Personal finance is hard. Most of the people I know struggle with it. It’s one of the most important skills of modern life, and yet there aren’t very many resources to help you learn it. This is one of them.
I like simple solutions. Simple solutions are rarely the best, but they’re simple. Simplicity makes them easier to understand, easier to act on. Simple solutions are the good in the blood feud with the perfect.
Personal budgeting has a very simple solution: don’t spend more than you make. Ultimately it all comes down to this. This can be difficult. People often feel that they can’t make more, can’t spend less. Neither of these facts are true. Cutting spending doesn’t have to be hard; it often is only because people lack visibility into where their money is going. This is where budgeting comes in.
A quick aside: you need to have a tool or system for budgeting. I’ve used Mint before. I’m a big fan of YNAB, which I use. Some friends use Excel spreadsheets. Pen and paper works just fine. It doesn’t matter what tools you use, and they don’t need to be fancy or complex. They just need to work for you.
Step Zero: What is your baseline income?
Your base income is the income you can be reasonably confident you will always make. If you are a salaried employee, it is your salary. If you’re on welfare, a retiree, or trust fund kid, it is your monthly stipend. If you work variable hours, say, guaranteed ten hours a week, it’s the money you make in ten hours. If it isn’t easy to say what this income is, make an educated guess and err on the pessimistic side. It’s always better to err on the pessimistic side when budgeting. If you accidentally make more money, it’s a present for yourself in the future. If you accidentally make less money, it’s a $30 overdraft fee.
For convenience, if at all possible you should do your calculations in post-tax, take-home income. If you get 10% of your paycheque deducted in taxes, and you include those taxes in your budget, you’re needlessly complicating things.
Step One: Categorize your spending
The first step is to categorize your spending in a way that helps you understand where your money goes, and empowers you budget to spend less of it. To do this, categorize all of your spending into sx categories:
- Monthly expenses (Fixed and Variable)
- Recurring expenses (Fixed and Variable)
- Discretionary expenses
- One-off expenses
Fixed Monthly expenses are the expenses you pay every month, that are the same, every month. They’re the most consistent expenses. Things like rent, bills, debt payments, etc.
Variable monthly expenses are expenses that you pay consistently month to month, but which you can’t predict exactly. Groceries, gasoline, things like this.
Recurring expenses are expenses that you pay on a regular basis, but which you do not pay every month. They may be fixed, or they may be variable. For me, the biggest example is car insurance: I pre-pay six months at a time in exchange for a discount on my rate. Annual membership dues can also go here.
Discretionary expenses are your disposable income. This is anything that is not necessary to your life. Entertainment, drinks, etc. Often this category is substantially more variable than your other variable expenses; you may buy $200 concert tickets one month, and spend $15 on entertainment the next.
One-off expenses are what they sound like. They are things that happen once. They are generally large purchases and unpredictable emergencies. Predictable emergencies are recurring expenses.
Step Two: Ensure your fixed monthly expenses are sustainable
This is a simple step. You should have a list of fixed expenses from step one. Rent, utilities, bills, debt payments. These should collectively sum to a sustainable number. A good rule of thumb is “no more than half of your take-home income”, however the specifics of your life may change this. If you live in a place such as Manhattan, with sky-high rents, this number can go higher. If you own a $50,000 house in Kansas, lower.
If your fixed monthly expenses are not sustainable, you need to fix this. Fixing this is easy: move into cheaper housing (keeping in mind that your commute costs are part of this). If cheaper housing isn’t an option, get a roommate. Split a house with a friend.
If lowering your fixed monthly expenses to <1/2 your income is very difficult, increase your income. Take side work. Get a job that pays tips. Work more hours. It might not be pleasant, but this is always an option. And remember: it is temporary. You should expect in life to trend towards wealth; you will gain experience, get promoted, find a better job. You will pay down your debts and eventually no longer have interest payments. Everyone busts their ass, but this is temporary.
Step Three: Evaluate your variable monthly costs
Most variable monthly costs are hard to reduce. For example, my variable monthly costs are gas, groceries, cafes, restaurants, and hydro. There’s always small gains to be had by cutting non-essential spending (your parents made do with instant coffee, don’t be a snob) but for the most part it is high work and low reward.
However, understanding where your variable monthly spending is going is very important. It tends to be important and non-negotiable, so if nothing else, you need to know how much space to make elsewhere in your budget.
To do this: track your spending for a few months. Just note how much you spend on gas, groceries, whatever. Don’t feel guilty if you think you’re spending too much; you’re in information gathering mode. Once you have a few months of records, look over them and try to estimate around the 90% mark. Pick one number. You should usually be under it, but sometimes be over it. Once you have this number, treat it as a fixed cost and repeat step two. You may not budget enough money some months, but you should have surpluses from previous months (already earmarked for this category) to tide you over. Over time, you’ll also build up a small buffer for these important expenses.
