to cut your real estate taxes by challenging the value that the local assessor puts on your property. You have to have good evidence, of course. You should call the assessor's office first to make sure you understand the formula for determining the house's value (the assessment listed on tax bills is often only a fraction of the real value that determines your tax).
If recent home sales in your neighborhood lead you to believe that your house is worth less than its assessment and a qualified real estate agent writes an appraisal in support of your claim, then you can file a grievance with the assessor's office and possibly get your bill reduced. The cost: $200 to $300 for the written appraisal. If an attorney handles the appeal for you, he or she will typically charge 50 percent of the first year's tax savings.
The above suggestions won't work for everyone, and you may have considered them already. But since you alone are privy to the numbers in your budget, you alone know how radically you need to cut. If our suggestions don't appeal, find your own alternatives.
One last word of caution
Over time, your income should rise as your career progresses and you manage to save money for investing. But, also over time, inflation will raise the cost of living. A mere 3 percent annual rise in prices will double the cost of everything within 24 years. At that time, you'll need twice as much money as you do today to live as well as you do now. So don't start spending your rising income on luxuries you've been denying yourself until you're sure that you're staying ahead of inflation.
They're the only practical way to get a grip on your spending -- and to make sure your money is being used the way you want it to be used.
2. Creating a budget generally requires three steps.
- Identify how you're spending money now
- Evaluate your current spending and set goals that take into account your long-term financial objectives
- Track your spending to make sure it stays within those guidelines.
3. Use software to save grief.
If you use a personal-finance program such as Quicken or Microsoft Money, the built-in budget-making tools can create your budget for you.
4. Don't drive yourself nuts.
One drawback of monitoring your spending by computer is that it encourages overzealous attention to detail. Once you determine which categories of spending can and should be cut (or expanded), concentrate on those categories and worry less about other aspects of your spending.
5. Watch out for cash leakage.
If withdrawals from the ATM machine evaporate from your pocket without apparent explanation, it's time to keep better records. In general, if you find yourself returning to the ATM more than once a week or so, you need to examine where that cash is going.
6. Spending beyond your limits is dangerous.
But if you do, you've got plenty of company. Government figures show that many households with total income of $50,000 or less are spending more than they bring in. This doesn't make you an automatic candidate for bankruptcy -- but it's definitely a sign you need to make some serious spending cuts.
7. Beware of luxuries dressed up as necessities.
If your income doesn't cover your costs, then some of your spending is probably for luxuries -- even if you've been considering them to be filling a real need.
8. Tithe yourself.
Aim to spend no more than 90 percent of your income. That way, you'll have the other 10 percent left to save for your big-picture items.
9. Don't count on windfalls.
When projecting the amount of money you can live on, don't include dollars that you can't be sure you'll receive, such as year-end bonuses, tax refunds, or investment gains.
10. Beware of spending creep.
As your annual income climbs from raises, promotions, and smart investing, don't start spending for luxuries until you're sure that you're staying ahead of inflation. It's better to use those income increases as an excuse to save more.
The dubious joy of budgets
If you're the type of person who always has plenty of cash, knows exactly where every penny goes, and never has trouble paying bills, skip this chapter. You're either too rich or too smart to need it.
For the rest of us, unfortunately, making - and sticking to - a budget is the essential tool for ensuring that our money gets used the way we need it to. Even if you're in the happy situation of having plenty of income, the homework involved in drawing up a budget can be instructive, since you may find that you are spending more than you wish on items like DVDs, electronic gadgetry, or restaurant meals.
Drawing up a budget is usually pure drudgery enlivened only by the reality of staring your foolish spending habits in the face. In fact, one of the chief impediments to budgeting is that most people would rather not know how they really use their money.
It's bad enough to learn this kind of information on your own. It's even worse when a spouse or significant other finds out, since it usually confirms his or her worst fears - and provides new ammunition for future "discussions."
Take heart. Any spending mistakes you're making are probably common and not impossible to kick. Moreover, the bulk of budgeting's pains are at the beginning.
After you have a budget in place - and you've fine-tuned it with a couple of months of actual spending - tracking your expenditures becomes almost automatic.
