Most people have a hard time figuring out why there isn’t enough money in the budget. This simple process will make everything clear immediately and show you how to make a budget quickly.
When was the last time you analyzed your bank accounts? I mean other than checking your account balance to make sure you have enough to pay the next upcoming bill? If you’re like most people, it’s not very often. Far too many people get caught up in the account balance and fail to understand why the balance is where it is. This is why you should make a budget and stick with it.
It’s Not all About the Balance
While your account balance is very important, it doesn’t tell the whole story. To make an analogy, let’s take a runny nose for example. When your nose is running, it’s almost second nature to grab a tissue and wipe it clean. However, you’re just treating the symptom and not the root cause of the runny nose which is the cold virus.
If you didn’t have a cold, you wouldn’t have a runny nose. Unfortunately, we cannot cure a common cold so all we can do is treat the symptoms, but in personal finance, we can treat the root causes of money problems 100% of the time. You just need to know how to find them.
Find The Cause Not The Symptom
When looking at your bank accounts, it’s important to remember the runny nose example. The low balance is the runny nose, and the underlying financial habits are the cold virus. If you find yourself with a comfortable amount of money at the end of each month, perfect, you don’t have a financial cold. However, if you find that it’s tight every month, chances are there’s something that can be done other than “just make more money.”
Money Just Amplifies Us
Making more money is great, but it won’t change your money habits and you may still find that it’s tight after getting a raise. Why? Money does not change people’s habits, it amplifies them. If you don’t understand where your money is going and the financial choices you’re making, once you start making more, your expenses will rise to meet your new income and the cycle will start all over again.
However, if you treat the root cause of money problems first, (financial habits) once you add more money, you will start creating a surplus and accumulating wealth over time.
First, Determine What’s Coming In
To find the root cause of money problems, you need to categorize your spending and income. Income is probably a little bit easier so it’s best to tackle that first. Figure out what is coming in every month. For most people, this is just income that you earn from work.
If you’re a salaried or hourly employee, this number should be easy to calculate because your paychecks should all be about the same and come in at regular intervals. Just add 4 weeks’ worth of paychecks together and you’ll know what’s coming in. For hourly or commissioned workers, take the average of the last three month’s incomes and use that figure.
Then Subtract Survival Expenses
Figuring out what’s going out is a little bit more complicated if you’re not actively keeping it organized. Start with things you need to survive first and subtract that from your income. Rent, Utilities, Groceries, car payments and insurances, and your phone PLAN should get first priority when deducting from your budget.
It’s mandatory that you have a place to sleep, eat, get to work, and communicate with the world. Everything else is optional. Once you’ve done that, you now know what your “spending money” is every month.
This is called discretionary income or disposable income because you can spend this however you like. However, you should save a portion of it to invest and build for the long term.
Next Comes Discretionary Expenses
If you’ve already run out of money, there is a big problem. Literally, every dollar you’re spending on non-essential items is adding to your debt load because you’ve used up all of your income on necessities.
No amount of cutting back on shopping or going out will fix the problem. You have to either move to a less expensive location, get a cheaper car, or cut back on your phone plan. It’s very hard to spend less on groceries.
Even if you start shopping generic, you’re only looking at about a 20% reduction in an expense that isn’t very large and chances are if you’re having money issues, you’re already shopping generic a lot.
This is a very rare problem to have though and I’m sure you’ll have some sort of discretionary income leftover.
Now Subtract Subscriptions
Now that you’ve figured out what you’re spending money is, deduct the recurring payments from that first. This is because you’ve committed to paying for them before the month even began when you signed the subscription agreement. This includes things like Netflix and Hulu, Cable, Weight Watchers, iPhone payments, gym memberships, magazine subscriptions, etc. Once you deduct those recurring costs, what’s leftover is your true “play money” figure.
If deducting these recurring costs puts you in the negative, you now know where your problem is. It’s with one of the subscriptions. You may even find that you’re paying for something you haven’t used in 6 months. Fortunately, these are easy problems to fix because these types of things can be canceled almost instantly with no penalty.
