FUNDAMENTALS OF FINANCE
A Guide for Helping Professionals
Adam J. McKee
SECTION 5.1: Where is My Money Going?
A major goal of this book is to get you on the right path toward building wealth at the same time you are providing comfort and safety for your family. That is a lot to do with a limited income! The first step? Assess your current financial situation, and then reassess it every month for the rest of your life. That’s a lot of assessing, but the financial rewards and peace of mind that it will bring are well worth the effort. Ever notice maps with a “you are here” arrow? Those maps would be pretty useless if you didn’t know where you were in relation to where you want to be. Your financial future is the same way. You have to have a very good idea of where you are before you can get to where you want to go.
The best way to stay broke is to spend what you make every month, and then spend a little more borrowed money. So many people take this stupid path through life that it seems pretty normal to many of us. Keep this in mind: If you don’t know any rich people, then everyone you know is doing it wrong! If you ever want to get out of the “rat race” of living paycheck to paycheck with no sense of security whatsoever, then you have to save. Most of us take the word “save” to mean money put in a special place like a savings account for long-term storage. We’ll make it even simpler at this point in the discussion. We’ll define savings as any money that you have that you didn’t spend (no matter where it is currently kept). To save anything and to know what you’ve saved, you need to have a budget. The absolute best way to keep a budget it using a spreadsheet (Excel or Google Sheets are popular options).
Here we’ll need to make sure you understand two related budgeting concepts. The first step in the budgeting process is to determine your gross income and your disposable income. Gross income is the total amount that you earn. Disposable income is the amount you actually receive when you get paid–this is often called “net income” and “take home” pay. As we already noted, the difference between your gross income and your disposable income can make you a little misty-eyed. Your disposable income, then, excludes all of the money that goes to employee benefits, federal taxes, state taxes, city taxes, social security, Medicare, and so forth. We’ll use the month as our basic unit of income because that will be our basic unit of bill paying.
The easiest place to mess up in the budgeting process is to underestimate your Total Expenses. This is because we live in a society of digital convenience, and it is very easy to spend money with no system of tracking it (that we actually use). Many of us use our debit cards multiple times per day, and there are literally hundreds of entries on our bank statements. We never take the time to reconcile those expenses and analyze where our money is actually going. To budget properly, that is exactly what we have to do.
Most of us have some pretty Regular Expenses that are easy to account for. Regular expenses are bills that occur on a regular basis (usually once per month) and that have a fairly predictable cost. Rent, mortgages, water bills, electric bills, and gas bills are among the most common. You can also include things that you plan to budget a certain amount for each month, such as groceries, entertainment, transportation costs, and restaurant meals. Some of these things are rather arbitrary, and you can categorize them any way you like that makes sense based on how you live and spend your money.
You will also need to calculate your irregular expenses. Irregular expenses are things that don’t fall neatly into your month-by-month spending pattern. Some insurance policies are paid every six months, property taxes are paid yearly, college tuition comes due in the Fall and Spring, and Christmas comes only once per year. You will have to think carefully about what to include in your list of irregular expenses, and you will probably add to the list as the months tick by and you realize that you forgot something. After you have made a list of irregular expenses for the year, take that total and divide by 12. That is the money you need to save every month to pay for irregular expenses throughout the year.
Calculate Your Total Expenses
Total Expenses = Regular Expenses + Irregular Expenses
Once you have your Regular Expenses and Irregular Expenses calculated, you simply add them together to get your Total Expenses. Now we come to the true test of how you are doing financially: Take your Disposable Income and subtract your Total Expenses from it. If the number is positive, you can breathe a sigh of relief. The number is your Monthly Savings. If the number is negative, then you are in trouble; this negative number is your Monthly Loss. Unless there was a large one-time expense, you have likely been operating at a loss for some time and not realized it. This is because you have been using credit cards and other forms of debt to make up the difference.
Calculate Your Savings Rate
Savings Rate (%) = (Monthly Savings / Gross Income) x 100
Note that I recommend saving at a bare minimum 15% of your monthly income. Your savings rate (as calculated above) may not be as far from the target as it seems. If you are contributing to your employer-sponsored retirement plan at a rate of 10%, then your savings rate only needs to be 5% to be saving 15% of your overall income.
Where Do I Get Those Numbers?!
When it comes to monthly spending, most people spend a mysterious amount of money on mysterious things. There are morning coffees, perhaps some breakfasts, a few lunches, a couple of movie tickets, and a host of other odds and ends. The only way to get a real grasp on where your money is going every month is to keep a spending diary and record everything you spend money on for at least one month. This, as you guessed, is a huge inconvenience.
The Psychology of Spending
People have a truly amazing capacity for rational thought. Although we can be coldly logical creatures in our thoughts and actions, the truth is that we seldom are. We are spontaneous and emotional creatures, and are prone to making big mistakes with money and not even realize that they are mistakes. If you are like me, you need to put measures in place to prevent you from blowing a lot of money. Sticking to a budget can be hard, but it becomes easier if you put barriers to poor judgment into place.
Perhaps the most useful such barrier is Envelope System advocated by Dave Ramsey. Dave’s use of the term Envelope is not a metaphor for something clever and complex. They are real, bona fide paper envelopes like you’d send a check to someone in. The big idea is to have an envelope for each budget category that isn’t a bill that you pay all at once. There will be an envelope for groceries, one for entertainment, and one for transportation. The specific labels will depend on your lifestyle and your discretionary spending categories that tend to “bust the budget.” There are a few critical psychological components that make the envelope system valuable. First, the majority of people do not pay off their credit card balances each and every month. Not doing so is tantamount to throwing your cash in the toilet. A second reason is that cash seems more “real” than plastic, so there is more psychological pain to blowing it.
Let’s say you have budgeted $800 per month for groceries and household incidentals like soap, toilet paper, and toothpaste. (You could separate these into any categories that you choose, but I find it helpful to organize by shopping trip and location). If you get paid twice per week, then you will withdraw $400 from the bank and stick it in your “grocery” envelope. That envelope must last you for the full two weeks until payday. Once it is gone it is gone, and there will be no more groceries until payday. My personal strategy involves buying in bulk to save money, so I usually do a major shopping spree near payday and hold out $100 for the “off” week when I’ll only need to buy perishables like milk, eggs, and bread. An important key to the success of the envelope system is to never, never allow yourself to cheat. If you have too much stuff in your shopping cart to pay for it out of the envelope, put some of it back. If you get any change back, that goes in the envelope.
Another common method of cheating is to move money between envelopes. This is forbidden. The whole idea is to force yourself to be disciplined and spend according to a budget. If you are stealing from the grocery envelope to add to the entertainment envelope, then the whole system is useless and you are just wasting perfectly good envelopes.