If your boss at work were to ask you for an analysis of the department's spending, you'd figure it out quickly enough. Budgeting your household should be approached in the same businesslike fashion. A variety of electronic tools can make the process easier
Listing Expenses
There are three steps to creating a budget:
1) Identify how your money is currently being spent.
2) Evaluate that spending to see if it meets the financial priorities you specified in Lesson 1.
3) Track your ongoing spending to make sure it stays within those guidelines (or to understand how your budget needs to be revised).
If you happen to use Quicken, Microsoft Money, or other such software, you're in luck. These programs generally make it easy to draw up a budget.
In Quicken, for example, every time you make a deposit, write a check, pay a credit card bill, or dispatch an electronic payment you are asked to assign it to a particular category, such as "salary," "clothing," "groceries," "child care," or "health insurance."
You can also create subcategories, dividing "auto" expenses into "fuel," "insurance," and "service." The program comes with a set of categories that handle most of the basics. You can edit the list to create categories that make better sense for your particular household.
And if you're away from home, you can track expenses at the Quicken Web site and then download the transactions later.
The drawback, of course, is that entering and categorizing all of your income and outflow is a tedious chore.
You can reduce the tedium by judiciously selecting categories. Let's say you are only worried about tracking your spending for recreation and leisure pursuits. You could create categories that cover those types of expenses, and let everything else accumulate under "miscellaneous revenue" or "miscellaneous expense."
The problem with that approach is that you forgo the opportunity to spot problems in other spending areas that you may not even be aware of.
A better solution is to track expenses using electronic banking. That way, you can download your payments and deposits directly from the bank, rather than having to enter them by hand.
The downloaded banking transactions generally show up without any categorization - meaning you'll have to add the categories by hand. But if you use a credit card that is issued by a bank that permits electronic access, then the downloaded charges from your card sometimes do come with categories attached (they aren't always right, so check them).
Either way, once you've got your spending tracked by category, drawing up a report requires only a few clicks of the mouse. Even better, such programs often have an automatic budget-creation feature that scans your spending in the past in order to estimate how much you'll spend going forward.
If your finances aren't wired, you can still get a good handle on your spending the old-fashioned way. Start by getting all your records together from the past 12 months, including pay stubs, loan proceeds, withdrawal slips, canceled checks, and itemized credit-card statements. Then go through them and compile totals for your income and expenses in a set of categories that makes sense for you.
At the end of this exercise, you may still have a sizable lump of spending that's undocumented - typically, the money you withdraw in cash and then spend on day-to-day needs. If this portion of your budget seems to be getting out of hand, keep a journal for the next four weeks in which you record every nickel you spend. You can use those results to extrapolate how your cash is being spent throughout the year.
Now that you've got a good picture of where your money is going, you can proceed to evaluate which parts of that spending should be raised or lowered. You might start with our Ideal Budget calculator, which compares your spending with recommended levels.
Setting Goals
Once you have a budget, it's time to go through your spending and figure out where you need to cut back.
This is especially urgent, obviously, if you spend more than you make - a scary position, for sure, but not uncommon. In fact, Labor Department numbers show that many families making $50,000 or less are spending at least a few percentage points more money each year than they actually bring in.
That doesn't mean that they, or you, are headed for bankruptcy. But it does show that Americans are in the habit of borrowing to cover both short-term expenses, like those on credit cards, and long-term ones, such as buying cars and homes.
Let's just say that if your spending exceeds your income, then your top priority in constructing a budget should be to slash your spending, pronto.
If your household runs in the black, you may still want to reallocate some of your spending. The calculator helps identify trouble spots by highlighting categories where your annual expenses are sharply higher or lower than average for households with similar demographics.
In some cases, a divergence will be perfectly reasonable. The average family spends only a few percent of its income on education, for example. But if you have a child in college or private school, or are taking some courses yourself, your education spending will be a lot higher -- and more power to you.
On the other hand, if the calculator shows that you're spending twice as much as the average family on meals away from home, and there's no obvious reason why that should be so, you may want to consider eating in more often.
When projecting your income, don't include money that you can't be sure to receive, such as highly variable year-end bonuses, tax refunds, or gains on investments. Instead, wait until the extra cash arrives, then save or invest it to produce more revenue for the future.
