Becoming a black belt and having a “mind like water” in your personal finances is very similar. It means you can take whatever is thrown at you without knocking your finances out of control. You can respond to any situation with perfect balance. Unexpected events or changes in your finances, good or bad, can be handled with optimum efficiency, and little or no stress. It means you can direct the flow of money where you need it almost effortlessly.

In an effort to help people gauge where they are in their personal finance development, I’ve defined what people at the various “belts” might look like. Where are you?

White Belt

You’ve recognized there is a problem with your finances and have committed to taking control. Recognition that there’s problem may come as a nagging doubt that you’re not meeting all your financial goals or a harsh reality check as you face mounting debt. You have a lot of stress concerning finances (even if you’re living within your means). You tend to fight with your spouse every time you discuss financial matters. You recognize your spending isn’t in line with your true values. You have no idea where all the money goes from month to month. You may be living paycheck to paycheck. If you saved $5 on your phone bill, it would just disappear somewhere but you don’t know where. Your idea of an emergency fund is a credit card or Home Equity Line of Credit. You frequently pay late fees on your bills and unnecessary bank fees. Net worth? What’s that?

Despite your lack of financial control, you have a strong resolve to take action even though the thought of facing the “deep mess” of your finances seems overwhelming. You and your spouse have agreed to work together. In an effort to get your spending under control, you’ve started using cash for your “out-of-control” budget categories. You’ve stopped using credit cards somewhat reluctantly and possibly out of the sheer pain of your dire financial straights. Despite some complaining, your family has agreed to use cash as well. You’ve taken initial steps to figure out what your basic monthly income and expenses are and have tried budgeting for at least one month even though it doesn’t match reality yet.

Most importantly, you’re no longer willing to BE IN DEBT!

You’re no longer willing to constantly WORRY ABOUT MONEY!

You’re no longer willing to FIGHT ABOUT MONEY!

You’re no longer willing to PAY LATE FEES!

You’re committed to TAKING RESPONSIBILITY FOR YOUR FINANCES!

You’re committed to WORKING THROUGH FINANCIAL ISSUES TOGETHER WITH YOUR SPOUSE!

White belts come in many shapes and sizes. Of course, those steeped in debt and on the verge of bankruptcy can be white belts, but so can those who are living within their means (see below). Being a white belt means you don’t have total control over where your money goes. Your spending doesn’t reflect your true values and is not conscious. The white belt is about recognition and commitment. You’ve recognized a need to change and are committed to doing what it takes to change.

Green Belt

You’re well under way implementing your financial-management plan. You’ve budgeted for at least 3 months in a row and have worked many of the kinks out. Your budget actually reflects reality.

You meet with your spouse about every two weeks to keep things on track. You often have to implement the 30-minute rule and meet several days in a row to prevent total melt-downs.

You’ve taken all credit cards out of your wallet and are using cash for all of your “in-person” spending. As a result, for the first time you feel like you have control over your spending. You’ve even started developing your own unique ways of managing your cash and have a tendency to give spontaneous testimonials about the virtues of cash whenever someone acknowledges your use of a cash envelope.

You’re well under way saving for a short-term emergency fund. You may not have it fully funded yet but you already notice feeling much less stressed having at least something in place. For the first time in your life, you may have even experienced an emergency and had the money to pay for it. You have created an initial net worth statement and have a general idea about your overall financial status.

If you saved $5 on your phone bill, you could probably redirect it rather than letting it disappear. You no longer pay late fees or bank fees. If necessary, you’ve made major changes in your lifestyle to ensure you can live well within your means.

Brown Belt

You’ve been on a zero-based budget for over 6 months and things are really humming. You may have occasional refinements, but things are mostly on cruise control. You’re able to manage your finances on one meeting a month and are able to get through most meetings without any arguments.

You’ve gone through at least one set of envelopes. You find that you’re keeping the cash envelopes the bank gives you when you cash a check or make a withdrawal because they are a better size than regular envelopes.

You’re friends have started noticing that you pay cash all the time and have asked you about it. You find yourself preaching the cash gospel and sharing your success whenever you can.

You have a fully-funded short-term emergency fund and have started reducing consumer debt or increasing retirement savings. You have a strong sense of control over your finances and can see significant improvement every time you refresh your net worth report (which you do at least once a quarter). You and your spouse have reconciled your financial differences and have a new-found sense of unity when it comes to finances. You’ve created a list of rules concerning what you both consider to be an emergency as well as what you want to do with any unexpected windfall money. By making these decisions ahead of time while you’re calm, you avoid big arguments when these events occur.

Black Belt

You laugh in the face of emergencies (mua-ha-ha) and can easily and confidently deal with anything thrown at you. Seriously, for all practical purposes financial emergencies don’t really exist for you any more. If you save $5 on a phone bill, you’re financial system allows you to know about it and easily redirect it exactly where you want. You have complete financial control over every dollar.

You no longer worry about finances. Instead of worrying about how to pay the bills on time, you think about what investments to make or which debt to pay off next. You’re amazed and shocked that people even pay late fees (you obviously are having a bout of selective amnesia). You are aggressively on track to pay off all consumer debt and/or save for retirement. In fact, sometimes you find it hard to spend extra funds because you’re so excited to become debt-free that you want to reduce your debt instead.

You finally feel like where you spend your money is a reflection of your true values. You and your spouse see eye-to-eye concerning finances. You only have major financial discussions when your financial situation changes dramatically.

You not only calculate your net worth quarterly, but also have calculated when you’ll become financially independent.

You kind of wish you’d get fired so you could find a job you really like (you have a full emergency fund and could get by for 3 to 6 months without any income). You only have to spend about 30 minutes a month on average managing your finances. You’ve cut up all your credit cards because you just don’t need or want them anymore.

Your belt level isn’t about debt, savings, or your net worth.

Some of you may have noticed that my description of the belts didn’t include savings percentages or require you to be debt-free. Your belt level isn’t about debt, savings, or your net worth. It’s about your ability to control your money, ensuring that each dollar is directed where you want. I’m sure I’ll get a lot of flack for saying this. Of course, savings and debt elimination are cornerstones of a solid financial foundation. But to enable you to save and pay off debt, you first have to get a handle on your inflows and outflows. As you gain greater levels of financial control, you can easily reach your savings and debt-reduction goals at an ever-accelerated rate.

The good news is, you can become a financial black belt even if you still have debt or haven’t reached your long-term goals. Of course, if you are a black belt, it won’t be for long before you do. As you progress in your career and get raises, or as you receive windfalls, you will be able to direct those extra funds with great focus and power to eliminate debt and reach your long-term goals. That’s the power of a black belt.

Take your finances to an “11″

I can’t avoid referencing this segment from This Is Spinal Tap. If you haven’t seen it, you should take a look.

I know many people who live within their means, pay off their credit card bill every month, and think they have arrived in terms of financial management. But the fact is, you can do these things and still be a financial white belt. I know this for a fact because I’ve been there.

There was a time when our income greatly exceeded our expenses. We saved ten percent and gave to our church. We also lived large and bought just about anything we wanted and were still living within our means. For the most part, we just accumulated a bunch of “stuff” and made a lot of emotional, at-the-register purchases. As we look back we kick ourselves for not using that money in a more conscious way. Had we been financial black belts, we could have greatly accelerated our journey to financial independence. Today, even though we have downgraded to a single income and increased our expenses (mortgage, child), we are doing more with what we have now than we did with two incomes, no children, and low living expenses. As a result we have been able to reach financial goals with tremendous speed and ease.

I’m not saying you have to choose between having fun with your money and saving it for later. As a black belt, you can set aside funds for frivolous spending and still aggressively meet your financial goals. The key is to spend consciously, making decisions as they relate to your values and your finances as a whole. If you plan wisely, you can have the best of both worlds.

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Q: what do you think about not spending anything on credit cards? everyone else is in trouble so why not use cash only!”

For the past few weeks I couldn’t get this statement off my mind. It’s one thing to have a strong position . It’s quite another to insult those who follow a perfectly legitimate and arguably superior system of financial management.

