Getting Your Financial Ducks In A Row

There are two important records that you need to keep if you’re planning to be successful in managing your finances – a budget and a net worth statement.  In this post we’ll talk about how to make a budget, and the benefits of having one. (I can almost hear you groan: Great, the financial guy says I need a budget.  I can’t stand the idea of a budget!)

It doesn’t have to be like that. It’s easy to imagine that a budget would be a constraint, but this is really just a fear of the unknown.  A budget is really just a spending plan, with priorities applied. There don’t have to be constraints at all – the process of monitoring is the most important part of it all, as you’ll see in a bit.

How to make a budget

Making a budget is much more simple than you think.  Track your spending over the past several months (if you can gather the records) and do the same for every expense you pay out from this point forward.  Organize these expenditures into categories (you make them up – have fun with it if you like) and begin to think about how your categories relate to your life and your values.  For example, you likely have a category for auto expenses, another for home or household expenses, maybe one for groceries, and another for restaurants.  You may also have categories for entertainment, gifts, and clothing.

Certain expenses are fixed – such as your mortgage, cable TV, and auto insurance (although each of these could be adjusted from their current amounts).  But other expenses can vary quite a bit, such as dining out, entertaining, and clothing.  And if you think about it, some of the fixed expenses might be more variable than you think – or at least they could be reduced.

What’s important about a budget is that you are now thinking about your expenditures as you make them.  As you track your spending, you’re going to notice that there are some categories that you spend a lot of your income on, while other categories may not have any expenditures in some months.

What you’re doing is prioritizing – even if you haven’t made a conscious effort to do so.  Those things that you spend a lot of money on are the things that are (presently) getting more of your attention, time, and money, while other areas are being short-changed.  Until you create a spending plan to track your expenses, you probably won’t realize what those priorities really are.  Now that you have your spending plan, you can understand the priorities – and you probably will make some changes.

For example, if it turns out that you’re spending exactly every penny that you earn or more (thus no savings), you may decide that savings for a rainy day is important to you (remember, no judgments here, we’re just reviewing the plan).  If that’s the case, then you need to figure out what categories of your spending plan are less important to you than saving for a rainy day.  Maybe it’s clothes.  Or your auto expenses.  Or gifts.  Whatever that category or categories may be, you are in control and can make wise decisions about what gets priority and what doesn’t, for your life.

Start with your “fixed” expenses – mortgage, homeowner’s insurance, utilities, etc..  Are these really fixed?  Is it possible to impact the cost of your homeowner’s insurance – maybe by choosing a higher deductible (for example)?  How about refinancing your mortgage to a lower rate?  Just be careful that you don’t draw out equity when you do this, or stretch out the payments beyond what’s reasonable – but this could free up some money each month.  Maybe you’ve been paying on your mortgage for several years now and have built up equity to a point where you don’t have to pay PMI any more if you refinanced.  What about your utilities?  Couldn’t you reduce the cost by bumping the thermostat up (or down, depending on the season) a degree or two?

There are a myriad ways to reduce or eliminate these “fixed” expenses – as well as to impact your more variable expenses.  Cut back on dining out.  There’s no shame in brown-bagging your lunch – if dining out isn’t a high priority for you.  The same goes for grocery costs (clip coupons, choose store brands), clothing (most folks have more clothes than they ever wear anyhow), automobile expenses (take the bus, or work out a telecommuting arrangement at your job), and so on.

The point is that unless you track your spending, you can only have a vague idea of what your spending priorities really are.  By tracking your spending, now you are fully conscious of where you are putting your money – and you can decide what categories get more of your hard earned dollars.

The benefit of a budget

As mentioned above, once you begin tracking your expenses you are now in a position to understand and take control of your spending.  Where before you thought that all these expenses were necessary, now you can begin thinking of where your priorities lie.  If you place a higher value on a particular category, let’s say it’s charitable giving, and that priority is higher than your priority for cable television, now you are in a position to consider how to reduce the one expense in order to put more toward the other.  Having organized your information you can plan out how your budget dollars will be spent.

The bottom line is this – if you’re going along merrily without any sort of plan or monitoring arrangement, two things are going to eventually happen:

1. You’ll never achieve the balance of priorities that you hope to achieve in your life; and
2. At some point, when your income is reduced either by a change in job situation or at retirement, you’re going to have to work out a budget because the expenses without a plan are greater than your income.

Most everyone comes to this point in their life – and those who have spent a bit of time working on understanding their outlays in advance are in a much better position to make changes and adjust to a reduced income when it occurs.

The psychology of a budget

It’s a ubiquitous message in the financial world – you should have a budget. (Perhaps the word “budget” is a turn-off for you, so please use “spending plan” or whatever term you’d like to apply to a system where you track your income and expenses.) For many, it seems like this budget thing is some sort of torture device or a method designed solely to punish you for your spending choices. But did you know that the simple act of tracking your expenses and income can begin to improve your financial situation – without guilt?

If you concentrate on the monitoring aspect of a budget (or spending plan), something interesting will occur. You’ll begin to notice where you’re spending money, and how much money you’re bringing in as income… and as you do this, you’ll automatically begin to make decisions that will help to improve the overall outcome. You’ll reduce expenses where they’re not as necessary, and perhaps bring in more income as opportunities arise.

Part of this may come about by virtue of a management principle known as the Hawthorne Effect – which was a study done in a factory that noted improvement to productivity any time the workers knew they were being monitored. The study leaders increased the lighting in the factory – and productivity increased. Then they reduced the lighting in the factory – and once again, productivity increased.

The Hawthorne Affect invokes the idea that if you’re paying attention to something, especially if you’re being accountable to someone else, it will likely improve. Your accountability can be to your spouse, a roommate, or anyone at all, such as an online community. You can also use software for accountability – such as Mint.com or Quicken software. You just have to get into the accountability mindset.

When you have something to compare to – either a goal expense amount or your historical averages – there is a tendency over time to push your self to improve what you’re monitoring to meet that comparison. This is another management principle known as the John Henry Effect. This principle was developed based on the folk story of John Henry’s competition with the steam engine, and how John Henry stopped at nothing, even death, to beat his competition (comparison). Of course you wouldn’t take your financial improvement to the point of your death – but it just might get you over the hump to improving your financial world. Having a competition, a sort of internal game-play, can be helpful to improve your financial situation.