Introduction to Budgeting for FI
Budgeting. Everyone has heard of the word, but how many have actually properly sat down and given it the respect it deserves? Budgeting is a crucial financial skill that everyone should have, especially if you are managing your own or your families finances.
In this guide I will talk you through some of the reasons to budget, the benefits if you get it right (and stick to it) and the basics of budgeting and organising your finances. We will also explore some of the common pitfalls
Reasons to budget
Whether your starting to take more financial responsibility, saving up towards a financial goal such as a dream wedding, holiday or your first home, or just looking to free up more disposable cash, budgeting is a great way to get your finances in order. Budgeting is a key step towards financial independence allowing you to effectively sort your income and expenses to determine how much you can save (… or spend!)
Benefits of budgeting
Successful budgeting will let you;
1. Know exactly where your money is being spent – so you might be able to negotiate a better deal or find a better service
2. Understand what ratios your money is being spent, and allow you to prioritise what you spend your money on based on your values
3. Maximise your savings rate towards your goal
4. Apply for home loans (mortgage), finance or certain jobs. All of these require good self finance discipline and introspection
5. Stop paying for services you don’t need, or want! (… that old gym membership that you never use because you moved towns?)
How to budget
Step 1: Create your goal and visualise it
The first step to budgeting is to write your goal – you need to begin with the end in mind. What is your goal? How will you know if you have achieved it? How will it feel to achieve your goal? Some example goals are below
- I want to stop living paycheck to paycheck
- I don’t want to stress out anymore when a big bill arrives like car registration or land tax
- I am saving up towards my dream vacation
- I want to save up $50,000 for a deposit on my first home
- I want to afford my dream wedding
- I want to quit my job to work part time but still pay all my expenses
Now that you have your goal or mission statement, let that be your motivation to make your budget, and stick to it!
Step 2: List ALL of your bills and expenses
This can be a tricky task. You need to list all of your outgoing expenses. What do you spend your money on? It could be groceries, your mortgage or rent, insurance, going out to dinner, movies, travel. Try to list every single one of your expenses – excel spreadsheets can be fantastic for this, but a paper and pen is just as useful.
Tip – Bank statement printouts can be very useful if you go through them line by line for the last 12 months!
Once you have all of your expenses for the last year, sort and organise them into categories. This is important as you can start to classify your expenses, for example into the following categories
- Vehicle (Petrol, registration, maintenance, insurance, cleaning…)
- Loan repayments (car, personal loan, etc)
- Home insurance
- Medical insurance and expenses
- Recreation (‘Fun’ money!) such as Movies, Alcohol, Eating out, Toys
- Pet expenses
- Mobile phone plans
- Internet / Wi-Fi plans
- Rent or Mortgage repayments
- Professional memberships or other work related expenses
- Home maintenance and gardening
- Charity or church tithes
Hopefully as your starting to classify some of these expenses, it is raising awareness about your spending patterns. Ask yourself if that spending really gave you value, or if it made you happy.
Step 3: List all your sources of income
For most people working as employees this is pretty simple – it is your salary (minus taxes of course). Also consider any income from investments such as managed funds, shares or rental properties you may have. A close friend of mine is now making over $400 a week from her side hustle, which she includes in her fortnightly budget. The trick here is to include stable income streams, which you can rely on.
Step 4: Do some math
Does your incoming match your outgoing? If not, you should be worried – you could be living above your means. The trick to successful budgeting is to of course reduces your expenses below your income – WELL below. Living below your means is the BEST (and most tax and time effective) way to save money and increase your quality of life.
Consider this: You want an extra $100 a week to allow you to save up for your dream vacation of travelling the world at the end of the year. You could get a better paying job or take on extra hours at work, which certainly would boost your income. As long as your expenses don’t increase (which is called ‘lifestyle inflation’ you will see an increase in your savings. But the hidden cost of taxation erodes your efforts; if you are on a 30% taxation tier, you will need to work an additional third of the time to realise that savings goal. Another way to achieve this is to shave $100 a week off your expenses. Because your saving dollars that have already been earned and taxed, there is no additional taxation burden.
Step 5: Your savings plan
If you have a particular goal in mind, like a $5000 vacation that you want to go on in 12 months, by dividing that up into weekly amounts you get a realistic number that you can target for your budget. In this case, the $5000 vacation split over 52 weeks in a year comes out to be $100 a week required savings rate.
You need to adjust your outgoings to your income, so that you can achieve $100 a week saving; this might mean re-evaluating your spending habits and adjusting them to your values; do you really need that designer clothing, or expensive coffee to go every day, or would you prefer to achieve your savings goal and go on that dream holiday? Remember to focus on the end, and use this as motivation to stick to the plan.
Some of the biggest discretionary spending areas that people fall down on are;
- Luxury items like designer clothes and shoes
- Expensive take-away coffee and food
- Alcohol at pubs and nightclubs
- Excessive or new cars such as big SUVs or sports cars
- Financing personal loans
- Holidays and travel
- ‘Keeping up with the Jones’
- Mobile phone plans for the latest handsets
Go back to step 2 and review your list – what can you do without? What really gives you joy? Maybe it is time to pear back on the expenses that dont really bring you any joy, or where you can find better value (like switching phone plans!)
Take your hard earned (and saved) dollars and put them to work. I recommend using online savings accounts to find the highest interest rates available. This way, whilst you are saving towards your goal, you can earn a little interest and let this do some of the hard work for you. The best way to save is to do so on autopilot – automating good behaviour by setting up an automatic .
Step 6: The hard part – Stick to it!
The hardest part about budgeting by far is sticking to it.
Common pitfalls of budgeting
The most common pitfall of budgeting is of course, not sticking to the budget! There are a number of reasons this might happen, such as having an unrealistic savings rate and aggressively slashing your expenses. Pressure from your family and friends, or the desire to spend more because of advertising may also tempt you to stray. If in doubt, refer to step 1. Budgeting so that you are able to save money and start investing towards reaching FI (financial independence) is a crucial skill to develop if you want to succeed as a smart investor!