The Next Dollar Roadmap – Starting Point – Creating Your First Budget
Picture for a minute a place you’ve always wanted to visit, but never been able to go.
Now, imagine that you’re planning a trip to visit this place.
The first pieces of information you’ll need to make your plans are 1) where you’re going and 2) where you’re starting from.
This may seem painfully intuitive, but the truth is nearly any plans we make to carry us from one place to another, be it in our career, education, relationships, and especially in finances, require an endpoint and a starting point.
The endpoint is easy to visualize. It’s the goal, the prize, where the fun and the glory reside.
The starting point is less glamorous. Ideally, there’s no room for imagination and objectivity here.
The starting point is where we are now. The harsh reality of our current status, which is inferior to where we want to be because if it wasn’t why would we be trying to get somewhere else?
However, if we fail to properly evaluate where we are, it’s impossible to know how to get to where we want to be.
Just like you can’t go to Chicago without knowing whether or not you need to travel north, south, east, or west, you can’t reach financial goals without an accurate appraisal of your present situation.
That appraisal is called a budget.
For many, ‘budget’ is an over-achieving four-letter word with six characters. It inspires a level of excitement equivalent to that of a trip to the dentist.
Is it fun? Not really.
Is it necessary? It is if you want to be successful financially.
You have to know where your dollars are coming from and where they are going if you want to have control over your money.
Benefits of Budgeting
In case you still have doubts, let me attempt to persuade you of the importance of budgeting by highlighting several of the benefits:
1) Budgets Expose Unknowns
It’s natural for us to assume that we are capable of making excellent judgments about our own circumstances.
I mean who could possibly know better, right?
That’s why 80% of us think that we are “above average” drivers.
And, in case you didn’t pick up on the irony of that statistic, it’s also a perfect example of how even though we may be in the best position to evaluate our own circumstances, it doesn’t mean we do it accurately.
After all, how can 80 out of 100 drivers be above average if it’s only mathematically possible for 49 out of 100 drivers to be above average?
Similarly, when most people first do a budget, they’re generally surprised to find out how much money they are spending in a few categories.
One of my biggies was dining out. In my 20s, I worked about 25 miles from home and it was much easier to pick up something than carry a lunch to work.
When I did a budget, I discovered that I spent more on food from restaurants than I did on food from grocery stores. This was two to three times the amount I would have guessed.
A budget empowered me to do something about it instead of remaining blissfully ignorant and wondering why I never seemed to have enough money left at the end of each month to pay off debt or save for the future.
2) Budgets Provide an Opportunity to Improve
You know what else I had back in my 20s?
A landline.
I feel grey hair emerging from my scalp as I write this but for those of you who may not recall such days, back in the day nearly everyone had phones that had to plug into the wall at their house.
Then came cell phones.
As cellular technology began to improve, many people began to question the need for landlines.
As I remember, we were paying $40 a month for a phone we rarely used. That’s $480 per year.
Doing a budget highlighted opportunities to make the use of our money more efficient by eliminating redundancy or waste, like an extra phone line.
Subscription services are a more modern place that you see inefficiencies. Are there similar services that you’re paying to receive from multiple providers?
Back to food, are there more efficient ways to spend money dining out versus dining in? Where is there waste in your household that can be eliminated?
When was the last time you actually went to the gym? Do you really need such a low deductible on that insurance policy? Did you know you were spending that much on clothes each month while simultaneously complaining about the lack of space in your closet or dresser?
Budgets are helpful for asking and answering questions like these so we can hone our money management skills and produce better outcomes for ourselves and our households.
3) Budgets Help Us Measure Progress
I’ve already pointed out that you can’t reach a specific destination without knowing your starting point.
It’s also helpful to be able to measure your progress along the way.
To do that you need milestones or goals to work toward, but you can’t measure progress toward those goals without having a baseline.
A budget provides a picture of your starting point so you can measure progress with your money.
Has dumping those subscriptions resulted in more discretionary funds each month?