To resolve this issue, or at least let the blog-reading community decide for themselves, I challenge Ramit to a good-spirited showdown: Credit Cards vs. Cash. Ramit can present the credit-card arguments and I’ll present the cash/debit arguments. The readers on each side can also chime in. I read a similar showdown about productivity a while back and thought it was useful.

Please leave a comment and let us know what questions or views do you have about credit cards vs. cash? What questions would you want to see addressed if a showdown takes place?

If Ramit accepts we’ll decide the terms, time, and format. Let’s have Ramit express his spirited feelings in a more articulate and useful way.

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“While I try my best to “get rich slowly” I have one huge issue: a husband. My husband likes to spend money. I’m referred to as the “Thrifty One Who Won’t Allow Me To Buy Stuff” and he’s referred to as “That Jerk Who Buys Stuff”. Do you have any advice for couples that need to have the other half put on a strict budget without making them feel like a child?”

I posted a comment at Get Rich Slowly in response, but I thought this excellent question deserved a more thorough answer, so here goes.

In my experience, there are 3 keys to making your personal finances work as a couple:

1. If you don’t already have an established method of managing finances, decide together to try an established, published system. Agree to stick to it exactly, unless you both decide to deviate.
2. Make the “personal” budget category a high-priority and fund it as generously as you can.
3. Don’t discuss finances for more than 30 minutes at a time or past 10:00 at night. If you don’t get through all the issues, meet again tomorrow.

1. If you don’t already have an established method of managing finances, decide together to try an established, published system. Agree to stick to it exactly, unless you both decide to deviate.

My wife and I have always lived within our means and have never had debt problems. However, we never saw eye-to-eye on the specifics of how to manage finances. I always felt like we were doing great; we were living within our means and saving 10% of our income for retirement. I figured we could spend the rest however we wanted. My wife always felt like the rest of our money was just wasting away on things that were useless. Even though we were doing better than a large portion of the population, she continued to experience significant anxiety and discontentment.

We both had read several personal finance books and tried to persuade the other to adopt the principles, but to no avail. I realize now that in many cases we weren’t rejecting the ideas, we were rejecting the messenger (the spouse).

Finally, after 10 years of marriage we faced a series of emergencies that forced us to either move from our home and dramatically reduce our standard of living or get a tight grip on our financial management. We figured we could barely make it through if we carefully managed every dollar.

In our desperation, we decided to attend Dave Ramsey’s Financial Peace University, a 3-month, weekly course in managing personal finances. Knowing that one of us had always rejected financial ideas proposed by the other, we agreed that we would follow the program to the letter, even though we didn’t know what it would consist of. If we BOTH disagreed (which we did at points) with the program, then we could alter it. But if only one of us disagreed, we would have to follow the program as the default.

This was one of the BEST decisions we’ve ever made in our personal finances. It allowed us to stop fighting each other. By having a completely objective third party telling us what to do, it was easier to accept the concepts. If we both felt there was a better way of doing things, we weren’t tied to Dave Ramsey’s system and could discuss how to alter it to better fit our needs. In short, it factored out personal grudges and judgments. We were left to judge the actual content and not the content-delivery system.

If you’ve always had a hard time agreeing upon a system, TRY THIS OUT! Don’t get stuck on a particular method. If you’re convinced a certain system will work and your spouse is not, find a different system you can both agree to try. Otherwise, your spouse will be resisting you rather than the content. It’s way more important to just get on the same page. Most main-stream systems for managing finances are theoretically sound. If you first get a system established, then you’ll at least have a base system from which you can discuss deviations.

2. Make the “personal” budget category a high-priority and fund it as generously as you can.

The “personal” budget category is a key to helping a budget work. Having personal money that you, and only you control makes budgeting as a couple tolerable. It’s easy to imagine why couples are financially miserable when they have to negotiate every single purchase with their spouse.

My “personal” funds are what I really care about the most. I don’t really care that much about groceries or household items or hair cuts. Sure, I care on a large scale – I don’t want to spend so much that we can’t meet our other goals. But I’m not that emotionally tied to them, so I can discuss them with my wife non-emotionally. On the other hand, if I had to negotiate every personal purchase – every book, CD, and soda – I’m sure we’d end up in endless arguments every month!

The fact is, many couples end up spending personal money anyway. They just hide it or manipulate the system. Why not explicitly budget “personal” funds and reap the benefits of knowing that money is yours.

Here are a few of guidelines for your “personal” budget category:

Separate checking accounts are ok for personal funds

It’s important to have at least a small financial slice to call your own. You can manage it however you want. If you don’t want to budget it, that’s ok. Waste it all if you want. Or save it for that new electronic gadget. While my wife and I keep separate checking accounts for our personal funds, we still have access to look at each others’ accounts if we want. But I don’t think I’ve looked once and don’t really care how she spends her funds.

Be as generous as you can afford

My wife and I budget $100 each for personal funds. Whenever I mention that to someone, they are always shocked the figure is so high. Well, you can afford to do that when you don’t have a car payment . Seriously, I give our personal fund a huge amount of credit for making our budget work and go smoothly. $100 is more than enough to feed my book-buying addiction. It’s also substantial enough that I could fairly quickly save for large purchases of several hundred or even a thousand dollars. There’s almost nothing I couldn’t afford over time, even that new HDTV I really want.

Personal funds can also act like a shock absorber, similar to the “cushion” budget category. Sometimes I want to eat out with my co-workers more than I have money allocated for. No problem, I just use personal funds. Similarly, I often buy my boy a toy now and again with personal funds. It’s easier than waiting and negotiating it with my wife. With such a generous personal fund I really don’t feel a loss from $5 or $10 every now and again.

One last benefit that can be a huge plus in marriage; having personal funds can make gift giving more meaningful. Before we started budgeting personal funds, gifts seemed less meaningful because all our funds were pooled and negotiated. Budget meetings were like, “Hey hun, I want to buy you some roses this month, so let’s budget $20.” How romantic. Now, when I give my wife spontaneous gifts, they are even more meaningful because I use my own money. I’m sacrificing my own interests for her sake. Let the romance begin.

Obviously, not everyone will be able to afford $100 each for a personal fund. We started out at $20 each and grew it from there as we could. Do the best you can. I recommend allocating at least $20 each for “personal.” That’s enough to buy one medium-size purchase like a book or CD a month. You certainly need to be meeting your debt reduction and savings goals first, but your “personal” and “cushion” categories should be close behind in priority.

Keep it even

This one’s easy. You always allocate the same amount to each person. I’ve never found a good or fair way to do it otherwise. This also goes for personal funds that we allocate from bonuses or other windfalls. If we get an unexpected windfall and I want that new road bike for $600, I should expect my wife to get $600 to spend how she wants as well. You can discuss variations to this rule if you like, but it should be the baseline assumption.

3. Don’t discuss finances for more than 30 minutes at a time or past 10:00 at night. If you don’t get through all the issues, meet again tomorrow

Doing finances as a couple is hard enough. Why complicate things by dragging a tired or distracted spouse through sometimes tedious and intense discussions. I’ve found that almost exactly after 30 minutes of discussing finances, I start to tire of the conversation. Suddenly I become contradictory and hard to work with.

Similarly, after 10:00, financial discussions should be prohibited. We’ve tried discussing finances after 10, or even 11pm and it wasn’t a pretty sight. I disagree with everything and am very grouchy. Every time it’s ended with contention and bad feelings.

These guidelines should be adjusted based on the personalities involved. Maybe both partners have a nicer demeanor and higher tolerance for talking about finances than me. Or maybe both are night owls. Great, expand the limits. On the other hand, you may need to shrink the allotted 30 minutes or move up the evening cut-off time if finances are a really tough issue. Just try to meet for a minimum of 15 minutes or it will be hard to make progress.

If you’re establishing a budget for the first time and have lots of issues to discuss, you may need to meet several nights in a row for 30 minutes to get through everything. That’s ok and should be expected. At least you’ll be able to do so in a civil manner.

