The Importance of Budgeting

Written by Paolo Lapietra

It’s always an interesting conversation when discussing budgeting with clients, colleagues, friends and family. The common theme is everyone is turned off by the thought of budgeting and the reasonings range from ‘I make enough to not have to worry,’ ‘I don’t make enough to even pay my essentials,’ or my favorite, ‘Whatever I’m doing now just works’. Regardless of what the reason is, the reality is you are not spending, saving, or investing as efficiently as you can. Creating a budget may seem like a lengthy, frustrating process, but it really doesn’t have to be. If you follow these four simple steps, you can create and maintain a simple budget that will help you become more financially efficient.

Analyze Your Income

The first step in creating a budget is understanding how much cash flow you have coming in each month to manage. When calculating your monthly cash flow, it’s important to only include your net pay and not your gross pay. Your net pay is the amount you receive after taxes and retirement savings deductions. For those who are self-employed or work jobs that are solely commission based, this can be more difficult due to the variability of income. For the entrepreneur or salesperson, the adage ‘Hope for the best and prepare for the worst’ really comes into play. It’s critical to know what you have coming in to fully understand what you can afford to spend.

Track Your Spending

Whether you make $250,000 a year or $35,000 a year, a common thought the week after payday is ‘…but where did it all go?’ This brings us to the second step, determining your expenses. When taking a close look at your monthly expenses, break them down into two categories, discretionary and non-discretionary.

Let’s start with the non-discretionary, or better known as, fixed expenses. These are the expenses that will not change month to month: mortgage/rent, car payments, loan payments, and insurance are all prime examples. These payments are your cost of living and need to be paid every month, come good times or bad. For that reason, it’s always important to factor them in first.

Next are the discretionary or variable expenses. These are the expenses that can change month to month, such as groceries, utilities, clothing, and entertainment. These expenses are considered discretionary because you can decide how much you spend on these specific categories. Some discretionary expenses can only be cut back on, such as utilities, while others can be cut out completely, like entertainment.

Now you’re probably thinking ‘Does he really think I’m going to write down every single expense I’ve had this month?’ which is a fair thought. Thankfully, there are numerous budgeting apps that will do it for you. Whether you choose Yodlee, Mint or YNAB, any one one of these apps will help you establish a strong understanding of exactly where your money is going every month.

Create Your Budget & Set Your Goals

After you analyze your income and subtract your spending, you will be left with either a positive or negative cash flow.  In either situation, this is the time to reflect on what you want to accomplish and build your budget accordingly.

If you have a negative cashflow, your number one priority should be becoming cashflow neutral, meaning your income minus your expenses should equal zero. This will involve taking a closer look at your discretionary expenses and seeing where you can adjust. If cutting back on your discretionary expenses is simply not an option, then you’ll need to increase your income. With jobless claims at or near all-time lows, picking up a side job is always a viable option to supplement your income.

If you have a positive cashflow, determine how much money you have net of your expenses to work with, and set goals for your financial future. While goals may differ from person to person, there are three goals that everyone should have, listed in order of importance. First, set a plan to pay off any high interest credit card or loan debt. As a rule of thumb, any interest rate above six percent should be considered a high interest rate. Second, establish and maintain an emergency fund. The emergency fund should have at least three to six months’ worth of expenses set aside for any personal dilemmas, such as job loss, illness, or major repairs. Third, contribute at least 10-15% of your gross income to your retirement account. After completing these three essential goals, any excess cashflow can be put towards your personal goals. It’s crucial to be reasonable with the amount you put towards any of your goals; the last thing you want is to put yourself in a situation where you’re overstretching your budget.

Update & Monitor

Analyzing your cashflow and creating a budget is the hard part, but after you complete your budget, it doesn’t mean that the job is over. As you can imagine, your budget that you create now will most likely need some tweaking as your income and expenses change throughout your life. Just as important as it is to have a budget, it’s equally as important to monitor and maintain it. Make a schedule and hold yourself accountable to go back and review your budget, check if you’re on track or off, and see if there are any changes that need to be made. You can’t make too many promises in this industry, but what I can promise you is that the first couple of months after creating and sticking to your budget will be tough. Thankfully, there’s a learning curve, and once you adjust to your budget it will become easier. Like anything else in life, hard work pays off, and putting in the extra effort now will be well worth it in the long run. Soon you’ll be on the path to financial wellness.