Now Comes Play Money
Once you have your play money figure, deduct everything else. If you still have money left over, great. If not, at least you know where your problem area is. If this is your problem area, you’re probably spending too much on consumer items or entertainment. If you have a negative figure but enjoy shopping or going out too much, consider cutting out a subscription or two to right the ship.
The End Goal
It’s also important to remember that the goal of this exercise is to have money left over even after play money expenses. Saving and investing is vital to long-term financial stability and cannot be skimped on. I don’t have them earlier in the process because you can’t save or invest money you don’t have. You need to have a surplus before you can invest.
If you’re looking for an easy way to invest for the long term, I suggest checking out Acorns.
Why This Exercise is So Effective
Using this simple exercise will tell you so much about your situation without being overly complex. Once you calculate your take-home pay, subtract your necessities. Once you’ve done that, subtract your subscriptions. Then subtract shopping and entertainment from the money that’s leftover.
What’s leftover is either your surplus or deficit. If you’re in a deficit, you’ll know exactly why if you subtracted in the order that’s described. Subtracting in this way also allows you to prioritize expenses if you’re having to choose between things.
Remember, the goal is to create a surplus every month that can be saved or invested for long-term growth. Invest enough money for a long enough time and you can add “investment income” to the top of the equation.
How To Add Savings in Automatically
When I was in the car business on commission, I did what I called the “Uncle Sam Savings Plan.” I had an extra $50 a week withheld from my pay for taxes. This way, I artificially lowered my take-home pay by $2600 a year and would get it all back come tax time because I had no outside income that had to be taxed.
Because I was living on my artificially lower income, I could deposit the tax check right into my investment account without feeling any pressure on my budget. It’s a great way to overcome a lack of self-control if you’re worried about that sort of thing.
Time For an Example
Let’s use an example of someone single making $52,000 a year so it’s an even $1,000 a week. After federal taxes are paid, they’re taking home $40,560. Take out FICA Taxes and you’re left with $37,336. I’m going to ignore state income taxes for this example, but so far the person’s effectively losing 28.2% (22% federal + 6.2% FICA) of their income to taxes. This leaves them with $3,111 take-home pay every month.
A Quick Note on Take Home Pay
However, you shouldn’t be calculating take-home pay this way. I’m doing this for example purposes. In reality, if the person is getting paid every two weeks, they should just be adding two paychecks together which in this example should be a little over $1500. The reason for this is is because you want to add what’s actually coming in, not what your take-home pay should be according to the tax code.
This way, when you receive your tax check in April, it can go straight into your investment fund with no effect on the budget. You won’t be counting on it every year. For the sake of this example, we’ll ignore the “Uncle Sam Savings Plan”
Now We Subtract
From that $3,111 coming in, assume they have rent of $1200 a month, utilities around $200, a car payment of $350, insurance of $100 a month, a grocery bill of $500 each month, and are spending $80 a month on their phone bill. All of these necessities total to be $2,430. Subtract that from $3,111 and that leaves $681 left for discretionary spending, saving, and investing.
From the $681, they subscribe to Netflix, and Planet Fitness and Hulu. All three are $10 a month for arguments sake. This leaves fun money at $651. If this person is spending more than $651 a month on consumer goods and eating out, financial problems will be on the horizon.
However, if they are spending less than this number, their habits are sustainable and should be fine. If they are spending more than that number but love going out too much, it might be time to ax a subscription or drive something cheaper.
If the rent going out were $2000 a month though, this would create a deficit of $119 before subscriptions are taken out. The added $800 in rent erases the $681 in discretionary income. This is a problem that cannot be solved by cutting back on everyday things.
This person needs to move or get rid of their car. Where the budget goes negative is where the root cause of financial problems lies.
Sum Up
I love this way of budgeting because it cuts out a lot of noise and brings problems to light very quickly. It also allows you to prioritize things when you have to choose one or the other. However, if you use this budgeting exercise and find that you’re creating a surplus every month and investing it, you’re well on your way to financial freedom. All it takes is the time from that point on.
Until Next Time,
Dom
