“It’s clearly a budget. It’s got a lot of numbers in it.” – George W. Bush
Tracking Your Life
Before even attempting to formulate a budget, or any financial plan for that matter, it is very important to track your general expenses and income. This can be done in a variety of ways.
Not only can a person use a spreadsheet on a program like Excel or Google Sheets, but there are a variety of applications that show how someone is using their money. Some of the more popular apps include Mint and Personal Capital; however, there are many others each with their own strengths and weaknesses. They work by simply summarizing transaction history from the accounts which you link it to, giving you very clear totals and an easy way to get a clear picture on your financial habits.
Whether using an automatic app or manually tracking your expenses, tracking is the first step to making any changes to your financial life. How can you know what the most effective changes will be without truly understanding where your money is going? Once you’ve categorized your expenses and discover which areas soak up the biggest amount of your income, it is time to take action.
To complete your financial snapshot, it is also important to know your net worth. This can give you a very strong, high-level understanding of your current financial position.
Check Your Net Worth
A person’s net worth is the difference between their assets and their liabilities. It is a widely used summary of someone’s financial position. The higher someone’s net worth, the richer they are.
If you find that you have a very high amount of unproductive liabilities, especially credit card debt or other types of consumer loans, it would likely be a best practice to pay those down as quickly as possible. The interest on those loans will continue to grow and eat into your net worth if you are not careful! Similarly, if you become over-leveraged, you could be in danger of losing a lot of your assets—too many loans at once and not enough income to make payments will typically spell disaster for your long-term financial position!
Categorize Your Spending
When you track, you should be able to sort your expenses into different categories. Certain apps, like the ones mentioned previously, sort expenses automatically (assuming all payments are made through your bank or online accounts rather than cash).
If sorting manually, be sure to divide expenses into general and specific areas. For example, you may have one category called “food,” and within food you would have groceries, restaurants, and delivery fees as subcategories. Thus, while food as a whole may seem small when compared to other general categories, there still might be plenty of space to adjust if you find that you are spending a lot on restaurants when you could easily buy cheaper (and even higher quality) food from the grocery store.
By isolating each expense area, you can take action to change it. Not only can it be a great step towards improving your quality of life in the short-term, it can have massive long-term implications through the savings that you would be making consistently thereafter.
Increase Your Income & Decrease Your Expenses
Simply put, there are two ways to increase your “profit,” or money kept after expenses; you must either increase your income or decrease your expenses. Ideally, you can do both!
Where to Add Income
Most people work some sort of salaried job. This, for the most part, restricts many opportunities for increasing income. At best, most people can expect a 2 to 5 percent raise to their salary each year. Sometimes they may earn a larger raise or a bonus, but most of the time the opportunities for income growth are quite limited. One option may be to increase hours and work overtime if that is allowed by your employer, but that may be unsustainable or unfeasible, not to mention it is a huge drain on time!
What’s the alternative? In order to be able to increase your income significantly, it is best to pursue a career where pay is measured by performance. A common example would be a job in sales or other commission based roles.
However, selling is certainly not for everyone, and it may make more sense to take a salary or wage based job in the field that fits your interests. But know that opportunities for salary growth may be quite limited by your employer, and it is ultimately up to them for as to how they will compensate you and if your salary will grow.
What about extra income outside of your day job? Most obviously, a person can get another job on a part-time basis. But this still has significant time costs and may not be a good long-term strategy.
Perhaps the most powerful strategy is to increase investment (or passive) income. This can be done through a number of different investments, including dividend stocks, funds, and real estate, among others. In time, these investments may become successful enough to entirely replace your salaried income, though many people use investments to simply complement their job earnings or allow for certain goals to be achieved.
The final, potentially very impactful way to increase your income is to start a business or some other entrepreneurial pursuit. Technically, a business has no ceiling in the amount of income it can make, unlike a predetermined salary. By offering a variety of products and services, and systematizing your efforts, income can be scaled dramatically.
Of course, there is a risk that the business could fail and this has to be taken into account before starting any ventures.
Increasing income can be quite difficult depending on the circumstances, so it is important to analyze all of the different options before pursuing any one in particular. In the meantime, it may be significantly easier to simply cut expenses to increase your effective “profit.”
Where to Cut Expenses
As Scott Trench, the author of Set For Life, has explained, the majority of a typical person’s expenses do not come from spending on luxuries or trips to the movies. Instead, the vast majority goes towards three areas: housing, food, and transportation.
Why is this? Naturally, a person spends a good portion of their budget on where they live. Whether it be buying or renting, housing typically takes up about a third of the average person’s budget. Of course, this is assuming that the person is not “house-hacking” and that they are not making any additional income from their home.
When it comes to food, many people chose to eat out quite often, especially if they spend long days at the office and do not pack a lunch to work. This adds up when multiplied across months of meals, since, shockingly, people need to eat!
Finally, transportation is one of the other major strains on a budget. More specifically, this cost is from a person’s commute to work in the vast majority of cases. Buying train tickets each day, paying for gas to get to and from work, and paying for parking in urban areas quickly increase a person’s transportation expenses. Auto insurance, car payments, and maintenance quickly add up as well. And this is not to mention the tremendous time cost of commuting back and forth to work every day!
Why is this important? When deciding where to cut, it may be far easier (and certainly more impactful) to reduce spending in those large areas. There simply is more room to cut!
Alternatively, you can look at it this way: a 10% reduction in $1,000 in monthly housing expenses is far greater than a 25% reduction in $200 in recreational expenses, and it would do a lot less to your ability to have fun in life! Similarly, is a new, $30,000 car really that much better than a used car for half of the price? Is there a way to better utilize transit or move closer to work to cut down on the commute time and costs?
The point is, as people like Scott Trench have shown, the emphasis should be on cutting the big expenses. These are the areas that bear the most weight on your budget, and more attention should be paid to them until they are under control. Don’t make yourself miserable by cutting out all of the fun from your budget, especially when there is plenty of room in the major areas. One less trip to a ballgame every couple of months is not what will make the biggest impact on your budget!
Of course, if a person is spending excessively on needless luxuries, or goes out partying every night of the week, he or she should first get those expenses reduced as they likely take up a disproportionately large part of that individual’s budget.
Either way, the focus should be on the largest areas which naturally have the most room to cut!
Unlike increasing income, reducing personal expenses is almost always tax free!
Think about it: when a person reduces their expenses by $100, that $100 is un-taxed and is free to be used for whatever else it may be. When a person increases their income by that same $100, it faces that person’s marginal income tax rate. As Scott Trench has stated to illustrate this point, “A penny saved is 1.33 pennies earned!”
Conclusion
If you want to learn something about yourself, track your spending. You may be surprised by what you find if you have never done it before.
By tracking your spending, you can figure out how to optimize your budget, increase your savings rate, and make your money go much, much further. A budget (and sticking to it!) shows a level of control over your life that will produce real results. Without one, you increase your risk of delaying progress towards your greatest goals.