The hardest part of doing anything is starting. If you're someone who has delayed getting serious about retirement savings, or budgeting in general, I would encourage you to simply begin, today. I'll describe my personal budgeting system, not because I think it's the best system, but because it's a place you can start if you're not sure where to begin.
In order to create a realistic budget, you first need to quantify what you currently spend your money on. You may already have some idea of what you spend on the basics like housing, food and utilities. But what about other large, less frequent expenditures like vacations, insurance and holiday gifts?
I recommend using a tool like Mint.com, which can automatically track purchases and categorize them for you. It will correctly guess the expense category for the vast majority of charges, and you can manually fix any errant transactions on either their website or mobile app.
Your goal should be to create a pie chart of all your expenses by category. You can start with as little as 30 days worth of data, but a year would be better.
Note: Mint works by storing the passwords for your bank accounts. This is obviously a security concern. If you want, you can replicate this same data manually. But I would caution you to be realistic about whether you are going to keep up with that consistently. Like many other pieces of my personal budgeting system, I highly value the capability to put things on auto-pilot.
Create a Budget
Next, you need to use that information to create a budget. I would start by simply budgeting for the actual amounts you spend. Don't try to cut down expenses just yet. Here is a fabricated budget for someone who is single, living with roommates and making $100k/year, which is a realistic salary for a junior software engineer in the bay area.
|CA Income Tax||$5,848||$487||$112|
Notice that I have included a weekly dollar amount. More on that in the next section. I have also maxed out the 401k contribution. Please read this before deciding to axe that budget item!
Pay Yourself Weekly
Most people either get paid twice a month, or every other week. I prefer to pay myself weekly. Basically I deposit my paycheck into a holding account, and I transfer set amounts every Friday into various specific purpose accounts. I'm never more than a week away from a paycheck. If spending money is running low, it's easier to hold out for a few days versus a week or more. This makes it more likely that I will stick to my budget and not cheat.
In addition, this system evens out irregular pay cycles. If you get paid on the first and the fifteenth of the month, some months you will have up to four more days on the second pay cycle. It also makes scheduling transfers easier. Instead of lining up transfers with you paychecks, they can happen weekly.
Consider Separate Accounts
I actually have 17 bank accounts. Some are savings accounts, but most are checking accounts. Why? It allows me to set aside money for a particular line item in my budget. I can see at a glance how much money I have saved for vacation. I can be sure that my mortgage check will never bounce; nothing else draws from that account.
Most importantly, I know when I'm out of spending money for the week. My wife and I both have our own accounts that receive $350 a week. We make most of our purchases that fall under the "shopping" category out of these accounts. I can drain that account guilt-free on "wants" over the weekend, knowing that all our actual needs are accounted for in other accounts. This makes me hyper aware of what I'm spending. In the ten years I have been doing this, I can count on one hand the number of times I have overdrawn.
To fund these accounts, I have a series of standing scheduled transfers on Fridays that move the budgeted amounts from the holding account into the various purposed accounts. Keep in mind there are 52.1775 weeks in a year, so I use the formula
transfer = yearly budget / 52.1175 to determine the amounts.
Many banks offer free unlimited accounts if you keep a combined balance over some low threshold like $10,000.
Save Before You Spend
The ability to discipline yourself to delay gratification in the short term in order to enjoy greater rewards in the long term, is the indispensable prerequisite for success. Brian Tracy
Separate accounts are only useful if you are placing money aside before you spend it. This is as apposed to using credit. This has numerous benefits:
- You cannot go into debt on a purchase you have budgeted for.
- You can spread the cost of once a year purchases like insurance and Christmas over the course of the year.
- You can blow a large amount of money on something relatively guilt free - you saved for it!
Perhaps the biggest benefit is that it forces you to wait for medium sized purchases. Maybe the new MacBook is out, and you are really tempted to drop $1300 for it. Great! It should only take you a few months to save for it. If you're like me, most of the time the impulse to purchase will fade over the course of even ten days, to the point where you may no longer think it's a good use of money.
If not, you can do ahead and purchase it without using credit. Plus, you'll know that it was something you really wanted. You were willing to make some sacrifice for it. To me, delayed gratification is the definition of maturity.
What about credit card rewards? You can still make purchases on a credit card and pay off the card from the correct account. Just make sure you are keeping track of your budget. If you can't consistently stay under budget using a credit card, and especially if you can't pay off the balance every week, I would recommend not using a credit card.
Emergency Fund & Contingencies
One of the great things about sticking to a budget is being able to set aside money for the unexpected. Even in hot job markets like software engineering, there have been regular downturns where many people find themselves out of work. One common strategy is save six to twelve months of expenses (rent, food, utilities) in an emergency savings account, and only touch it in the case of job loss or catastrophic medical issue.
For the example budget, rent, food and utilities total $2,100 a month. To save
6 * 2100 == $12,600 would take just 25 weeks, or half a year, at the budgeted emergency savings rate of $500. Afterwards, you free up that money for other things. Just remember to bump your emergency savings as your expenses increase!
Having an emergency fund is your number one protection against going into debt unexpectedly. Some people will also dip into the emergency fund for things like replacing a stolen bike or a busted water heater. Personally, I keep a separate smaller account for items like that called "contingencies".