Limiting the time spent discussing finances has a great benefit. You become much more focused on the issue at hand. Agendas for budget meetings are entirely appropriate and helpful. A time limit will help you get clarity on exactly what needs to be addressed. Rather than allowing yourselves to digress, you will stay on topic and have more efficient meetings. This can also have the side effect of making things less emotional which is a VERY good thing when talking about finances.

Conclusion

It’s no surprise money is the #2 cause of divorce. In our marriage, even when our financial situation has been good, it’s still been one of our major issues. Following these steps has helped us get to the point where finances are no longer a major issue. For the first time in tens years, we see eye-to-eye. Sure, we still have an occasional disagreement, but these steps have alleviated a huge amount of tension and stress in our relationship. I hope they can in yours too.

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Starting a new personal finance or budgeting system can also be a deep mess. It will usually get worse before it gets better. But it WILL get better with consistent effort.

One of the painful things about getting control of your finances is that you inevitably find out you don’t have nearly as much income as you thought to pay for all your expenses.

My wife and I came to this stark realization and it wasn’t easy. We allocated all our income to our necessities and high-priority goals and realized we didn’t have any left for vacations, gifts, or other desires. Over time, as we’ve improved our financial management and increased our income, we’ve been able to meet some of these desires, but we still frequently have to face the stark reality of a limited income.

Some friends of ours also recently felt the “deep mess” of their finances. After going for years living on the edge of their means, they finally sat down and took a hard look at their finances. When they realized that they weren’t setting themselves up to win financially, it wasn’t pretty. All of a sudden they had to look really hard at their values and what expenses and goals were the most important. Heated discussions ensued as they worked out their differences concerning personal wants, lifestyle desires, and financial goals. It’s hard to realize that you can’t keep living the way you’re living. We are creatures of habit and comfort. But after working through their differences, they were able to make better decisions that set themselves up financially to win. In fact, they made some significant changes in their lifestyle including their housing situation.

For some people, facing the hard truth and uncovering the deep mess forces them to make major lifestyle decisions. The biggest single expense for most people is housing. If you are constantly squeezed financially and have already done your best to lower your spending, you probably are paying too much for housing and may need to downgrade. Especially recently with interest rates rising, those who got into a house with a variable-rate mortgage may not be able to meet the inflated monthly payments. They become “house poor,” barely able or unable to meet all their needs and none of their wants. Of course, it ends up being a values issue, but I personally would rather downgrade my housing to be able to have more of my other wants.

Dealing with finances is certainly not easy, especially as a couple. The good news is, once you take all of your finances “out of the closet,” at least you’ll know what you’re dealing with and can make intelligent decisions from there. It’s better to know the stark, sometimes harsh truth than to live in ignorance, hoping or inaccurately assuming you’re on track to meet your financial goals.

What have been your experiences uncovering and reorganizing the “deep mess” of your personal finances? How did it turn out?

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Overview

• Use cash for out-of-control categories – Since you may not know when your next paycheck will be, it’s more important than ever to keep a tight grip on variable expenses that tend to get out-of-control.
• Build up a short-term emergency fund (STEF) equivilant to four weeks of expenses – A STEF will help smooth out the bumps inherent in an irregular income
• Determine the timing and priority of expenses ahead of time – Planning the order in which expenses must be paid and allocated will relieve a ton of stress. You’ll know exactly where your income needs to go before you even get it.
• Create a sample budget as a reality check and baseline – A sample budget helps to ensure you are not only living within your means but also achieving your high-level, long-term financial goals.
• Chunk your income and allocate it once or twice a month – By using your STEF as a shock-absorber for fluctuations in income frequency, you can almost budget like a good-old corporate employee. While you may not envy the corporate lifestyle, a steady paycheck sure makes budgeting easier. By allocating your income in chunks you can budget like a corporate employee while keeping a self-employed lifestyle.
• Create a “just-in-time” budget, allocating only what you need until the next paycheck – By allocating only what you need until your next paycheck, you’ll be able to squeeze every penny out of each inflow. Don’t allocate your full grocery budget for the month if you only need half of it until your next paycheck.

1. Use cash for out-of-control categories

My first recommendation is to use cash for variable expenses that tend to get out of control. This is crucial for living within your means. You’ll be amazed at how much you can reduce and control your spending just by following this principle. Using cash will give you complete control over the total amount you spend in a given category. When the cash is gone, it’s gone. This is especially important when you need to make the most of each monetary inflow because you may not know when your next inflow will be.

2. Build up a short-term emergency fund (STEF) equivilant to four weeks of expenses

The second step is to build up a short-term emergency fund equivilant to 4 weeks of expenses. This step alone could save you hundreds of dollars in late fees and will give your life a little more peace. It will also keep you from going into debt when an emergency hits. Most importantly for those with an irregular income, a STEF will allow you more flexibility in budgeting and will help compensate for lost income during periods of unemployment or under-employment. For detailed instructions on how to create and manage a STEF, see my previous post.

What if your income varys drastically?

If your income varys drastically, you may want to increase your STEF to 2 or even 3 months of expenses. The more drastic the fluctuations the more of an emergency fund you’ll need. The goal with the emergency cushion is to store up funds in times of plenty to compensate for the times of scarcity. Start with a STEF of 4 weeks and adjust up as needed. However, don’t adjust down. A STEF should be a minimum of 4 weeks of expenses.

3. Create a “Timing of Expenses” list

A “timing of expenses” list simply shows all your bills and when you have to pay them. This will help in our next step to prioritize the order in which expenses should be paid. It will also act as a reference to help ensure you pay your bills on time. To avoid late fees, make sure all your bills are on auto-pay. If auto-pay is not available, highlight the bill so you’ll always remember to pay it on time. As you write your bills down, note on each item if the payment day changes from month to month. There are three main scenarios:

• Paid on the same day each month (e.g. on the 15th of every month)
• Paid every x number of weeks (e.g. paid every other Tuesday)
• Paid every x number of days (e.g. paid every 30 days).

Once you create this list, updating it every month should only take a minute. After a few months you should be able to predict within a day or two when each expense will occur.

4. Create a “Priority of Expenses” list

Note: The “priority of expenses” list and the “timing of expenses” list can be combined depending on personal preference.

When living on an irregular income, it’s important to have clarity ahead of time about exactly where your income will go when you’re paid. Having a pre-determined plan combined with a STEF will help you sleep well at night and decrease the feelings of impending doom and uncertainty that you won’t be able to pay the bills. The “priority of expenses” list is the main tool in helping you decide ahead of time where your income will go. It is essentially a budget arranged chronologically and by importance, rather than by grouping similar categories. You will refer to this list every time you are paid in order to determine where the money goes.

First, list out all your bills in chronological order

List all your bills in chronological order. This will show you the hard landscape that your other categories have to fit around.

Next, list out the rest of your remaining budget categories in order of importance

For most, this list will probably start with necessities like grocery and clothing, followed by high-priority items like savings (STEF, retirement, long-term savings) and debt reduction. Of course, housing would also be considered a necessity but is probably listed under “bills”.

As an example, my list might be ordered like this:

• Bills (in order of date due)
• Mortgage – 12th
• Utilities – Every third wednesday
• Car payment – 23rd
• Allocations (in order of importance)
• Grocery
• Gas
• Cushion
• STEF (if needed)
• Retirement savings
• Medical
• Car maintenance
• Haircut

This is an extremely abreviated list but you get the picture. After the bills, the most important categories are first and the least important, last. In other words, I first need to make sure I eat and can pay for necessary travel. Then I want to make sure I pay myself (retirement savings) and replenish any STEF if needed. Expenses like medical and car maintenance may not be used every month but will accumulate over time. Therefore it usually won’t matter when in the month I assign those allocations. If I happen to be sick early in the month, I could either use medical funds already allocated in previous months or move that expense up on the list for just that month. Finally, I figure I can allocate my haircut last. If I have a bad month, I could go without one entirely.

Your “priority of expenses” list shouldn’t vary much, if at all, from month to month. Include all your budget categories, even if they don’t apply every month. If you have categories that don’t apply in a certain month (like birthdays), just skip it and move to the next category when allocating funds.

