Get a Black Belt in Budgetsu: Advanced Budgeting Techniques
“I love budgeting!” — No One, Ever
Budgeting is the algebra of personal finance. We learn it as kids because we have to and as adults we try to avoid it as much as possible. Companies know this, so there are plenty of budgeting apps that can automate budgeting so we can focus on more important things, like which filter to use for the cat’s latest selfie.
Still, it’s important to regularly check that you’re staying within your budget, because no one can get rich unless they spend less than they earn. This week we’re sharing some advanced budgeting techniques, because if you want to get a black belt in personal finance it’s useful to know not only “Budgeting 101” but also some sophisticated strategies so that we you have a target to aim for.
These techniques are often more effective than traditional budgeting, but we don’t really recommended them for anyone who doesn’t already have a consistent savings strategy. If you want to adopt one (or all) of these techniques, we are going to assume that:
- You have one or more sources of consistent income
- You are already saving a significant portion of your income (at least 25 percent)
- You understand that budgeting is just one part of a successful financial strategy
- You already have a fully loaded emergency fund
Pay Yourself First
Pay Yourself First (PYF) is a classic budgeting technique that’s been described in seminal personal finance books like Rich Dad Poor Dad. “Pay yourself first” means that when you receive new money, you always contribute first to your savings before anything else. If your goal is to save half of your income, then you put 50 cents of every dollar you receive into savings immediately, before giving any money to your landlord, your loan company, or the friendly people at the Apple store.
The purest form of PYF is achieved through payroll deductions to tax-advantaged investment accounts. If you have a 401(k) plan through your job, your company automatically deducts a certain percentage of your paycheck and invests it in your retirement account.
This strategy has a lot of benefits. First, it’s automatic, so you don’t have to think about saving, which makes it easier to stick with your savings plan. Secondly, payroll deductions mitigate loss-aversion. If someone gives you 100 dollars, it’s emotionally difficult to give 50 dollars away to future savings. It’s much easier if our employer just gives us 50 dollars in the first place, and quietly puts the other 50 dollars in our retirement account. Moreover, when we contribute money to tax-advantaged accounts through payroll deductions, that money not only grows tax-deferred, but is also invested pre-tax, reducing the money that we have to give away to the government each year.
Even if you don’t use payroll deductions to save, you can still benefit from a PYF strategy. If you have student loan debt, for example, every time you get a paycheck for $1,000, you can immediately pay $500 toward your student loan principal, leaving you $500 to pay for other expenses and make bad decisions at the bar.
The risk of the PYF strategy is that you can run into trouble if you pay yourself too much money without planning for future expenses. If you make $3,000 dollars a month and you automatically invest $2,000 toward investments, will the remaining $1,000 cover your costs if your water heater breaks or you get into a car accident? This is why PYF is an advanced budgeting technique that requires a fully loaded emergency fund and a forward-thinking financial mindset.
The Last Dollar Budget
The Last Dollar Budget (LDB) requires you to do something that financial planners generally discourage: spend everything you earn, down to the last dollar. The trick is that this budgeting technique includes money “spent” on savings.
The LDB technique works because you can’t spend your extra money on junk if you don’t have any extra money. LDB doesn’t let you have any extra money each month. Every dollar is accounted for and spent on something. Most of this “spending” should go toward saving and investing.
LDB requires you to have an intimate knowledge of your spending habits and to forecast how much money to allocate each month for utility bills, groceries, and everything else. For this technique to work, you need to have been tracking your spending for several months. After you learn your spending patterns and overall budget, any excess money can go to your number one savings goal — whether that means paying down debt, saving for a house, or investing for retirement.
The risk of LBD is that it requires consistent, active management of your spending. This can get tiring after a while, and it won’t be a lot of fun for most people (our CEO is the exception to this trend). LBD will require self-discipline that is only acquired after many months of consistent saving.
Segregated Income Streams
Segregated income streams (SIS) is the easiest of the advanced budgeting techniques to use, but it requires that you already have a strong personal finance strategy. A prerequisite of SIS is having more than one source of income. If you are in a long term relationship, you probably have two incomes already, and SIS gets easier if you have three income streams or more.
Let’s say that you have a full-time day job (teacher), a part-time weekend job (DJ), and you have one rental property. Your teacher’s salary makes up 50 percent of your income. Your rental property adds another 35 percent and your mad music mixing skills bring in the remaining 15 percent. You’re in a great position to use SIS.
SIS means that you treat each of your income streams separately, and they each match up with one or more saving or spending obligations. Just like in Ghostbusters, you never cross the streams. Your teacher’s salary goes toward your savings goals. Through payroll deduction, you contribute five percent of your salary to your retirement plan and your school makes a matching contribution. The rest of this salary goes to saving for a second rental property.
The income from your current rental property pays your daily living expenses: groceries, bills, and a regular donation to charity. Your DJ income is fun money. You’ve already met your goal of a 50 percent savings rate and your living expenses are covered. Why bother budgeting this income? You can blow it on bad decisions at the bar because it’s segregated from your other income, so it won’t affect your overall finances.
Reaching Budget Nirvana
What’s great about these techniques is that you can use just one of them or all of them together, and you can use them to different degrees.
By taking the time needed to create a Last Dollar Budget, you can predict how much money you can Pay Yourself First each month. And if you have Segregated Income Streams, you can put energy into budgeting some sources of income toward savings, without worrying so much about your fun money.
Do you have a favorite budgeting technique that you use already? Or do you still need to take Budgeting 101? Let us know in the comments.
Alejandro is a financial planner with Monte Largo Financial Advisors LLC.