Your goal should be to reduce your spending to about 90 percent of your income, with the aim of plowing the rest of that money into the financial objectives you deem most important.
Once you've set your budget goals, you need to develop the habit of tracking your expenses on an ongoing basis - something that's most easily accomplished using personal-finance software. The aim here is to make sure the spending stays within the limits you've set.
But there's a second aim: Very likely you will discover that some of the goals you set were unrealistic. If so, ease them slightly. No point in giving yourself an unreachable hurdle, but neither should it be too easy.
Often it takes two or three revisions before you achieve a budget that you can really stick to. If juggling the numbers leaves you wishing you could free up some extra cash, push on to the next section of this lesson for suggestions.
Cutting Costs
The most common spending problems are caused by a house that's too large, a car that's too luxurious, or a credit-card lifestyle that's too lavish for your income.
Whatever your situation, here are some common ways that people can reduce monthly bills.
Eliminate trivial but needless costs
Look first for small savings - not because they'll end your budget problems, but simply because they're easy to find and take advantage of. For example, swear off that mid-afternoon Danish or expensive premium latte. Shop for clothes and household furnishings only during sales. Keep your house warmer in summer and cooler in winter. Take on chores that you usually pay someone else to perform, such as mowing the lawn or shoveling snow.
Seemingly inconsequential savings do, in fact, add up.
Reduce larger expenses
These recommendations are decidedly more painful. If you smoke, for instance, take steps to quit. Don't buy season tickets to anything. Trade in your luxury car or sport utility vehicle for something a lot cheaper to buy, fuel, and maintain (we did say this was painful).
On the assumption that those kinds of changes may be too wrenching, here are some other specific areas where many people can find savings:
Refinance your mortgage
If new mortgages are costing at least two percentage points less than the rate you're paying, refinancing may save you significant dollars; check our refinancing calculator to be sure.
Cut your taxes
Usually this means taking better advantage of itemized deductions, and it's a lot easier to do if you are either self-employed or have some income from work you do outside of a regular job. That opens up a range of new deductions -- from expenses for work-related items to a home office -- that are much harder to claim if you're an ordinary working stiff.
On the investment side, you can save some money by selling, and then writing off, investments that have lost money. You can use such losses to offset any gains you may have in a given year. If your losses outweigh your gains, you can deduct as much as $3,000 of investment losses from your ordinary income each year. Those with higher incomes may also be able to save some money by shifting money out of taxable bonds into tax-free municipal bonds.
Appeal your home assessment
If you're a homeowner, you may even be able to cut your real estate taxes by challenging the value that the local assessor puts on your property. You have to have good evidence, of course. You should call the assessor's office first to make sure you understand the formula for determining the house's value (the assessment listed on tax bills is often only a fraction of the real value that determines your tax).
If recent home sales in your neighborhood lead you to believe that your house is worth less than its assessment and a qualified real estate agent writes an appraisal in support of your claim, then you can file a grievance with the assessor's office and possibly get your bill reduced. The cost: $200 to $300 for the written appraisal. If an attorney handles the appeal for you, he or she will typically charge 50 percent of the first year's tax savings.
The above suggestions won't work for everyone, and you may have considered them already. But since you alone are privy to the numbers in your budget, you alone know how radically you need to cut. If our suggestions don't appeal, find your own alternatives.
One last word of caution
Over time, your income should rise as your career progresses and you manage to save money for investing. But, also over time, inflation will raise the cost of living. A mere 3 percent annual rise in prices will double the cost of everything within 24 years. At that time, you'll need twice as much money as you do today to live as well as you do now. So don't start spending your rising income on luxuries you've been denying yourself until you're sure that you're staying ahead of inflation.
10 Ways to Simplify Your Budget
I’m always looking for ways to simplify my finances (I’m weird like that, I know), and recently I’ve been scrutinizing my already-simple budget to make it even simpler. I thought it would be helpful to share some of the ways to make your budget as simple as possible.
The goal is to reduce headaches, eliminate the need for complicated tracking schemes, and reduce the time you spend on your budget and finances to about 15-20 minutes per week. I can’t claim these ideas are original, or that I haven’t discussed them in various places before, but in my experience, they work. They’re simple and powerful.