5. Create a sample budget as a reality check and baseline

Having an unpredictable income makes it hard to ensure you’re meeting all your financial obligations, not to mention your financial goals. Therefore, it’s important to create a sample budget based on averages to see if you can meet your obligations AND achieve your goals, despite fluctuating income. The sample budget will give you a baseline from which you will vary from month to month based on your actual income. You should update your sample budget whenever you have a significant change in overall income or expenses to ensure you’re still on track with your long-term financial goals.

First, calculate your average income over 6-12 months. Then calculate your typical monthly expenses including contributions to savings and other financial goals (e.g. debt reduction). Enter in budget amounts for a sample month including these income and expense figures.

If you can’t meet all your obligations AND financial goals on your current average income, you’re due for a change. Otherwise you will never get ahead and always be flirting with increased debt. You need to eliminate unecessary expenses or find additional income streams until you can meet all your obligations, necessities, AND savings goals on your average income. In some cases, a dramatic change in lifestyle may be in order.

6. Creating your actual budget – tips and tricks

Now it’s time to create your actual budget. All the steps until now have helped you create a solid set of reference materials to help you make budget decisions. In fact, you’ve basically made all the decisions about your budget already. Now you simply need to adjust the timing of payments and allocations based on when your income is available and how much there is.

Dealing with income

There are two ways to deal with income depending on how frequently you’re paid. If inflows are infrequent – roughly once or twice a month – treat each check individually and allocate it only for the time period until your next check. If inflows are frequent – roughly more than four times a month – group the inflows and allocate them once or twice a month.

Allocate infrequent inflows check by check

If you’re paid once or twice a month, it’s most efficient to allocate each check individually for the time period until your next check. Let’s look at an example. Let’s assume you are paid $2,000 on the first of the month and you anticipate you’ll be paid again in ten days. Refer to your “priority of expenses” list, determine which bills are due in the next ten days, and allocate the $2,000 accordingly. If the $2,000 doesn’t cover all your bills, or it doesn’t cover the bills and your necessities (e.g. food) for the next 10 days, use funds from your STEF and allocate it as needed. In this case you would designate the STEF amount used as “income” on your budget.

If the $2,000 covers all your bills and necessities for 10 days, continue on down your “priority of expenses” list allocating until the $2,000 runs out. Remember, after your necessities are allocated, replenishing your STEF should take top priority.

Allocate frequent inflows in chunks

If you recieve inflows more than four times a month, it’s easiest to allocate your income in chunks rather than each inflow individually. If you recieve your income in the form of checks, save them up and deposit them twice a month. If your income is automatically deposited into a bank account, just wait and allocate it all every two weeks. It’s easier to allocate a larger chunk of income twice a month than to constantly be allocating fragmented deposits. With your full STEF in place, you’ll be able to safely deal with income twice a month without worrying about negative bank account balances. The STEF acts as a shock absorber, allowing you to budget almost as though you had a regular income.

Split up single budget categories and allocate them in smaller pieces to create a “just-in-time” budget

Occaisionally you may want to split up a single category, allocating part of it with the current inflow and part with a later inflow. If income is tight, this type of optimization will help you squeeze every penny out of a paycheck. By doing so, you create a “just-in-time” budgeting system, allocating only what you need, when you need it.

For example, Let’s say you have an inflow of $2,000 at the beginning of the month. $1,000 may go to a housing payment, $200 to utilities, and $300 for a car payment leaving you with $500 to allocate. Even though you could fully fund a $300 grocery budget category with the remainder, doing so wouldn’t leave enough for other categories like gas, personal, and cushion. Instead, if you think your next inflow will be in two weeks, just allocate what you think you’ll spend in the next two weeks on each budget category. Instead of allocating the full $300 for grocery, you might be able to get by on $150, leaving you more money to allocate to your other important categories and making it less likely you’ll need to dip into your STEF.

Allocate bills/obligations first, then everything else

Every time you allocate money for a period, follow the “priority of expenses” list, first allocating your bills and obligations and then allocating the rest to your other expense categories according to priority. Your allocations may vary from month to month but having the “priority of expenses” list should make the process much easier.

What if I make more than average in a month?

If you make more than average in a month you should have already referred to your “priority of expenses” list and funded all your budget categories. With the remaining income you should fully replenish your STEF to prepare for future months when you recieve less than average income. Allocate the rest however you want.

What if I make less than average in a month?

First cover all the expenses you can from your allocated categories. Hopefully you will already have most of your expenses allocated already. If you run out of income to allocate, you can either take money from your STEF or skip the remaining categories if they are optional (like “haricut”). Fortunately, by the time you run out of income to allocate you should be near the end of your list where the categories are less important. Depending on how much your income varies, you may need to dip into the STEF quite a bit. It’s ok, that’s what the STEF is for. In the worst-case scenario, you should be able to cover a whole month of expenses on NO INCOME.

Conclusion

With a little planning and a methodical approach, budgeting on a self-employed or irregular income can be just as easy as budgeting on a regular income. By using the techniques above, you can take much of the variability out of your planning and know ahead of time exactly where your money should go.

Please let me know your comments and questions. Also let me know if there are points that need additional explanation or clarification. Do you have any additional tricks you’ve learned? Please leave a comment and let me know!

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More From sjpeer

• 3 reasons most budgets don’t work and how to fix them (a.k.a. How to create a budget that works)
• How to create a zero-based budget
• How to become a personal finance “black belt” | Getting Finances Done

If needed, review the following posts and start TODAY!

• How to create a zero based budget
• 6 ways a short-term emergency fund can help save your budget
• How to control and track your spending effortlessly

Please post a comment with thoughts, questions, and experiences.

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• How To Create Your First Working Budget With Excel Or Pen And Paper
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In my last post, I covered why most budgets don’t work and how to fix them. One of the ways to make your budget work is to create a zero-based budget. Today’s post outlines how to create your first zero-based budget. Over the next few weeks I’ll be addressing various aspects of creating and managing a budget. Let’s start with the basics. Some of these steps may seem obvious or simplistic. But for those who just can’t seem to get a budget started, I hope to give you some step-by-step detail that will help make creating a budget easier.

What is a zero-based budget?

A zero-based budget is one where your total income minus your total expenses equals $0. In other words, it forces you to assign every dollar of income to an expense (or savings) category. As Dave Ramsey puts it, you’ll be “spending your month’s income on paper” before you spend it in real life.

Benefits of a zero-based budget

Using a zero-based budget and properly dealing with the difference from month to month will allow you to gain total control over every dollar you spend. If you get a bonus or spend less than you planned during the month, you can easily redirect that money where you really want it instead of letting it dissipate through unfocused spending.

A word about spreadsheets

I highly recommend using a spreadsheet to do your initial budget because it’s very easy to calculate amounts and rearrange the order of items. If you don’t have Excel, you can download the free Open Office CALC spreadsheet software or use a free online spreadsheet like Google Spreadsheets or NumSum.com. Simply using paper and pen is ok too. If you do, you may need to re-write it a couple of times and be sure to double check your calculations.

When first starting your budget I would NOT use the budgeting tools in Quicken, MS Money or other automated tools. You may be able to use those tools effectively once you have a solid hold on your budget, but for now it’s best to make your budget by yourself so you know every nook and cranny. That way you’ll be less likely to make errors due to not understanding how an automated tool is built. You will also be more likely to use a budget if you create it yourself. Once you have a high degree of confidence that your budget is working properly, feel free to experiment with pre-built tools and spreadsheets like pearbudget.com.

Preparation: Get out those statements

Before you get into the thick of things, you’ll want to do a little preparation by collecting the following:

• Pay stubs
• Records for other income such as bonuses, gifts, and tax returns
• Copies of your recurring bills
• If you track expenses in Quicken or MS Money, print out monthly reports of your expenses for the last few months
• If you use checks regularly, it may be useful to have your check register on hand

Agree to be civil

Now take a few deep breaths. If you are doing this with a spouse, agree to be civil. Ask yourself “how can I do this and enjoy it?” As you go through the initial steps of allocating, don’t nit-pick too much. If one person wants to budget funds for a category and the other disagrees, let them budget the funds and you can go back later and adjust once you know if you’re over and by how much.

