The FI equation can be summed up as Income – Expenses = Net Income. From there, net income (whatever is left over) can be invested into assets that grow, which eventually grow large enough to allow you to retire. One issue here is that too many people focus on the income side of the equation and completely forget about the expenses side. This makes sense, as income is easier to understand because it typically comes from one source (a job) while expenses come from many. Well, it’s time for you to start focusing on the expenses side with the use of a budget.
A large majority of Americans do not budget. According to Hanscom Federal Credit Union, 41% of Americans in 2014 said they used a budget. While this number was up from 2013, I believe we can do better. Creating a budget and sticking to it is a key practice of financial independence. It not only helps achieve FI, it also helps you stay FI. You want to keep the wealth you have worked so hard to build, so you need to make sure you budget.
If you don’t have a budget, you’re in the right place. I hope that you are ready to create your budget after reading this post. The art of budgeting can be split up into two main activities: tracking and evaluating.
Before I continue, let me just say that tracking and evaluating are typically done on a monthly basis. I’ll explain more below. Let’s dive into each category and help you start your first budget!
Tracking Your Spending
There is no sense in evaluating your monthly expenses if you don’t already know your spending habits. Can you say what you should spend per month on groceries if you don’t know how much you spent over the last few months? Therefore, my first bit of advice is to start tracking your monthly spending.
There are many ways to track spending. You can use online applications, excel, or pen and paper. I highly recommend tracking your expenses using online software, specifically Mint. Online software automates the process of tracking for you. You will want to make this as easy as possible for yourself so that you actually stick to it.
Know Where Your Spending Comes From
You need to know which bank accounts your spending comes from. This advice might seem elementary, but it is necessary. Before tracking your spending for the next month, please do what I am about to say in this section.
You are going to dedicate the next month to tracking your spending and want it to be as easy as possibly. Before the beginning of the next month, do the following:
- Go through your wallet and pull out every debit/credit card.
- Lay out the cards in a neat and orderly fashion in front of you.
- Pick the main spending card you will use for the month.
- Put the rest of your cards away, but not back in your wallet.
Now you are ready to track your expenses. For the purposes of this post, there are two types of expenses: fixed and variable. As you go about your regular spending for the month, I want you to categorize into the two types of expenses.
Fixed Expense Budgets
In a nutshell, fixed expense do not change from month to month. Think of your typical mortgage or rent payment. Every month, you know exactly how much you are going to pay. The fixed expenses in my budget are categorized as:
- Auto Insurance
- Cell Phone Plan
- Student Loans
- Church Offering
These expenses do not change. Every month I know exactly how much I will be paying. These budgets are typically easy to spot and manage because they are constant.
Variable Expense Budgets
Variable expenses, as expected, tend to fluctuate every month. I am going to give these a bit more detail, as variable expenses might be a bit tougher to understand. The variable expenses in my budget are categorized as:
- Automobile Gas
- Automobile Maintenance
- We budget roughly $200 per month on automobile maintenance. Yes, this means we actually set aside $200 per month to plan for any car troubles. A lot of people believe that emergency funds should pay for auto repairs and I couldn’t disagree more.
- You can learn more about this from my post on Car Ownership: The True Cost and Why I Sold My Car
- Home Utilities
- This should technically be “groceries and toiletries”. This budget catches groceries, toiletries, and cleaning supplies for our apartment.
- Pets (we have 3 cats)
- Gift Giving
- Experience Life
- This is a new category my wife and I introduced this month. This budget catches everything that we deem a “life experience”. This can be traveling, going to a local concert, or trying a new restaurant in town.
- Everything Else
- To simplify life, we use this budget to catch everything else that comes our way that is not an emergency. Some examples from this month include my haircut, a dvd we rented, and a new pair of shorts I needed because I only own one.
These budgets are tailored made for my life. They are not a one size fits all set of categories. My hope is that my budget categories can give you an idea of how you should categorize your own spending.
Evaluating Your Spending
A Window Into Your Life
Now that you understand a bit about the different budget categories, it is time to learn how to evaluate them. Moreover, it is time to learn how to improve them. You might discover that you are spending much more or much less per month than you initially thought. If your spending is less than your monthly income, then you are on the right track to FI! If your spending is more than your monthly income, then you need to take action.
“You can have anything, but not everything” is a common phrase used in the FI community. The point of financial independence is to be able to enjoy a life where you can afford anything, but not everything. This should apply to your budget. Your budget should be a window into the life you want to live. I do not value a fancy home, a nice car, or luxurious items in general. My wife and I value experiences. Even then, we do not value every experience that exists. To be specific, we value local adventuring.
You have all of the information you need to take action. It all comes down to determining what you value in life and how you can reflect that in your budget. Yes, you can start clipping coupons and signing up for gas rewards programs, but it doesn’t answer the question of what you value. Let me explain what I mean.
When I was evaluating my budget, I noticed that I was spending a lot of money on things I did not truly value in life. I had two newer model cars, I was going out to eat a lot, and buying expensive gadgets. By the time I wanted to take a local trip somewhere, I had nowhere in my budget to do so! It took the realization that I valued local experiences with my wife more than gadgets and newer model cars.
Your values may look entirely different from mine. If you value fancy cars, then you probably have to increase your car budget but decrease your travel budget. If you need to live in a luxury apartment, you need to increase your rent budget and decrease your “go out to eat” budget. Like getting that weekly, expensive massage? Great! Increase that budget but decrease some other.
I am not trying to condemn one lifestyle over the other. The point I am trying to make is that your monthly spending should reflect what you truly enjoy in life – but you have to accept the fact that you cannot truly enjoy everything under the sun.
This post should probably be titled: “The Psychology of Budgeting” or something. Maybe even “The Reality of Budgeting”?
I know I promised you I would help you start your first budget. So, let me end this with some action items for you.
- Pick a debit/credit card you are going to use for the entirety of a month.
- At the start of the month, save your receipts for every expense.
- Categorize the receipts. You can loosely base them off of mine from above.
- At the end of the month, evaluate your spending. Before you can optimize, you need to understand why you are spending the way you are. Try to get your spending more in line with your values. THEN you can optimize.
I hope you feel comfortable enough to start your budget. You will not get it right the first time. It took me two years to finally feel like I got it right. Let me know how you are doing in the comments below!