by Having trouble setting and sticking to your budget? Setting a budget is the first step towards financial freedom and I’ll show you a detailed step-by-step process on how to set and stick to a budget.
Contents
Why you need to Set a Budget
According to a Gallup poll, only one in three americans prepare a detailed household budget. Slightly fewer Americans (30%) prepare a long-term financial plan outlining their savings and investment goals in detail.
OK, so that kinda explains why the total U.S. consumer debt is at $13.86 trillion.
If you want to achieve financial freedom and let your money work for you instead of you work for money, you will 100% absolutely need to set a budget.
How to Set a Budget
To set a budget, you need to calculate 4 things:
- Living Expenses
- Retirement Goal
- Emergency Goal
- Savings Goal
The old adage goes: You can’t manage what you don’t measure. That is exactly true when it comes to budgets. If you routinely spend more than you earn, you might run into trouble after a few months.
With each goal, you will determine how much you need in the future, then determine how much to contribute each month to reach your goal.
1. Living Expenses
In this example, we tallied all of our living expenses which comes to $2300 per month.
2. Retirement Goal
How much money would you say you need to retire comfortably? Your monthly living expenses are $2300, equating to $27,600 annually.
You can generally live off your investments in perpetuity using the 4% rule. For example, if you amass a retirement nest egg of $1,200,000, you should reasonably be able to live the rest of your life by extracting 4% per year, equating to $48,000 per year.
Since your expenses are $27,600 annually post-tax, it would seem that $48,000 (in today’s dollars) a year pre-tax would be a reasonable retirement goal that would allow for you to pay taxes and provide a buffer for future unexpected expenses.
We can now narrow our problem to several variables:
When: In 31 years
What: Amass $1,200,000 in today’s dollars
How: Invest in an S&P 500 index fund with a historical 7% after-inflation annual compound growth rate
Using this calculator, we can determine that your monthly contribution should be about $949.60, but we’ll round up to $1000 to provide another small buffer.
3. Emergency Goal
You need to build up an emergency fund for piece of mind to cover unexpected expenses like car repairs, hospital bills, or transitioning between jobs. It is generally recommended that you keep at least 3 months of living expenses in your emergency fund. Since in this case your living expenses are roughly $2300, you’ll want to save about $6900 in your emergency fund. Once you’ve amassed $6900, you might want to devote more of your income into your 401k or your Savings. For sake of simplicity, let’s devote $500 a month to the emergency fund, but you can adapt as necessary.
4. Savings Goal
You need to save money to reach your pre-retirement goals such as buying a home or paying for a wedding. Savings does not mean putting money under your bed! It means putting money into investment vehicles that will GROW your money. These vehicles include bank savings, certificates of deposit, bonds, and index funds. $400 a month invested in a portfolio yielding 5% can amass you $28,237 after 5 years and $68,833 after 10 years. WHOA.
If you have a specific goal, like you need $40,000 in 5 years for a wedding, you can perform the calculation for the needed monthly contribution like in the previous retirement example.
And as you increase your income, you can increase your retirement savings and pre-retirement accounts. SCORE!
Here is what our sample monthly budget now looks like:
How to Stick to a Budget
But what’s the point of having a budget if you don’t stick to it?
Think you have the willpower to avoid the temptation of spending your money on things you don’t need? Studies have shown that willpower is overrated.
Say you want to stick to a diet. Would you leave freshly baked donuts on your countertop every morning? Imagine the willpower you’ll need to restrain yourself every day from indulging on one, two, and for me, THREE tantalizing donuts!
The two ways to stick to your budget and grow your money are to
- Automate your investments
- Use a tool to track your spending
Automate your investments
Employer-sponsored retirement plans:
My employer-sponsored retirement plans are funded automatically. Every month, my employer takes the same amount of my paycheck and puts it in a retirement plan. Due to dollar cost averaging, if the fund I buy drops in price, I’ll end up buying more it that month. And if the fund rises in price, I’ll end up buying less. My investments keep piling up and I don’t have to lift a finger.
Brokerage account:
I also fund my brokerage account every month in the same manner I do my employer-sponsored retirement plans. It’s done automagically and I don’t have to think about it. Schwab and Vanguard are very good brokerage firms that I highly recommend.
Once you automate your investments, your savings will be out of reach. Instead of cash being in your hand today, tempting you to spend it on the latest MacBook Pro, your money will be in an investment account growing month after month, year after year.
If needed, you can change the amount you contribute each pay period, so don’t worry about locking yourself in. If your budget changes, you can modify your contributions by contributing less or more each pay period.
Automate the Tracking of Your Spending
Mint
Yes, you can use a program like Excel and spend hours manually typing in line by line everything you buy in any given month.
OR, you can do what I do and use Mint to automagically track my spending. It securely keeps track of all of my debit card and credit card expenses, and categorizes them category like food, transportation, housing, clothes, etc. Mint then tallies exactly how much I spent on each category each month and whether or not I exceeded my budget.
It is extremely easy to set up and easy to use. Best of all, it’s FREE! They might show you a few credit card or savings account ads that that aren’t very intrusive, and I just end up ignoring them.
You can track the trends of your spending or even use their Budget feature to see how closely you are following your budget.
Adjust as Necessary
Your budget can change your living expenses change (new baby, new cat) or if your goals change (I want to retire in 10 years instead of 15!!)
If that’s the case you can adjust your budget to fit your needs.
If you get a raise at work, it’s extremely tempting to move into a bigger house, buy the newest vehicle, or the latest gadget.
But if you want to build wealth and achieve financial freedom, it is to avoid this so-called “lifestyle creep”. You don’t need to keep up with Joneses’. The Joneses’ really don’t care what kind of shoes you’re wearing, when you can spend YOUR time however YOU want to.
The Bottom Line
Setting a budget is as easy as calculating 4 things:
- Living expenses
- Retirement Goal
- Emergency Goal
- Savings Goal
Once you figure out how much you spend and what your goals are, you can easily follow your budget by automating your investments and expense tracking. Your investments will likely grow over time passively while accumulating compound interest and capital growth.
Now I’d like to hear from you:
What challenges have you faced with setting and sticking to a budget?
What kind of account do you recommend for an emergency fund? Would a checking or savings account suffice?
The purpose of an emergency fund is to provide you money fairly quickly when you need it.
Most checking accounts pays close to zero interest, so your money will lose value quickly in those accounts over time due to inflation.
There are more complicated strategies, like building a CD-ladder, but navigating the complexity and potential early withdrawal fees in my opinion make it not worth it.
A high-yield savings account in my opinion, is the way to go!