If things tend to get heated, I also recommend setting a time limit for your budgeting. My wife and I tend to do well in chunks of about 30 minutes. Once we go over that, I start to get grouchy. It’s ok to do this a little at a time. If you schedule 30 minutes a night for several days, you should be able to get through everything.

Step #1: Write down all your sources of income for the month

Let’s get started. If you have a fixed paycheck once or twice a month, this step will be easy. Just write down how much you make every month. If your finances are really tight, you should do a budget for each paycheck to ensure you have the funds on hand to pay bills that occur in that time period.

If you are self employed or have an irregular source of income, you’ll want to wait until you get an actual check and then follow this process for just that check. In the meantime, you can follow this process for the money you have available in your bank account. Just use your balance as the income. For example, if your bank account balance is currently $3,000 then put that amount as your income. As we go through this process you’ll be allocating how you’ll use that $3,000 until your next paycheck.

Do I put down net or gross income?

It really doesn’t matter if you put down net or gross. If you use gross (the amount before taxes, insurance, etc that are automatically deducted from your paycheck) you need to be sure to include the categories and amounts that are automatically deducted from your paycheck in your budget. I prefer using net so that I don’t need to write the extra expenses down every month. Because taxes and insurance are the same from month to month I prefer to simply check the amounts every quarter or so to make sure everything is still the same. It’s more efficient to track them separately.

Of course, if you’re self employed, be sure to allocate for paying taxes.

Step #2: Write down a list of expenses

Write down a list of all the expenses you expect to have this month. I’ve included a list of possible expenses below to prompt your memory. Be sure to include expenses unique to only this month. Do you have a friend or family birthday? Is your registration due? This step may actually unearth some expenses that you forgot about. If you think of expenses that are coming up but not in this month, that’s ok, just go ahead and write them down and we’ll deal with them a little later.

• Income
• Paycheck 1
• Paycheck 2
• Other Income 1
• Other Income 2
• Expenses
• Taxes (if using gross income or you are self employed)
• Mortgage Payment
• Second Mortgage payment
• Household (yard)
• Utilities: Gas
• Utilities: Elect/Water/ Gar
• Auto: Gas
• Auto: Insurance
• Auto: Maintenance
• Auto: Registration
• Satellite TV
• Life Insurance
• Debt reduction
• Babysitting
• Clothing
• Grocery
• Grocery: Eat Out
• Grocery: Eat Out
• Grocery: Nonfood
• Medical
• Hair cut/personal care items
• Charitable Donations
• Emergency Fund
• New car savings
• College Fund
• Dry Cleaning
• Gifts: Birthdays
• Gifts: Christmas
• Gifts: Holidays and Other
• Household: Maintenance
• Retirement Savings
• Magazine Subscriptions
• Entertainment: Dates
• Entertainment: Video rentals
• Personal money (1 for each individual)
• Cushion

You’ll probably miss an expense or two at first and find yourself part way through the month saying “shoot, I forgot to budget for that.” To address this scenario, be sure to budget a “cushion” account (last week I called it a “grease” account, but I think cushion is simply more understandable and descriptive, so I’ll stick to that). I recommend starting at about $100 at first. Over time, you’ll be able to get a feel if this is too much or not enough.

Include savings and debt reduction in expenses

When I say “expenses,” I really mean “funds that will be spent or allocated to other purposes.” Saying “expenses” is just so much easier. Include any savings allocations, debt reduction payments, or any other monetary outflows in your expense list.

Step #3: Identify your expense types

For this step, simply go through all the expense categories and mark if they are fixed, semi-fixed, or variable. Just write an “f,”"s-f,” or “v” next to the category (or in another column if using a spreadsheet). Fixed expenses are those that don’t change from month to month like your cable bill. Semi-fixed expenses are those that may vary slightly from month to month like a phone bill. As a rule of thumb, semi-fixed expenses shouldn’t vary more than $10 in a month. Variable expenses are those that vary from month to month more than $10 like groceries or gas expenses.

Step #4: Allocate your fixed and semi-fixed expenses first

The reason we marked each expense type was to determine the order to allocate them in. First allocate your fixed and semi-fixed expenses. I recommend doing this simply because it’s easy. Your fixed expenses will probably include your largest expenses, such as your mortgage, so it will be easier to deal with the smaller amount left over. Plus, most of your fixed expenses are probably not very negotiable without dramatic lifestyle changes or disruptions so they give you a sort of “hard landscape” around which you will fill in the variable expenses.

Once we are done allocating all our expenses, we’ll circle back and see if we want to eliminate one or more of the fixed expenses. For now though, allocate them all.

Average out your semi-fixed expenses

For your semi-fixed expenses you’ll have to average out how much you’ve spent over the last 3-4 months. No need to get too crazy or precise as long as your in the ball park. You’ll be wrong anyway.

How to deal with periodic expenses

There will be many expenses that won’t occur this month but that you will need to save for like car registrations, birthday and Christmas gifts, and some insurance payments. To ensure you have enough money when the time comes you need to start saving that money now.

Most people just divide these expenses by 12 and save that amount each month. DON’T TAKE THIS APPROACH WHEN STARTING A BUDGET. You will end up short unless that expense is a full year away. Instead you need to take each expense, count how many months away it is, and divide the total payment amount by the number of months. For example, if I have a car registration payment of $100 due in four months, I will divide $100 by 4. That means I should budget $25 a month to save towards the registration. As soon as I pay the registration, I can then divide the next registration payment by 12 and save little by little for next year.

This approach may cause a little strain on your budget at first because you will need to be saving a larger amount each month for the expenses coming up in the short-term. However, once you make the payment, your monthly allocation will go down for that category freeing up extra cash that you can redirect wherever you want.

There is one other approach I should mention. My wife and I find that we will fairly consistently receive “windfall” money two or three times a year in the form of bonuses, gifts, or tax returns. Occasionally we will budget portions of the windfall to periodic expenses so we don’t have to worry about saving from month to month. The only problem with this approach is that if you don’t have enough windfalls, you could end up having a periodic expense and not enough money to pay it.

Step #5: Allocate your variable expenses.

Now that you’ve gotten a good chunk of your income out of the way, it’s time to deal with what’s left (hopefully it isn’t depressingly little). So far we haven’t worried about calculating income minus expenses. If you want to, you can do a quick calculation at this point so you know how much left over you’re dealing with. Or you can just speed through and budget your variable expenses and do a mass calculation at the end.

Try not to scrimp too much on your necessity categories like food, clothing, and transportation/gas. Most people underestimate these categories.

Personal money

I highly recommend allocating personal money for each spouse. Having your own money to spend however you want is crucial to making a budget work. Even if you can only afford to budget $10 or $20 dollars, it will help your budget feel more manageable.

Step #6: Calculate the difference between income and expenses.

Ahhh, the moment of truth. Subtract your total expenses from your total income. This is where a spreadsheet comes in handy. You might want to be sitting down when you do this.

Step #7: Adjust your categories until income = expenses

Now comes the hard part. You need to adjust your categories until your income equals your expenses. This is where you will need to make some trade-offs between one category and another. This step is usually where the most conflict occurs between couples because it exposes their conflicting values. If things get too heated, it’s probably better to take a break and continue later. Just remember that this is your first budget and you will refine things as you go. You don’t have to feel locked in to the decisions you make now.

What to do with a positive difference

If you’re in this situation, congratulations! Now you just have to allocate the remaining money. The whole point of a zero-based budget is that you need to ALLOCATE EVERYTHING. That way the remainder won’t just disappear through unconscious spending. The good news is you can allocate it any way you want. If you are going to allocate it as money to blow, that’s fine as long as you consciously do so. Some other suggestions for allocating this money include:

• Pay down debt
• Save for retirement or your children’s college
• Save for larger purchases like vehicles or furniture
• Save for a vacation

What to do with a negative difference

I’m guessing that the vast majority of people will have allocated more expenses than they have income resulting in a negative difference. Don’t be discouraged! The first time we did this, reality hit us hard. We had to do a major evaluation of our priorities and really distinguish between our wants and needs.