Has the money saved from skipping the restaurants made me more or less happy?
Do I worry at all about carrying a higher deductible for my car insurance or is the extra cash more beneficial?
Sure, these are still somewhat subjective questions, but with a budget, they’re being asked with quantitative factors in mind instead of just guessing.
That’s the power budgeting gives you.
4) Budgets Help You Get Buy In
If you’re single and no one else is dependent upon your income, then you can skip on down to the next section.
For those of you who are in a relationship, or you have others in your household who depend on your money in order to live, you’re going to need to recruit their help to make your budget successful.
Imagine setting a cap on your spending for clothes, groceries, or gasoline, only to have a spouse who likes to take long drives while wearing Armani suits and eating caviar.
You’d be married to an odd spouse and your budget would be rendered useless due to their frivolous spending.
By setting a budget you can establish a reasonable range of expectations about spending on a variety of categories, preventing awkward or frustrating misunderstandings about how money is going to be managed in your home.
If I may, I’d also recommend that you include your family when you set your budget. It is much more likely to succeed if all the stakeholders have an opportunity to voice their opinions and contribute to the process.
How To Build a Budget
Did you know that if you were traveling from Boston, Massachusetts to Lisbon, Portugal (also a port city) by boat and were just one degree off in your navigation you would travel 3,124 nautical miles across the Atlantic and end up 51.86 miles north or south of Lisbon?
You probably didn’t and you probably never cared, but it is a useful metaphor for illustrating the importance of accuracy.
It can be tempting to just get your budget “close enough”, but the effectiveness of your budget is also correlated to its accuracy.
Just like you wouldn’t want to aim for Lisbon but land in Nazaré, it doesn’t make much sense to do a half-baked budget and continue to be frustrated by a lack of clarity about where your money is going each month.
Do yourself a favor and be thorough. It will get easier as you continue to update your budget regularly.
In the interest of accuracy, let’s walk through the steps of creating a monthly budget.
1) Add Up Your Income
If you have a steady predictable income, this step should be pretty easy.
If your monthly income is somewhat irregular because you own a business, work on commission, or some other variable, look back up to a year in the past and average the amount you receive in income each month.
Even then, you might want to set your expectations conservatively.
It’s much easier to figure out what to do with extra money at the end of the month than it is to find more.
Personally, I’ve always left bonuses or the third payday in three payday months off of my budget and used that money to beef up emergency funds or savings for larger expenses.
The primary thing to focus on is being sure you set your income target at an amount you can realistically reach.
2) List ALL Your Expenses
At this point, you’re just going to list the expenses you have each month, not the amount of those expenses.
We’re just trying to establish a place to record everything so that when we begin applying actual dollars to the budget, all your expenses have a place to go.
If you must, dig up credit card statements and bank statements to help ensure that your list is complete. Again, it will only be as effective as it is accurate, so be sure to capture everything.
3) Organize Expenses Into Similar Categories
To be able to draw conclusions about your spending habits, you’ll need to organize your expenses into categories.
For example, you may want to lump all of your charitable giving into one category if you give to multiple organizations.
Or create a single category for kid-related expenses if you have multiple kids involved in multiple activities.
The point is to streamline things as much as possible so the end result is discernable and useful for improving financial decisions.
Here is an example list of expense categories we have used for years in our household:
Once you have a list of categories, group them into gifts, needs, wants, and savings.
This will add visibility to areas of your budget you have more control over.
As an example, you will probably have a higher degree of control over the amount you spend on entertainment each month than you will on your electric bill.
Logically, it will be more helpful to focus your attention on the parts of your budget that are either large expenses or places that you have a high degree of control.
4) Set Your Budget
Now that you have things organized, it’s time to begin applying numbers to your budget.
I recommend that you begin by taking the average of the previous 12 months of spend for each category and insert those figures into your budget.
This will give you a clear picture of your previous spending behavior so you can realistically set expectations going forward.
This is also where you’ll begin to realize just how much you’ve been spending in different categories and some ideas will begin to percolate about how you can use your money more wisely.