Let’s first look at setting up a budget. If you haven’t done it yet, it’s probably because budgets seem intimidating to you, or they are too much hassle to set up and maintain. Those are both valid points — which is why you should follow this simplified plan if these things apply to you. Now, there’s plenty of fancy software out there for setting up budgets, but I don’t think they’re necessary. A simple spreadsheet will do — and if you can create a SUM formula to add up the total of a column of numbers, you have all the spreadsheet knowledge necessary.
Create a simple spreadsheet for your budget, if you haven’t already, and start by listing your income and your monthly expenses. Estimate, in round numbers, how much you spend on each expense every month. You can adjust later, but it’s better to err on the side of too high a number, rather than putting a low number and breaking your budget.
Now let’s look at ways to create a simple budget:
60 Percent Solution. There are many ways to structure your budget, but the simplest I’ve found is the 60% solution. Basically, this budget asks you to fit your regular monthly expenses within 60% of your gross income, so that you have room for savings (long-term and short-term), retirement and spending money (”fun money”). These are the things that most often break a budget, because most people don’t budget for them. Now, your percentage will vary, but the percentages given here are just rough guidelines:
60 percent: Monthly expenses — such as housing, food, utilities, insurance, Internet, transportation. This is the part most commonly thought of as a budget.
10 percent: Retirement — and if you’re doing it right, this is being automatically deducted from your paycheck for a 401(k) investment.
10 percent: Long-term savings or debt reduction. It’s best to invest this in something such as stocks or an index fund, and this can serve as your emergency fund. But if you are in debt (not including a home mortgage), I would advise that you use this portion of the budget to pay off your debts, and even draw some from the other categories such as retirement to increase this to about 20 percent for now. Once your debts are paid off, you can switch this to long-term savings. You still need to have an emergency fund, but while you’re in debt-reduction mode you can either create a small, temporary emergency fund out of the money from this category or the next.
10 percent: Short-term savings — this is for periodic expenses, such as auto maintenance or repairs, medical expenses (not including insurance premiums), appliances, home maintenance, birthday and Christmas gifts. For this savings account, be sure to spend the money when you need it — that’s what it’s for. When these expenses come up, you will have the money for them, instead of trying to pull them from other budget categories.
10 percent: Fun money — you can spend this on eating out, movies, comic books — whatever you want. Guilt free.
Fewer categories. A lot of budget software asks you to fill in a million categories and subcategories. Those can be useful if you want to track all that stuff, but I don’t. I recommend simplifying: just use broad categories like food and gas and spending and utilities. Use what works.
Pay bills online. As much as possible, pay your bills online. These would be most of the bills in the first category above — utilities, rent or mortgage, cell phone, Internet, etc. If you can’t pay electronically, have your bank send out a check to the vendor. Make these payments automatic, so you don’t need to worry about them.
Automatic savings. Make your savings automatic as well. Every time your paycheck is deducted, have a scheduled transaction transfer a set amount from checking to savings. Use a high-yield online savings account such as Emigrant Direct, HBSD, or ING Direct.
Cash. For everything else, use cash. If you’re doing automatic bill payments and savings deductions, the only things you’ll likely need cash for are gas, groceries and fun money. Withdraw these amounts in cash twice a month, rather than using checks or credit cards. The reason is that it’s simpler — with cash, you don’t need to worry about overspending, or tracking how much is left in that category. You can see how much is left. Leave the credit cards for when you absolutely need them — traveling, for example.
Envelopes. If you use cash for three categories, for example, use three envelopes. This is an old-fashioned system, but I use it because it works. I have an envelope for groceries, gas and fun money. If I’m going grocery shopping, I bring the groceries envelope. I know how much is left in the envelope before I go grocery shopping. I spend the cash for groceries, and then can easily see how much is left now. Simple, and no tracking necessary. When the money is gone, you’ve spent your budgeted amount. If necessary, you could transfer cash from one envelope to another, and there’s no need to adjust your budget.