For many families this process will expose that they have been spending more than they make and can’t support their current lifestyle on existing income. It can be extremely hard to realize that lifestyle changes are in order, but at least you now know the truth and can fix your problem instead of going into more debt.

Here are some suggestions for adjusting your budget:

1. Identify all your non-necessities. Yes, cable is a non-necessity.
2. Each spouse should rank the non-necessities in terms of importance to them
3. Eliminate or reduce those that both spouses agree are a low priority

Hopefully by eliminating or lowering the easier “consensus” items you will now be at a zero balance. If not, you will have to negotiate which categories are most important to each of you. You may have to make a lifestyle change by either earning more income or lowering your cost of living. In some cases, moving to a less expensive place may be in order. Housing is usually the largest expense and can make the biggest difference to your expenses. Not long ago, my wife and I almost had to move in order to live within our means because we had a bad year with some unexpected medical expenses. That is what prompted us to really take control of our finances. If we hadn’t got on a budget, we would have had to move to a less expensive home.

Step #8: Print out your final budget

I strongly recommend you print out your final budget and put it in a binder. This gives you a hard-copy record of your decisions. The problem with keeping only an electronic version is that you sometimes can’t be sure if it’s been changed from the original. Printing a copy allows you to put a stake in the ground for your decisions up to that point. It will also be useful when reconciling at the end of the month and planning next month’s budget.

Next steps

Congratulations! You’ve now completed your first zero-based budget. Now that you have a budget in place you will need to execute your plan and follow up at the end of the month to deal with what you actually spent. Over the next few weeks, I will be covering some ways to make tracking your spending and reconciling your budget much easier. The first month you use a budget, review it as often as you need to stay on track. Take a few moments each day to review your spending if necessary. I recommend reviewing your progress at least each week at first. Once you get your budget down, and with a few tips and tricks, you’ll be able to stay on track with a single monthly review.

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• 3 reasons most budgets don’t work and how to fix them (a.k.a. How to create a budget that works)
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Why most budgets don’t work

There are three major problems with a common budget:

1. They don’t reflect reality.
2. They don’t connect from one month to the next.
3. They don’t track the surplus money left over after all the categories are filled.

1. Most budgets don’t reflect reality

Budgeting is an exercise in being wrong. Every time you sit down and write out all your categories and how much you think you’re going to spend, you’ll be wrong. Being wrong month after month quickly can get discouraging and many people give up. What’s the point in trying to predict how much you’ll spend each month if you know you’ll be wrong.

So you overspent. Ok, at least you know you overspent and that could be helpful in planning next month but where did that overspent money come from? How are you going to reconcile the difference?

Unfortunately there’s no way around being wrong. There’s really no solution besides developing obsessive tendancies and even then…good luck. You must first accept that you’ll be wrong…every month. My wife and I have never been right even though we’ve had an established budget for years. Accept it.

Now I’m NOT saying you won’t start getting really close. In fact, in many categories you will be right. But so far I’ve never been 100% right. Don’t get discouraged if you’re just starting out because for the first few months you’ll be REALLY wrong. It took us about 3-4 months until we started getting into our budget groove.

One way to get your budget closer to reality is to allocate every dollar of your income. If you have money left over after addressing your needs, allocate it. I don’t care where; put it in a “fun” category or direct it towards meeting a financial goal. Don’t just say “oh, I have leftover money. I must be doing really good at budgeting.” If you don’t allocate everything you will end up wasting that which is left over and your budget will be broken from month to month.

Another way to close the reality gap is to be realistic about what your needs are. Things like shelter, clothing, and food are not optional. Many people have unrealistic expectations about what they will spend on these categories. I’m certainly an advocate of being thrifty and looking for good deals but you can only take it so far. If you refuse to face how much you really need to spend in these categories to survive without eating ramen every night, your budget will not be an effective tool.

Yet another way of helping your budget reflect reality is to make sure you have a way of dealing with the difference between your budget and actual spending. And that leads us into our second problem.

2. Most budgets don’t connect one month to the next

Quicken is a great example of why this problem exists. Quicken’s budgeting feature seems great. It allows you to easily enter budget amounts and will even pre-populate projected amounts for you. At the end of the month you can run a nice neat report telling you how much you over or under-spent. There’s just one problem. There are no tools for helping you deal with the difference (if there are, please let me know about them). You just enter in the next month’s budget amounts using the exact same process and projections as the month before. This makes for a nice, neat, pretty budget sheet but not a very useful one.

Many people think a budget is a static document. You fill out one template reflecting all your categories and how much you should spend each month and use the exact same sheet from month to month. That’s not a budget. It’s a dead document. A real budget is a living document or series of documents. It changes from month to month and should be a reflection of reality, not a theoretical exercise.

The fact is, your expenses change from month to month. Car registrations sneak up on you. Unexpected birthdays pop up. Unexpected expenses happen. And you can’t always just take your yearly expenses and divide by 12. If your car registration is coming up in 3 months and you haven’t saved anything for it, dividing by 12 will only leave you with a quarter of what you need to pay it. The unique expenses for every month need to be dealt with individually, not just from a nice clean Quicken projection.

For a budget to work, you must link one month’s budget to the next.

Is there too much money left over? Great. Where does it go? Should we pay off debt, save for retirement, save for a vacation, or just blow it and buy that new toy? I’m not against throwing caution to the wind as long as it’s done conciously and not by default.

Is there too little money to cover all our spending? Where did it come from? Will we be spending less on groceries, lowering our savings contribution, or going into more debt?

3. Most budgets don’t track the surplus money left over after all the categories are filled

For a budget to work, you must allocate ALL of your income to categories. As Dave Ramsey puts it, you must “spend your whole month on paper” before you spend it in real life. Other analogies that come to mind are Stephen Covey’s concept of the spiritual creation before the physical creation and David Allen’s idea of writing down EVERYTHING that is on your mind so you can get it out of your head and on paper.

Stephen Covey Comparison

Let’s look at the Covey analogy. Covey says that you should “begin with the end in mind.” One way of doing so is to create what you’re trying to achieve spiritually first, and then physically. A builder doesn’t build without a blue print. You should have a good idea of where you want to go either on paper or in your mind before you set out. Doing so makes your efforts more effective.

When it comes to finances, by writing ALL YOUR PLANNED SPENDING down on paper first (spiritual creation), your chances of actually following your plan significantly increase (physical creation). You’ll also be much more likely to achieve your larger financial goals (physical creation).

David Allen GTD Comparison

Now let’s consider David Allen’s idea of capturing everything on paper. He teaches that you should get anything and everything down on paper that occupies your mind. Doing so frees up “mental RAM” and allows you to spend your time more effectively rather than eating up endless mental cycles on the same issues, questions, and to-dos.

Similarly, by writing down how you are going to spend every dollar, you free yourself from mental worry and guilt and allow yourself to think about much more enjoyable things. Combine this with using cash for those categories that tend to be out of control and you can literally eliminate financial worry and anxiety. Every dollar you spend will be focused and controlled with very little effort.

No matter how you want to look at it, you need to allocate EVERY SINGLE DOLLAR ON PAPER for a budget to be of maximum effect. Why? Doing so forces you to really think about where you want your money to go and insures you use each dollar to it’s fullest. You’ll probably notice that when you don’t allocate every dollar, your left over dollars usually end up spending themselves. You end up with nothing to show for it, not even the concious realization that you had fun wasting that money.

Spend frivolously and feel good about it

By saying that you need to allocate every single dollar, I’m not saying you can’t have fun with your money or spend frivolously. Go ahead and conciously decide to have fun or even waste the leftover money. Allocate it as “fun” money to be spent however you want, whenever you want. By doing so you may enjoy spending that money even more. You’ll be able to do so with confidence and no guilt that you should be spending it elsewhere.

