Financial Fundamentals (Pt. One) - Budgeting
If there is one thing I hear consistently, from people across all walks of life, it’s that we usually learn the hard way what we don’t know about personal finance. Whether it’s because we missed a contribution deadline and paid higher tax, only paid the minimum on a credit card and got in a debt cycle, or withdrew from the wrong account and got hit with a penalty - I often field questions that start with “I should probably know this, but…” Now until schools start to incorporate personal finance into their curriculums, we have to seek out this information on our own and hopefully find the answers before it costs us. For that reason, I wanted to put together a series that goes all the way back to the fundamentals of personal finance. Without a solid base, all the “hot tips” in the world won’t help set you up for financial freedom. And the first building block is the plain friend no one wants to go to the dance with, budgeting.
Why Do I Need a Budget?
I know - no one likes budgeting, whether its at work or at home. But there is a reason why companies place so much emphasis on it - if they don’t know what they are spending, they don’t know if they are making or losing money. Often, we don’t really consider ourselves in the same way as a company or business, but in this case we should - and we should seek to make sure our revenues are greater than our expenses. According to the Canadian Financial Capabilities Survey from 2019, 1 in 6 Canadians have current spending that outstrips their income. While budgeting doesn’t eliminate this overnight, it will certainly help to identify where the spending is happening, and if we need to make any changes in our habits. As well, those who have a consistent budget are half as likely to be falling behind on their financial commitments as those who don’t. And given that 22% of Canadians feel that finances are their biggest cause of stress (according to a recent Ipsos-Reid poll), having something that clearly outlines what your financial picture looks like can help reduce some of that stress.
How Do I Build a Budget?
There are so many ways to build a budget - depending on your own personal style any of the following may work for you:
App - there are several apps out there such as Mint, YNAB (you need a budget), Pocket Guard, Honeydue, Personal Capital, among others
Excel - if you like to keep things digital but want to be able to customize to your own situation, it doesn’t get much simpler than excel (as shown here).
Pen & Paper - if you like to keep it old school, maybe actually writing it down makes it more serious but this would be essentially the same as excel, just off-line.
Envelopes - this probably doesn’t make the most sense if you are getting into serious savings, but if you physically take your rent money and put it in an envelope in a safe / drawer, etc. you won’t accidentally spend that cash.
Ultimately, you want to set up a system that you will stick to so whatever works for you - use it! If you have a spouse and you need to account for them to, you may have to adjust your preferred method to account for theirs unless you keep your finances totally separate (and even then, if you are in a serious relationship debts and successes are shared).
What Should I Include in a Budget?
The important thing is to be thorough and capture both sides of the equation of “money in v. money out”. You will want to make sure you include:
Income. This one is usually pretty easy, most people know how much money they make. Where it can get a little trickier is if you have variable income, or bonus income that is not guaranteed. A safe number to use would be average earnings that you can count on (please note this will be different depending on your job, compensation schedule, etc. there is no hard and fast rule). Now while you are including your employment income, do you have rental income? If so, include that. Do you receive tax credits? Pension from another job? Include all of these so there is a clear picture of income coming in.
2. Expenses. This is the one that trips people up. Some expenses, like rent or a mortgage are consistent and show up on our banking every month - those are easy to keep track of. Some change through time (like groceries) or only happen once a year (Christmas shopping). To try to get a clear picture of spending, I would track what you spend for no less than 3 months, but even further if you can. Then add in your seasonal
expenses and divide those to get a monthly figure (if you are budgeting by month) to get a total look at what you are actually spending. If you don’t use a lot of cash you can go back and fill in this data using credit card and bank statements, and it’s going to be “pure” data, because you weren’t trying to track anything, so you wouldn’t have altered your spending. However, if you use a lot of cash your accuracy going back a few months isn’t likely to be very high so you should probably track your spending going forward.
3. Debts. This technically falls under expenses (as you should be including ongoing debt repayment in your expenses), but for those that don’t have a set repayment schedule (such as an open line of credit), I am going to put this separately. If you have credit card debt, or an outstanding student loan, make sure you include this. You’ll definitely want to note the balance, interest rate, and minimum payment so that you can work out a reasonable monthly amount that is going towards debt repayment. This will also give you a chance to look at what paying off these loans quicker does to your cash flow, as well as savings in term of interest.
One item that you also want to include in expenses if you can, that seems counter-intuitive, is savings. While savings aren’t expenses that reduce your net worth, they should be accounted for in your budget so that you know how much you have in free cash flow at the end of each month after you’ve taken care of all your responsibilities - including paying yourself. What your savings are being used for will be a topic for another day, but for now it’s enough to make sure we are saving as part of our strategy.
I’ve Built It, Now What?
Once you know what you are bringing in each month, and spending each month, we can start to make sure we are using our dollars wisely. We have two main questions to answer immediately: Once I subtract my expenses from my income is the final number positive or negative (cash flow), and how much debt do I have relative to things of value (net worth)?
If your monthly cash flow number is negative, don’t get down on yourself - from the same Financial Capabilities Survey, over 73% of Canadians have some sort of outstanding debt or have used a payday loan in the last 12 months, and on average Canadians owed $1.71 for every $1.00 in disposable income earned in Q3 of 2020 (according to Stats Canada). If your monthly income after expenses is negative, it’s either because you are spending more than you earn, or because your debt load is high enough that interest payments are eroding your ability to meet your monthly needs (or sometimes a bit of both). While building a budget won’t fix this overnight, it will let you identify areas for improvement so you can start moving your finances in the right direction.
In our next installment, we will look at monthly spending and getting cash flow positive, before we tackle debt repayment.
Elyce Harris is a CFA Charterholder working with Cornerstone Investment Counsel, a registered ICPM in Alberta, Canada. She is also a licensed insurance broker in Alberta. While every effort is made to ensure the accuracy of statements, errors may occur. If a specific stat or carrier policy is cited, a source will be provided, however this is not done for generalizations.