Budgeting. The word itself makes most people cringe. The process of budgeting can be very cumbersome and frustrating. First, you have to sort through statements and online transaction ledgers to identify all of the regular expenses you encounter on a regular basis (mortgage, car loan, utilities). Once you have them figured out, you begin the struggle to make sense of all the expenses that occur each month, but do not quite have a consistent, predictable pattern (groceries, entertainment, clothing). Still further, you realize there are even more that do not repeat themselves in any consistent pattern over time (auto repairs, home improvements, vacations, medical expenses), but will certainly come up at some point down the road.
Eventually, you refine and revise the numbers to arrive at a budget. Some folks even track their spending through software programs such as http://www.mint.com and Quicken. A few months later, however, you realize that your actual spending has deviated from the budget you set and struggle to figure out how it went wrong. As frustration sets in, you begin to believe that this whole budgeting thing just isn’t worth the time and effort.
The breakdown that occurs in this process is simply that budgets are an incomplete cash flow plan. Further, the tracking systems listed above provide an excellent backward-looking perspective on your finances, but do little to help you maintain control moving forward. Without a system in place to effectively manage your cash flow on an ongoing basis, a budget alone is worth about as much as the paper it is written on. A proper cash flow system will keep you in control of your money rather than allowing it to control you.
One highly effective method to manage household cash flow is to automate and segregate your spending. A decade ago, this method was very difficult to implement due to technology barriers. The systems that existed at the time typically included the use of envelopes and cash. Today, advances in online banking have made it incredibly easy to put an effective system in place.
In my last article (add link), I outlined that the financial world we live in continues to get more and more complex as we continue to advance as a society. It is virtually impossible today for a household to remember all of the expenses that flow through a household in a given month, let alone the irregular expenses that pop-up along the way. As such, it is important to systematize your cash flow to ensure all of your spending needs are met.
Ramit Sethi writes about the importance of automating your finances in his NY Times bestseller, I Will Teach You to be Rich, and has a short video on his website to describe the process in detail (http://www.iwillteachyoutoberich.com/blog/automating-your-accounts-video/). In our firm, we use the First Step Cash Management System (click the video link at www.firststepcashmanagement.com) with our clients, which takes Ramit’s system a step further.
In a nutshell, the First Step system breaks down your spending into three buckets – Static, Control and Dynamic. The objective is to automate as much of your spending as you possibly can so that you have a much smaller and more manageable amount to think about on an ongoing basis. While it may appear on the surface that you are giving up control by doing so, you will find that it is incredibly liberating.
The Static bucket consists of predictable expenses that repeat each month. All of these expenses are the result of a spending decision or commitment you have made in the past. Your decision to buy a home, vehicle, or take out loans to attend college has led to an ongoing, predictable financial commitment moving forward. Often, these commitments take shape in the form of debt or utilities, but would also include commitments to own a cell phone, subscribe to the newspaper and cable TV, or membership at a golf or health club. Because your income is a finite amount, these commitments you have made have a direct impact on the other two buckets. Since they are very easy to plan for and often carry severe repercussions if you miss a payment, every expense in this category should be set-up with automatic payments each and every month.
The Dynamic bucket consists of savings to meet short-term (real estate taxes, auto insurance, season ticket renewals), mid-term (remodeling, dream vacation) and long-term goals and obligations (Roth IRAs, college funds). In many respects, this bucket represents savings. However, it is also comprised of irregular expenses such as home maintenance and car repairs that occur infrequently, but tend throw a damper into your finances when they inevitably do.
Technology has provided the means to plan for all of these expenses in a very effective manner. Most banks will allow you to open as many savings accounts as you desire. As such, if you have 10 savings goals, you can open 10 savings accounts, label them according to the goal you are working toward, and automatically fund each account every week, month, or every time you get paid. For example, if you wish to take a $5,000 vacation each year, you simply create an automatic transfer of $416 per month into your “Vacation Fund” and can be 100% confident that you will have the resources to go in 12 months, and you know exactly where that money will come from. The Dynamic bucket is the place to make your life goals a reality.
Finally, the Control bucket consists of everything left over. By this point, you have automatically funded every obligation and goal that is important to you. As such, whatever is left over is the only amount you have to exercise control over. It is notable that this bucket must be used on certain items that many people would consider needs, such as gasoline, groceries and clothing. However, to varying degrees, you have control over the amount spent on each of these categories. If you decide to eat out more often in a given month, your grocery bill will be lower. If you take a long road trip to visit family, your gasoline bill will be higher. As such, the Control expenses typically represent the areas that your “budget” goes wrong. By lumping them together, you can plan for these inconsistencies by altering your behavior in small ways. To simplify the decision-making process further, you can automatically fund this bucket as a separate checking account on a weekly basis.
The direct link between the life you desire and your ability to fund that lifestyle is cash flow. Automating your finances will help you gain control, make smarter decisions with your money, and instill confidence that the life you desire is attainable.
This article was originally published at the Financial Planning Association’s All Things Financial Planning Blog.