What is budgeting? Ask a few people and you might get a few different answers. The reason is because cash flows in and out of your account whether you are intentional about the budgeting process or not. Cash flow management, or budgeting, is simply that — the process of gaining a better understanding how you are managing your spending to ensure that it lines up with your priorities. Without budgeting, we can fall victim to spending our money on items that will not help us reach our desired lifestyle or financial goals.
It can be overwhelming for some to start, but often we find that once people get in the habit of monitoring their cash flow, it is an enlightening process and one that can improve your life greatly. Let’s look at a few of the most common ways people keep a budget.
The “Fly by the Seat of Your Pants” Method
More than half of our population uses this method of budgeting. This is what we talked about in the first part of this blog with not really paying close attention to how you are spending.
In this method, the person looks at the bank statement occasionally to make sure they are spending less than they are making.
Advantages:
- Not time consuming
- Not seeing your spending habits might help some to simply not worry about it. They say ignorance is bliss!
Disadvantages:
- Unaware of spending habits
- Easy to misalign spending with long-term priorities
Generally, we see people use this method when they haven’t really planned out their life goals or financial goals. The other time we see this method being used is when people haven't been properly trained on better ways to do it.
Money is a tool to help us reach our desired lifestyle. At Summit, we believe each of us has a specific purpose to fulfill, and intentional goal setting and cash flow management can put us on the fast track to helping us find and achieve our purpose!
The Envelope System
A budgeting method that was popularized by the radio talk show host Dave Ramsey, this system is a cash-only system.
The idea is to take your paychecks in the form of actual cash. Have an envelope for each budget category (i.e., groceries, dining out, utilities, gas, car payment, mortgage, etc.). Place the cash in each envelope for how much you think you might need for that pay period. You should even have envelopes for the different types of savings accounts, retirement, emergency fund, and down payment on a future home purchase. Every dollar you make then has a place and a purpose.
Advantages:
- Good for those that struggle with overspending
- Tougher mentally to spend cash than swiping a card
Disadvantages:
- Hard to manage cash
- Too much cash on hand can be risky (no recourse if money is lost, stolen, etc.)
The envelop system can be a powerful way of managing your cash flow. Having cash in your hand can be a really great way to prevent over-spending or to avoid spending on items that are really not all that important to you long-term. You worked hard for that cash and handing it over in an exchange for something is more difficult than swiping a card.
But having cash on hand comes with risks too. If you are prone to misplacing things, or if you are worried about theft, with a debit card you can always call and cancel the card, order a new one, dispute charges — there’s little recourse to recovering lost or stolen cash.
That being said, there are some apps and tools online that create a virtual envelope system. This can be a good alternative to having physical cash. Just remember, when the envelope is empty for that category, you can’t spend any more in that category unless you borrow from another envelope!
50 / 30 / 20 Budget
A lot of people find success with a budget method called the 50 / 30 / 20 budget. The way it works is by dividing your take-home pay into 3 imaginary buckets:
50% Needs
- Groceries
- Housing
- Utilities
- Health Insurance
- Car Payment
30% Wants
- Shopping
- Dining out
- Hobbies
20% Savings
- Retirement
- Emergency / rainy day fund
- Vacations
- Big purchases
The 50/30/20 budget works best when we have separate bank accounts for all three of those buckets.
Advantages:
- Simple solution for budgeting
- Effective in aligning priorities with spending
- Can put much of it on “autopilot”
Disadvantages:
- Easy to “borrow” from one bucket to another
- Perhaps so easy that you don’t think to revisit and readjust it from time to time
The reason this budgeting system works so well for many is because it is similar to the one that people default to when they are not intentional about budgeting, the “Fly by the Seat of Your Pants” method described earlier. But the key difference here, is we are still monitoring our spending, and by separating our buckets into three categories, we are defining what is a need vs a want and we are prioritizing our spending in a way that aligns with our goals.
It might not be the most detailed or complicated method, but it is effective for many and that’s what the goal is.
Zero-Based Budget
Zero-based budgeting is a budgeting technique that gets a little more in depth but can have some great payoffs. The way this method works is by assigning each dollar that comes in with an exact purpose. There are no leftover dollars in the zero-based budgeting system, hence the name.
Advantages: Total control
Disadvantage: Time consuming
Often, zero-based budgeters set up a spreadsheet to help them. Others can do it in a notebook or even on the back of a napkin. The idea is to write your income at the top (every dollar you expect to come in that month) and then a line item for each expense underneath. You will also create line items for unforeseen expenses, allocate a portion of the annual expenses such as insurance premiums (or Amazon Prime!), as well as various types of savings accounts. At the bottom of your spreadsheet, you should end up with zero dollars left over.
One tip here to make this system work better. A lot of banks will categorize your spending (account aggregation tools such as mint.com can do the same thing). By checking your spending over the past 3 or 4 months you can see how much you spent in each category which should help when setting up a zero-based budget for the first time, so you are not way off in your numbers.
Budgeting is a lot like dieting. Dietitians will tell you that a good diet is not one that necessarily helps you lose weight really fast, a good diet is one that you can maintain throughout your life. That means choosing a diet with foods you enjoy and not making it too hard on yourself. The same is true of budgeting. Choosing a budget method doesn’t have to add a lot of time or stress to your life. Rather, find a budgeting method that works for you. If you are in control of your finances and your spending is in sync with your priorities, then you are doing it right!