Decide before you’re in the heat of the moment

Like using cash, allocating all your funds allows you to make more concious decisions about where your money should go. Instead of waiting until you’re standing at the register, you can decide where your money will go while your looking at the big picture. Your decisions will be more rational and less emotional. You will also be able to direct your money towards meeting your larger, longer term goals. Instead of pittling money away, save for that new car or piece of furniture. Or for real financial peace, pay off debt.

Harness the power of focus

Allocating every dollar allows you to harness the power of focus. Take your plumbing, for example. Water by itself isn’t very useful in a puddle or lake. But give water the contraints and focus of a pipe and all of a sudden it can be used for your toilet or sink. Focus water through a hose and you can water your lawn or put out a fire. The constraint actually makes the water more powerful and useful. Similarly constraining your money by allocating every dollar makes your money more useful and powerful. Your ability to save and reach your goals will be increased.

See if you can identify with this personal example. Before we got our financial acts together, every time we recieved a bonus, raise, gift, or other unexpected income the money would just seem to slip through the cracks. Most people tend to expand their lifestyle to meet their income. In contrast, imagine if you were able to focus and direct every extra dollar. Every time you got a bonus, heck, every time you saved $5 on your phone bill, you would be able to easily redirect that money to another purpose. Your power and ability to aggressively meet your financial goals would increase dramatically. Without an effective budget, what is the point of trying to save a few dollars when they disappear anyway. But with an effective budget every dollar counts and is directed exactly where you want it.

Another benefit of allocating every dollar is that your budget will reflect reality more closely. If you have money left over after allocating your needs, that extra money almost always WILL be spent one way or another. If your budget doesn’t reflect that, it doesn’t reflect reality enough to be effective. To eliminate financial stress and a sense of being out of control once and for all you MUST KNOW where your money is being spent. You must TELL IT WHERE TO GO rather than letting it decide.

Using a Zero-Based Budget

A critical tool to help solve these basic budget blunders is the zero-based budget. Now if you’re expecting something flashy, you’ll be disappointed. A zero-based budget simply means that you allocate every dollar of your income so that your income minus your expenses equals “zero.” It’s as simple as that. No special forms or fancy software are necessary. Using a zero-based budget forces you to allocate every dollar and will help your budget more closely reflect reality.

Always track and DEAL WITH the difference between “budgeted” and “actual”

Make sure you follow up at the end of every month and write down what the difference is in each category between what you budgeted and what you actually spent. You then need to deal with that difference. Don’t just look at it and say “oh, there’s a difference. Good to know.” You must either reallocate the money on paper or carry the difference over to your next month’s budget.

For example, if you spent $5 more on your phone bill than you thought (a common occurance since the phone bill tends to be quite variable), you must spend $5 less in another category. One option is to see if you spent $5 less than you thought in another category that month. If so, simply adjust your allocations on paper. If there is no unspent money in your categories then you need to carry that $5 over to the next month and allocate $5 less in a category for your next month’s budget.

Implement a “grease” category

To deal with small instances of overspending, I always budget a “grease” (a.k.a. “blow,” “cushion,” “RealityBites”) category of about $100 that gives me a cushion in dealing with such instances. Since you know you’re going to be wrong (see above) you might as well plan for it. This account acts like the “grease” that keeps the financial gears turning. It picks up my slack. And if I have extra “grease” money left over at the end of the month, it directly gets realocated for something else the next month (often something fun as a little reward).

Putting it all together

I realize that I’ve skipped over many specifics. Implementing some of these concepts may seem a bit confusing at first. If so, no worries. I’ll be addressing specifics in future posts. For now, let me summarize the steps you can take today:

1. Implement a zero-based budget. Stay tuned for examples and templates.
2. Allocate every dollar of income to a category. When you subtract your budgeted expenses from your income, it should equal $0.
3. Be sure to budget a “grease” category to deal with minor inaccuracies.
4. Be realistic about how much you are going to spend on necessities. Most people under-allocate in the categories of food, clothing, and transportation.
5. Know that your spending won’t exactly match what you budgeted. If you are just starting, you may be WAY off. That’s ok. Do a little, learn a lot. It WILL get better. If you’re married, be easy on your spouse.
6. Calculate the difference between “budgeted” and “actual” spending and either adjust the current month’s allocations or deal with the difference in next month’s budget. I realize there are some BIG procedural holes and questions here that I’m skimming over for now. Stay tuned.

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Where you spend money reflects your values.

Steve Pavlina recently posted on his blog asking people’s opinions about what he should do with excess money (my term, not his). Congratulations to Steve for achieving such financial abundance. Steve is in the wonderful position of making significantly more money than he needs to live. We’re not just talking living below your means, but rather living below your means with a lot to spare. Once you’re in this position you can really use money to build a legacy. His question brings up an interesting point that applies not only to people with financial abundance but to even those buried in debt; where you spend money is a reflection of your values.

How much do you value fast food?

It’s true, look at where you spend your money and you’ll have a pretty good idea about what you value. Some might reject this idea; “I don’t value fast food THAT much.” But when the rubber hits the road, you chose to eat out at McDonalds rather than going to a movie, buying a book, or saving that money. You had to make a trade off and the fast food won.

What trade-offs are you willing to make?

In fact, the process of budgeting is a process of making trade-offs. Do you really want to save for that new piece of furniture? What are you willing to give up to get it; will you spend less on grocieries, eating out, entertainment, or something else? If you have financial abundance maybe you have to decide that the piece of furniture is more important than saving an extra thousand dollars. There is a finite amount of money and it can only be spent once.

Use your finances to refine your values

Looking at your spending can be a great way to reflect on what you really want. After looking at where your money goes, do you think it reflects your real values? If not, maybe you can get some insight into what trade-offs you can make to align your spending with your percieved values.

What should I do with my bonus?

Recently my wife and I recieved a bonus from work and were deciding where it should go. Among the options were paying off debt, going on a family vacation, or buying a miriad of items on our ever-growing wish list. Paying off debt was a leading option because we’re trying to agressively get out of debt right now. Getting some of our “things” was also a luring option because there were some things we could get with a large chunk that we couldn’t usually buy otherwise. In the end we chose to put our money towards travel.

The decision actually surprised us because we usually view vacations as being very dispensable. There’s really nothing physical to show for them in the end vs. buying something or reducing debt which are much more tangible. But at the same time, we haven’t gone on a true vacation for a while and we realized that having the shared experiences and memories of a vacation were more important than paying off debt or buying a “thing.” We decided that from now on we’re going to have at least one full-fledged vacation a year. It may not be the best “financial” decision, but it is a more accurate reflection of our values.

It’s important to note that we may not make the same decision every time. Had we already been on a vacation or two, or had we not already agressively been paying off debt, we may have chosen another option. The point is that we were able to utilize our finances and the budgeting process to clarify our family values.

Value Conflicts

One of the reasons finances can be such a subject of contention in marriages is that they’re tied so strongly to values. Conflicting values are manifest in our finances. Financial arguments are almost always values arguments in disguise. That’s a big generalization, but think about it yourself. Do you really care how a green piece of paper is distributed? What you really care about is that you can obtain what you value. If your spouse disagrees, it’s a reflection on how much they care about you and your values. No wonder financial discussions can be so financially charged.

What to do with excess money? Let your values decide.

So back to Steve’s question; what should he do with his excess? Spend it on what you value. The great thing for him is that he can start manifesting his values through his finances with great gusto. Do you value security? With such financial abundance you can quickly pay off all your debts and save a large nest egg. Do you value serving others? Donate large sums to your favorite cause. Do you value entertainment? Get all the gadgets and toys you’ve always wanted. In any case, start with what you truly, conciously value and direct the money to that end.

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One of the first steps of sound financial management is tracking your spending. Once you track your spending and are able to see where the money goes, it’s easier to attempt to control your spending. How can you control something when you have no idea what it is you need to control? The bottom line is, tracking your spending goes hand in hand with controlling it.

Tracking, but no control

However, despite the wonderful resources available to track your spending, it still seems to be out of control for most people. Money management programs such as Quicken and MS Money are great tools to help you track your spending. In fact, electronic methods of payment such as debit and credit cards are also great at helping you track your finances. Every transaction can be easily downloaded or viewed. But if these tools are so wonderful at tracking expenses, why are most people’s finances out of control?

