Friday, April 11, 2014

My take on budgeting

Most personal finance experts recommend creating a detailed budget as the first step.  Ramit Sethi in his book (and blog) I Will Teach You To Be Rich takes a radically different approach of ditching budgets because they cause undue anxiety and guilt.  I recommend a middle ground: start organizing your personal finances by creating a rough budget.

My approach is outlined as follows:
  • Use the 80/20 rule in your budgeting.
  • Have a goal of how much you want to save each month.
  • Create a budget only for your most expensive recurring items (usually car and housing).  Subtract the sum of those and your saving goal from your monthly take home pay and you get your "Misc" category.  "Misc" is the amount of money available to spend on your smaller-ticket items as well as discretionary expenses.
  • Review your budget each month:
    • Are you meeting your saving goals?  If not, either make it more realistic, cut your spending, or look for ways to make more money.
    • If you are easily meeting your saving goals, set it higher!
    • Consider signing up for and use it to guide your budgeting.
Step 1: Assess your cash flows and decide how much you want to save.

From now on, I'll refer to your monthly take home pay as X.  It's the amount you receive from your monthly paycheck if you're salaried.  If your income varies (i.e. you're an entrepreneur, you're paid by commission, you're hourly, you frequently work and get paid overtime, etc), then make a conservative estimate of your monthly take home pay (after taxes, Social Security, etc.)  Decide how much money you want to save each month.  If you have no idea, try starting with 20% of your take home pay.  Let your monthly saving goal = S.

Step 2: Housing Expenses.

If you rent, this number is simple, it's your rent.  If you rent with roommates or split it with your spouse or partner, it's simply your share of the rent.

If you have a mortgage, the process is a little more complicated.  Add up the following expenses first:
  • Monthly mortgage payment (estimate it if you have a variable interest loan.  Omit it if your house is paid off.)
  • Property taxes.
  • HOA fees (if any.)
  • Property insurance (if paid yearly, take the pro-rated monthly share.)
  • Maintenance.
    • Please note you need to set aside some money each month in case something goes wrong and you need to fix it.
    • If unsure, go with 50% of your monthly property taxes.
    • If you didn't perform any maintenance this month, save this money instead of spending it on your "wants".
Step 3: Transportation Expenses.

If you're lucky enough to have reliable public transportation and don't have a car, purchase a monthly transit pass if it's offered.  This will be your monthly transportation expense.

If you have a car, add up the following:
  • Car Payment (0 if your car is paid off.)
  • Insurance (calculate the pro-rated monthly expense if you pay your premium annually or semiannually.
  • Gas: Estimate based on your average monthly driving and your car's MPG.
    • If you work 5 days a week, estimate your weekly miles driven by multiplying your round trip commute distance by 6 (not 5 since you need to also run errands.)  Then multiply this figure by 4.  Let D = your answer, your monthly miles driven.  Of course, if you can estimate it more accurately, do it!
    • Get the MPG of your car.  If you don't track your MPG, look it up on
    • Get the average price of gas from
    • Divide D by your car's MPG then multiply the average price of gas.  This is a rough estimate of your monthly gas expenses.
  • Registration Fees: They're usually paid yearly, so divide it by 12.
  • Car Maintenance:  You need to set aside some money in case your car breaks down.  It's difficult to gauge how much but I use a rule of thumb of $0.05 per mile driven (which you calculated in the step above.)  Like with housing maintenance, if you didn't perform any maintenance this month, save this money in a reserve account.
Step 4: The 10% Rule: other significant expenses.

Any single recurring expense that's not covered above and is over 10% of your take home pay should go into your budget.  I pick 10% since it's easy to calculate and you can have up to 10 of them anyways.  Examples may include:
  • Medical payments
  • Debt payments (credit cards, student loans, etc.)
  • Child support or alimony
  • Health Insurance
  • Tuition and college expenses (if you have adult children who need this support.)
  • etc.
Step 5: What's Left Over?

Add up the numbers from steps 2 - 4 and subtract them from X.  Subtract your saving goal S from that result.  This is what you have left for all your miscellaneous expenses (i.e. food, clothing, cell phone bills, entertainment, fitness, etc.)  These expenses, individually, may be small compared to your housing or car expenses but they surely add up!

Let M = "Miscellaneous Expenses", the amount you calculated above that's left for everything else.  If you got a negative number here, you've clearly done something wrong or created an unrealistic budget - go back and adjust your savings goal or look to downsize your car or housing!

Step 6: Test Your Budget

Your budget should only have the following items:
  • Housing
  • Transportation
  • Other Big Expenses
  • Misc
  • Savings
 You want to test if the budget you created above works.  There's no single way to test but if you don't have any ideas, you can try my suggestion:
  • Create or set aside 2 bank accounts.
  • Take your next paycheck and split it into 2.
    • Put your savings goal S into one account.  Call this Account A.
    • Put what's left over from your paycheck into the other account.  Call this Account B.
  • For 1 month, try only spending money from Account B and only if you run out do you try spending from Account A.  Pay cash only for this month.
  • Transfer the money for Housing and Car maintenance to a 3rd account.  If you performed maintenance this month, pay it from your savings instead of A or B.
  • If you pay off your credit cards every month and need money to pay them off this time, pay them off from your savings, not Account A or B.
There are 3 possible end results after a month if you've followed the steps above correctly:
  • 1. You still have money left in Account B: Congrats, you are not going over your budget!  You can consider increasing your savings goal and running through the process again for the next month.
  • 2. You spent all the money in Account B and tapped into Account A: Either your savings goal is unrealistically high or your budget is too high.  You may want to downsize your larger expenses like housing or transportation if it's realistic or managing your Misc category of expenses in greater detail.  Consider cutting back on things you don't care too much for (i.e. If you don't use your cell phone a lot, consider downgrading the plan.  If you eat out frequently but know how to cook, try cooking at home more.)
  • 3. You ran out of money in both Account A and B: This is not a good sign as you're spending more than you are taking in.  Your spending is not sustainable and you need to seriously look into cutting aggressively or earning more money.  As per #2, start by cutting your biggest expenses before micromanaging your finances by creating a detailed plan for your Misc category.
 My Budget

I'll walk you through the process above for creating my own budget:

Step 1:

Take Home Pay = $2900.
Saving Goal = $1000.

Step 2:

Housing expense: $850.

Step 3:

Car Payment: $0
Miles driven per month: ~1500
Average gas mileage: 33 mpg (I drive a 1999 Honda Civic and have been tracking the gas mileage over the last 3-4 years, and that's the average figure I've gotten as opposed to the EPA estimates.)
Average gas price: $4/gal
Gas Expense = 1500*4/33 = $182
Insurance = 700/6 = $116.67
Maintenance = 1500*0.05 = $75
Registration fees = $82/6 =  $13.67
Total Car Expenses: $387.34/mo.

Step 4:

(Nothing here.)

Step 5:

Money left over for everything else = 2900 - 850 - 387.34  - 1000 = $662.66.

Realistically, about half of that goes to food and another $100 goes to utilities and cell phone bills.  So this leaves about $200 for discretionary spending and the small ticket items each month.

This pie chart summarizes where my take home pay goes each month:

 How do you approach budgeting?  Please share it in the comments below!

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