For many people the word “budget” conjures feelings of restriction. (Just like the word “diet”.) However a good budget should be the exact opposite. It should facilitate you having enough money for the things that really matter so you need not feel restricted. In this article I reveal a better budgeting technique using the model “Pay Yourself First (in practice)”
Cue Skyhooks tune…
Budget…is not a…dirty word! Budget…is not a…dirty word!
Once on live TV I was challenged to come up with a better word for a budget. The interviewer felt the word was too creepy.
The reality, as you can probably guess is that it has nothing to do with the word but the meaning we associate with it.
In fact the origin of the word “budget” is in the leather case or wallet that bureaucrats used to carry their financial plans.
Of course the problem is that for many people budget conjures feelings of restriction. (Just like the word “diet”.)
A good budget should be the exact opposite. It should facilitate you having enough money for the things that really matter so you need not feel restricted.
You achieve this this by following the wealth principle I call “saving for the significant and minimising the insignificant.”
Pay Yourself First (in practice)
It’s likely you’ve heard of the principle to pay yourself first.
Back when I was a graduate engineer I thought this principle meant to put a certain percentage of my income away for wealth creation. Then I wondered “what next? How do I manage the remainder?”
Now that I’ve had the benefit of working with lots of people on their cash flow I’ve created this model to help you create an effective budget that sets aside money for the significant things in your life plan.
(Download a PDF version of the model here)
Top-down or bottom-up?
To follow the principle of pay yourself first ideally you work from the top as you allocate your income into pots of savings.
However, if you find that you never have any savings and in fact spend more than you earn the top-down approach won’t feel possible – because it’s not yet. To extricate your butt from the spending fire first you need to get control. You do that by starting at categories 5 and 6 and working upwards as you increase your control.
In short if you are in stages 1 or 2 in the Six Stages of Wealth Creation you would start at the bottom and work upwards to improve your cash flow management. Everyone else can take the planning approach and go top-down.
Your pots of money
1. Financial Independence
The first pot you allocate is how much you need to regularly invest so you accumulate enough net wealth to “retire” – or make work optional – when and how you want it.
In addition you include the additional regular loan repayment s you need to make to ensure you are free of personal (non-investment) debt by your financial independence target date.
2. Pre-retirement Essentials
The second allocation is to all the big things you want and need to do, buy or experience between now and the point you achieve financial independence.
For example: car upgrades, major home maintenance, family holidays, replacing major household items, parental leave. (The list goes on.)
In my experience many people find these items either blow their savings or are funded by debt. Why borrow and pay interest on predictable expenses when instead you could be earning interest? Earning interest in advance actually reduces the true cost of the items and the amount you need to save.
3. Irregular Expenses
In this pot I include all expenses you pay at least every year but less frequently than monthly.
For example: clothing, utilities, insurance, gifts, parties, subscriptions.
Again from my experience it is often the irregular expenses that end up blowing the savings of otherwise consistent savers. The problem for them is that whilst they are saving, usually by automated pay deductions, they are not saving enough. Month-to-month they may have savings but not year-to-year.
Often when clients actually separate their irregular from their regular expenses they are shocked by how high a proportion are irregular expenses. That observation alone is an insight into why they may be spending too much.
The expenses may be out of sight but they should not be out of budget.
4. Existing regular commitments
This category is the allocation for repaying all of your existing debts as per the current minimum required repayment.
For many people this is the first line item they put in when working out their budget.
The reason loan repayments is item 4 is that when you take a planning approach you first allocate items 1 through 3 to work out how much you can afford to borrow.
The way many people actually work out how much to borrow is a combination of:
- What the lender says they will lend them
- Their income less the regular spending that comes to their mind (i.e. untracked)
5. Regular Essentials & Comforts
All the regular items you spend at least every month.
When you take the planning approach you get to this point and discover how much you can afford to spend on comforts. And some things you thought were essentials get re-categorised.
It’s at this point many people start prioritising between lifestyle now and future significant goals.
- Which is more important to me?
- If I don’t save up for that future goal, but still want it how will I create the money to afford it? (e.g. I’ll only be able to afford X if I get a promotion – so I’d better start investing in professional development.)
6. Impulses and Indulgences
The final category is a little allocation for spontaneity.
How much to allocate to each pot
If everyone were identical in situation and value-system then we could define a nice neat package of percentages to allocate to each pot.
But we’re not.
To create a budget that is meaningful and motivating to you it needs to relate to your goals for your money.
That’s not as hard as it may sound. You already know what you want – it’s in your head, you probably think about it regularly. Just get it out of your head and onto paper and then put a number and time frame next to it.
Automatic wealth creation
Once implemented good budgeting should also be as automatic as possible. That’s the next step of smart cash flow management.
If you’re interested in how to put this all into place talk to me about Cash Flow Coaching.