Once again, for expenses that are irregular, I recommend taking the average over the previous twelve months and adding 1% or 2% more to account for inflation.
If you want to get deep into the weeds, you can make monthly adjustments if you expect expenses to be significantly higher or lower in a given category, but you should know going into it that doing so will require a lot of effort.
After you have your expenses listed, begin looking for opportunities to make changes.
- Where are you spending more than you’d like?
- Where are you spending too little?
- How much is left after you total your expenses against your income?
- How much of your monthly spending can you control and how much is more difficult to adjust?
- Are you saving anything?
Start moving dollars around where you can to set a budget that is consistent with your financial goals.
I will get into more guidelines as we walk through the Next Dollar Roadmap, but here are a few that are relevant to budgeting:
- You absolutely must spend less than you make each month. If that means you need to sell things or move, then do it.
- Aim to keep your combined housing and transportation expenses below 30% of your take-home pay.
- Save at least 15% to 25% of your income in tax-advantaged retirement accounts.
5) Document It
Be sure to document your budget in a place that is easy to reference when possible.
To adjust behavior so that it aligns with your budget, you’ll need to be able to reconcile options with available funds as you are faced with purchasing decisions, not after.
The simplest, most effective, but also high hassle way to do this is to use the envelope system.
Using the envelope system, you’ll put the amount of cash you need for each budget category into an envelope. Once there isn’t enough cash left in the envelope you have to stop spending in that category for the remainder of the month.
Like I said, it’s effective, but it’s also a pain to set up.
To me, apps are the easiest way to track expenses against budget goals.
Whatever method you choose, just be sure it’s readily available so you don’t unwittingly overspend in certain budget categories.
6) Adjust Spending to Match Goals
This sounds like a very simple and logical step, but if you don’t follow it your budget will fail to fulfill its purpose.
Like a failing dieter who allows themselves frequent “cheat meals” and quick snacks, you’ll find yourself frustrated by a lack of progress if you can’t stick to your budget.
I’ve adopted a phrase that I probably saw in a movie that applies well to personal finance.
“It’s just math, and the math don’t lie.” – unknown movie
Math is an unbiased, objective, unaccommodating, unwavering, inflexible, uncaring judge.
If you spend more than you make, you will fail financially. It’s just math, and the math don’t lie.
If you make saving and investing a priority, you will succeed. It’s just math, and the math don’t lie.
You’ve got the plan, now all you have to do is follow it.
7) Update Regularly
This is the step that causes most budgets to fail.
It can be a lot of work to account for all of your expenses and plug them into your budget, but there are a few ways to help yourself out.
First off, if you can use debit or credit cards your bank or credit card company will probably have online balance sheets that update automatically.
Typically, there is an option to download transactions to a spreadsheet that should save you some time if you’re keeping your budget in a program like Excel.
If you want to take further advantage of technology, it may be worthwhile to use a budgeting app like Quicken, EveryDollar, Monarch Money, or Empower.
All of these apps can be connected to multiple accounts and pull all of your expenses in to one common place for quick accounting.
Most of these apps do charge fees, but if that’s what it takes to help make sure you’re keeping your budget then it’s probably worth it.
Find a system that works for you and stick with it.
Wrap Up
When I was 34, I got some feedback from my doctor about high cholesterol.
I didn’t think you were supposed to have to worry about that until you were 50 or so, so I was a bit surprised.
You might even say it felt a bit unfair.
As I sulked a bit, it occurred to me that there was only one person who could fix the issue and I saw him every morning in the mirror.
The bad news is he’s the guy that got me into that spot. The good news is I had control over the health choices I made.
I decided to exercise and eat better and I’m happy to say that I got back into shape.
We too have control over our financial circumstances. It can be tempting to focus on how it feels like someone is after our money at every turn, but we won’t improve our situation until we take control of our money.
A budget is the first and most fundamental step in exerting control over your finances.
Stop being a financial victim and use a budget to take ownership over your money.