15-20 minutes a week. Now, the budget and spending plan I’ve outlined above is fairly simple and headache-free — but you shouldn’t assume that it doesn’t need any maintenance. You should devote 15-20 minutes a week to ensuring that your finances are in order. Just this little amount of time each week will greatly simplify your financial life, reduce headaches, and prevent any messes from occurring later. Set a day and time when you take a look at your finances each week. Set aside 30 minutes, just to be safe. Now take 5-10 minutes to enter your transactions into your financial software (I use MS Money, because it came with my computer, but a spreadsheet or other financial software will do fine). If you’re following the plan above, all you’ll need to do is go online, look at your bank account, and enter your deposits, bills paid, ATM withdrawals (only do this twice a month!), and any other fees. It shouldn’t take long. Now spend another 5-10 minutes to review your budget and make sure that all bills have been paid that should be paid. If not, pay them. It’s that simple. You’re done. Now go back to reading your blogs.
Fewer accounts. Some people have complicated systems set up with lots of different accounts. I say simplify. You don’t want to be checking a million different accounts. You should have one checking account and one or two savings accounts (one for emergency fund and one for periodic expenses). You could have a bunch of investment accounts if you want, but I’ve found it simpler to just have one. I lose diversity, but my fund is already pretty diversified.
Dump credit cards. Multiple credit cards are also a headache. Simplify by just having one. Or do what I do — have none. This will draw the usual outraged or preachy reaction from those who really love their credit cards, but I don’t care. I don’t like credit cards. Call me old fashioned. They charge high interest and they’re potentially dangerous (if you run up a high bill and an expense comes up that you need to pay for which means you can’t pay your credit card bill on time, you now are stuck with high-interest credit card debt). Use a debit card if you need to.
Pay all bills at the same time. It often just takes a simple call to get a vendor or creditor to change the due date on your bills. If you can get all your bills to be due on, let’s say, the 10th of the month, you can do all your bill paying at once. For some people, this will mean they will need to do a bit of scrimping to get ahead enough so that they can afford to make all their month’s payments at the beginning of the month, but it’s worth it. You can pay all your bills and be done with it.
The goal is to reduce headaches, eliminate the need for complicated tracking schemes, and reduce the time you spend on your budget and finances to about 15-20 minutes per week. I can’t claim these ideas are original, or that I haven’t discussed them in various places before, but in my experience, they work. They’re simple and powerful.
Let’s first look at setting up a budget. If you haven’t done it yet, it’s probably because budgets seem intimidating to you, or they are too much hassle to set up and maintain. Those are both valid points — which is why you should follow this simplified plan if these things apply to you. Now, there’s plenty of fancy software out there for setting up budgets, but I don’t think they’re necessary. A simple spreadsheet will do — and if you can create a SUM formula to add up the total of a column of numbers, you have all the spreadsheet knowledge necessary.
Create a simple spreadsheet for your budget, if you haven’t already, and start by listing your income and your monthly expenses. Estimate, in round numbers, how much you spend on each expense every month. You can adjust later, but it’s better to err on the side of too high a number, rather than putting a low number and breaking your budget.
Now let’s look at ways to create a simple budget:
60 Percent Solution. There are many ways to structure your budget, but the simplest I’ve found is the 60% solution. Basically, this budget asks you to fit your regular monthly expenses within 60% of your gross income, so that you have room for savings (long-term and short-term), retirement and spending money (”fun money”). These are the things that most often break a budget, because most people don’t budget for them. Now, your percentage will vary, but the percentages given here are just rough guidelines:
60 percent: Monthly expenses — such as housing, food, utilities, insurance, Internet, transportation. This is the part most commonly thought of as a budget.
10 percent: Retirement — and if you’re doing it right, this is being automatically deducted from your paycheck for a 401(k) investment.
10 percent: Long-term savings or debt reduction. It’s best to invest this in something such as stocks or an index fund, and this can serve as your emergency fund. But if you are in debt (not including a home mortgage), I would advise that you use this portion of the budget to pay off your debts, and even draw some from the other categories such as retirement to increase this to about 20 percent for now. Once your debts are paid off, you can switch this to long-term savings. You still need to have an emergency fund, but while you’re in debt-reduction mode you can either create a small, temporary emergency fund out of the money from this category or the next.