Despite the ease of tracking spending using credit cards, credit card debt is rampant. Americans carry, on average, $5,800 in credit card debt from month to month (www.cardweb.com). The Federal Reserve states that, on average, the typical credit card purchase is 112% higher than if using cash. It seems the convenience of using credit cards makes it a little too easy to spend money.

Control, but no tracking

On the other side of the fence are cash and check transactions. While spending with paper currency gives you a higher degree of control (especially cash), it’s a pain to track. Nobody enjoys balancing their checkbook, compulsively saving receipts, or entering expenses into a spending notebook.

The secret to tracking and controlling your spending effortlessly

So what’s the solution that will allow you to track what you spend and maintain total control over your spending? The answer is CASH.

“What? Cash? I thought you just told me that cash is a pain to track? Plus I LOVE the convenience of my credit card.”

Ok, before you blow me off, just hold on for one more minute. I’m not saying that ALL spending needs to be cash, just the categories that are out of control. As my wife and I worked out our financial plan we realized there was a very small set of categories that were out of control. These will vary from person to person but our hard-to-control categories were:

o Grocery

o Household

o Eat Out

o Clothing

o Personal

This is by no means an exhaustive list. Figure out your own hard-to-control categories and you’ll know which ones you should use cash for. Your other expenses will be dealt with separately and I’ll explain how you should manage them in another post. As a first step, we just want to get these categories under control.

So, here are the steps to tracking and controlling your spending effortlessly. And the great news is you can start it TODAY!

1) Identify which categories are problematic (you tend to overspend).

2) Commit to not buying ANYTHING in that category with a credit card.

3) Go to the bank and withdraw the amount you think you will or should spend on the category UNTIL THE END OF THE MONTH.

4) Put that money in an envelope and write down the date, how much you took out, and the category. To simplify things you can just write this information on the envelope, but feel free to record it in any trusted place.

That’s it! Financial peace has just been achieved. Well, not quite. One of two things will happen. 1) You won’t spend all the cash and will have money left over at the end of the month or 2) you will spend all the cash before the end of the month and need more.

If the first scenario happens, great! Keep the money in the envelope and just add to it at the beginning of the next month. On the other hand, if you spend all the money and need more, don’t stress! Just go withdraw the additional cash that you think you need for the rest of the month and record it on the envelope.

Either way at the end of the month you will now have an idea of how much is needed for that category and will be able to estimate next month’s amount more accurately. Don’t worry about getting it exactly right for now. It will typically take doing this for about 3 months until you have a really accurate estimate.

Even then, these problematic categories are problems because they tend to fluctuate so much. If you’re tight financially, this is a great time to see if what you think you’re spending is in touch with reality. It’s also a perfect way to control your spending by deciding before hand how much you really think you should spend on that category. Just like they always taught me in Sunday School, it’s important to decide ahead of time how you’re going to respond in tough situations. Similarly, you should decide how much you want to spend BEFORE you’re standing the grocery aisle trying to justify purchasing that extra bag of cookies.

Now, if you already track your spending electronically (e.g. in Quicken or online) you should be able to make very accurate estimates from the get go. If that’s the case, great! Your just one step ahead and this process will be a little easier. Even so, you may have trouble tracking some spending such as single transactions that cover multiple categories. Wal-Mart is one of the biggest offenders. I can’t tell you how many times, in the name of tracking every penny, we agonized over a Wal-Mart receipt trying to determine which portion was grocery, household, medical, etc.

Goals of the process

While going through this process there are a few goals you should work towards.

1) Figure out how much you really spend.

2) Make your spending habits more conscious.

3) Control your spending.

Figure out how much you spend (get in touch with reality)

One of the huge benefits of going through this process is that over a few months you will get a very accurate idea of what you spend with very little effort. One thing many of you will have noticed is that you won’t have a perfect “to the penny” record of what you spend. Rather, you will just know the total amount you spent for the month. Enjoy this fact. Enjoy the freedom, the need to not have to calculate every single transaction. You just open the envelope and if there’s money you can spend it.

At the end of the month it will be very clear if you didn’t budget enough; your envelope will be empty and you will feel like you just didn’t have quite enough.

The analytical crowd may cringe at not tracking every cent but let me ask you, what’s the benefit of tracking every penny versus the total amount? There are very few situations in which it really matters. These days, most of the expenses will be at Wal-mart anyway. The goal is really just to get an overall amount that you tend to spend. By not tracking every penny we will still have an accurate budget but it will be accurate on a summary level rather than a detailed level. As we address your non-cash expenses you’ll see that you WILL know how much you spend every month to the penny but you won’t necessarily have a record of WHERE you spend your cash expenses.

Now I can still see the analytical people out there still cringing. If you REALLY want to track every single purchase, go ahead. If you really have no idea where you’re spending your money, it would be very useful to see where it’s going. If you currently use credit cards you can just look at your statement. Otherwise, feel free to keep receipts and enter them into a notebook or Quicken. In fact, my wife and I had used Quicken faithfully for years so we already knew where we spent our money. Most people have a pretty good sense where the money goes. They just need a way to control the outflow.

Make your spending habits more conscious

Really the goal for now really isn’t to reduce your spending, although for most people that will be a natural result. Instead, you just need to make your spending more conscious. Don’t just pull out plastic and not worry whether or not you have the money.

One great thing about cash is that it’s very tangible. Most people have a visceral reaction to spending cold hard cash. It can be hard to see those Georges sniff, Hamiltons (baby) sniff-sniff, and Franklins triple-sniff fly out the window. Plus it’s a very visual medium. An empty envelope definitely sends a signal that credit cards simply can’t duplicate. I can’t tell you how many times I told myself I’d pay with a credit card and just worry about where the money would come from later (I only did this in a previous life, of course).

Control your spending

Notice that I said “control” your spending, not “reduce” your spending. The main point right now is to simply control what you spend. Decide ahead of time how much you are going to take out; how much you think is reasonable for that category. By making that conscious decision you have already increased your chances tremendously that you won’t overspend. If you run out, you will have to make a very conscious decision whether or not to withdraw more. True, it’s not as convenient to withdraw more many than just using a credit card. And that’s exactly why you won’t spend the 112% more that I mentioned earlier.

Credit cards in their place

By promoting a cash-based spending system, I’m not saying credit cards are bad or evil. I used credit cards for years and paid off the balance each month. I still carry a credit card with me for emergencies and reimbursable business expenses. If fact, I actually work for a company that provides merchant accounts (the ability to accept credit cards) to small businesses.

However, the very statistics I use to promote credit card acceptance at work proved to be the reason I decided to stop using them for most purchases. At our company we constantly pitch that customers spend 2-3 times more when paying with a credit card versus cash or check. While this is a great way for a small business to grow their sales, it’s also happens to be a great way for you to grow your expenses. Credit cards are like that kid telling your first grade son potty jokes; they just aren’t a good influence on your personal finances.

What about debit cards?

Debit cards play an important role in managing your finances and will be discussed in later posts. Debit cards combine convenience with a more responsible approach to spending; the money has to be in your account or you can’t spend it. They are great for expenses that don’t vary much. In fact, we used to pay for gas with cash but after a while we realized that we didn’t really reduce our spending by paying with cash and it was a LOT more inconvenient having to walk into the convenience store. The bottom line was that I didn’t drive to work less because I was paying with cash so it made sense to use the debit card.

Give cash a “30 day trial”

So here’s the challenge. Try this today! Try it for a month. You’ll be surprised at the insights you gain. Sure it’s a little more inconvenient but one of the ultimate benefits will be stress-free financial control and you probably wouldn’t be reading this if that weren’t attractive to you. I encourage you to take a look at Steve Pavlina’s article on the 30 day trial concept. It would be a great approach to get your finances kick started.

Please post your comments and experiences as you try this out. If you happen to already use cash, let us know how you manage it physically (via envelopes or some other way).

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