Step Four: Manage your recurring expenses
Step four looks a lot like steps two and three, but with the added complication of this spending being long-running. This only complicates things a little bit; simply amortize your costs over the number of months it takes to recur.
Say you have a $600 lump-sum car insurance payment every six months. Divide $600 by six to get $100 per month. Treat this recurring cost as if it was a monthly cost of $100, and repeat step two. Do a similar process for step 3.
One thing to keep in mind: many financial emergencies are predictable over the long term. You should treat these like recurring expenses, and squirrel away some money for them every month. You can get very detailed, expecting an $X medical expense every Y months, or you can simply work towards having a general emergency fund. Whichever strategy you use, you account for it in this category.
These expenses tend to be either very obviously necessary (car insurance) or very obviously unnecessary (club membership). Once you categorize them, it should be obvious which things you need to stop doing if you don’t have enough money.
Step Five: Make a savings goal
Once you’ve completed steps one through four, you will have an idea of your baseline expenses. This is, essentially, how much money you need to make more than. If you don’t make more than that, you have a problem, and you need to start cutting things out of your life until you spend less than you make. Alternatively, once you do this, you know how much money you need to make; go figure out a way to make that much money.
Assuming that you make more than you’ve spent up to this point, it’s time to make a savings goal. A good first goal is to have six months’ cost of living in emergency savings. Your cost of living is steps one through four. Choose an amount of money that you want to use to make progress on this goal, and budget for it.
How do you choose what amount of money to save? At this point, you save every single penny that you make above your baseline expenses. Call this your maximum savings expense. The things in the following steps come out of this; you need to decide how to balance them against your savings.
Step Six: Discretionary spending
Discretionary spending is nice-to-haves. Money you would like to spend, but don’t need to spend. If you’ve followed this guide so far, this step is very very simple. You’re allowed to spend as much as you want on discretionary spending, up to your maximum savings rate, but you are not allowed to take any money out of your baseline expenses, ever.
How much you choose to spend on luxuries is up to you. But now you have a nice balance between your baseline, your savings, and your discretionary. Your baseline gives you security: You know that you can keep spending that, forever, without going into financial ruin. Your discretionary spending gives you value right now. Your savings gives you value in the future. The question at this point is simple: Do you want the value now, or in the future. No matter what you choose, you know you’ll be alright.
Step Seven: Slush fund
You’ve made sure your baseline expenses are manageable. You’ve decided on a reasonable amount of saving. And you’ve bought all your friends a round of drinks. But you still have money left over (a nice problem to have!). What do you do with it?
You put it in a slush fund. Any money that has made it all the way to step seven is free. You can do whatever you want with it. You can use it to top up an expenses category, to buy the top shelf rum. You can use it to give your savings a boost. You can change it all into pennies and swim in it, Scrooge McDuck style. It doesn’t matter. The important part is that this money is yours. You don’t have to be disciplined with it.
I recommend keeping this money separated in some way from the rest of your money, to show that it has cleared your budget process. One useful strategy is to open a separate bank account for it. If you have a problem with impulsive spending, make yourself do all of that spending on a debit card tied to that account. You can use that card on whatever you want, without any guilt. And if the card is declined? Doesn’t matter, just means you have to wait until next month to impulse spend again.
A word of caution: your slush fund is freed from any responsibility, but the flip side of that is that you will naturally become undisciplined with it. Whenever possible, if you know you will spend a certain amount of slush on a certain category, you should make a budget line for it in one of the previous steps. You want a giant savings account, not a giant slush account.
Step Eight: One-offs
One-offs come out of your slush fund. It’s that simple. Want to buy a new gaming PC? Check your slush fund. Is your slush fund balance big enough to cover it? Then it’s yours. Not so much? Then live with a lower framerate.
As one-offs are slush spending, the same rules apply. If at all possible, you should create budgets for one-off purchases and save towards them that way. Treat them as another savings goal. If you fly home for Christmas, and you know it will cost $500, budget savings towards that just like you would any other recurring expense.
That’s a lot to take in, but that’s my budgeting strategy. Ultimately, no budget can help you if you spend more than you make. But a good budget can help make it easier to spend less. If you follow the above, you should have a very good idea of where your money goes. Once you know where it goes, you’re in a position to judge which things you can cut.
If you suffer from anxiety around your finances, these steps should also help you. By carefully protecting the critical parts of your finance, you gain the peace of mind that they will always be ok. By defining some of your income explicitly as discretionary, you no longer have to feel guilty about spending that money. And by making specific budgets for savings goals, the process becomes automatic. You don’t even have to think about it, and one, two, five years later, you will have a good nest egg.
Finally, if after all of this, you look at your income, you look at your expenses, and you still can’t make ends meet, then you know what you have to do. You need to make more money, and you have a clearly defined goal for how much.