10 percent: Short-term savings — this is for periodic expenses, such as auto maintenance or repairs, medical expenses (not including insurance premiums), appliances, home maintenance, birthday and Christmas gifts. For this savings account, be sure to spend the money when you need it — that’s what it’s for. When these expenses come up, you will have the money for them, instead of trying to pull them from other budget categories.
10 percent: Fun money — you can spend this on eating out, movies, comic books — whatever you want. Guilt free.
Fewer categories. A lot of budget software asks you to fill in a million categories and subcategories. Those can be useful if you want to track all that stuff, but I don’t. I recommend simplifying: just use broad categories like food and gas and spending and utilities. Use what works.
Pay bills online. As much as possible, pay your bills online. These would be most of the bills in the first category above — utilities, rent or mortgage, cell phone, Internet, etc. If you can’t pay electronically, have your bank send out a check to the vendor. Make these payments automatic, so you don’t need to worry about them.
Automatic savings. Make your savings automatic as well. Every time your paycheck is deducted, have a scheduled transaction transfer a set amount from checking to savings. Use a high-yield online savings account such as Emigrant Direct, HBSD, or ING Direct.
Cash. For everything else, use cash. If you’re doing automatic bill payments and savings deductions, the only things you’ll likely need cash for are gas, groceries and fun money. Withdraw these amounts in cash twice a month, rather than using checks or credit cards. The reason is that it’s simpler — with cash, you don’t need to worry about overspending, or tracking how much is left in that category. You can see how much is left. Leave the credit cards for when you absolutely need them — traveling, for example.
Envelopes. If you use cash for three categories, for example, use three envelopes. This is an old-fashioned system, but I use it because it works. I have an envelope for groceries, gas and fun money. If I’m going grocery shopping, I bring the groceries envelope. I know how much is left in the envelope before I go grocery shopping. I spend the cash for groceries, and then can easily see how much is left now. Simple, and no tracking necessary. When the money is gone, you’ve spent your budgeted amount. If necessary, you could transfer cash from one envelope to another, and there’s no need to adjust your budget.
15-20 minutes a week. Now, the budget and spending plan I’ve outlined above is fairly simple and headache-free — but you shouldn’t assume that it doesn’t need any maintenance. You should devote 15-20 minutes a week to ensuring that your finances are in order. Just this little amount of time each week will greatly simplify your financial life, reduce headaches, and prevent any messes from occurring later. Set a day and time when you take a look at your finances each week. Set aside 30 minutes, just to be safe. Now take 5-10 minutes to enter your transactions into your financial software (I use MS Money, because it came with my computer, but a spreadsheet or other financial software will do fine). If you’re following the plan above, all you’ll need to do is go online, look at your bank account, and enter your deposits, bills paid, ATM withdrawals (only do this twice a month!), and any other fees. It shouldn’t take long. Now spend another 5-10 minutes to review your budget and make sure that all bills have been paid that should be paid. If not, pay them. It’s that simple. You’re done. Now go back to reading your blogs.
Fewer accounts. Some people have complicated systems set up with lots of different accounts. I say simplify. You don’t want to be checking a million different accounts. You should have one checking account and one or two savings accounts (one for emergency fund and one for periodic expenses). You could have a bunch of investment accounts if you want, but I’ve found it simpler to just have one. I lose diversity, but my fund is already pretty diversified.
Dump credit cards. Multiple credit cards are also a headache. Simplify by just having one. Or do what I do — have none. This will draw the usual outraged or preachy reaction from those who really love their credit cards, but I don’t care. I don’t like credit cards. Call me old fashioned. They charge high interest and they’re potentially dangerous (if you run up a high bill and an expense comes up that you need to pay for which means you can’t pay your credit card bill on time, you now are stuck with high-interest credit card debt). Use a debit card if you need to.
Pay all bills at the same time. It often just takes a simple call to get a vendor or creditor to change the due date on your bills. If you can get all your bills to be due on, let’s say, the 10th of the month, you can do all your bill paying at once. For some people, this will mean they will need to do a bit of scrimping to get ahead enough so that they can afford to make all their month’s payments at the beginning of the month, but it’s worth it. You can pay all your bills and be done with it.
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