Budgets: Are you doing it wrong?
Conventional wisdom: If you want to be fiscally responsible, you need to have a budget.
How many of you have a budget? Is it working for you?
Here is what I usually see when folks bring me their budgets - They have a spreadsheet with a lot of categories (Rent, Groceries, Eating Out, Utilities, Toiletries, Clothes, Entertainment, Gym, Phone, Travel, Netflix, Laundry, etc). And when you add up income and subtract expenses, everything looks good - there is more income than expense. But they are still having problems managing their money. The problem is, that spreadsheet isn't as much about reality as it is about good intentions.
Before we talk about how to do a budget right, we need to talk about what exactly a budget is:
A budget is a plan or roadmap for how to spend your money.
I like to imagine that spending money is like driving on the road. Except this is a bizarro world with no signs on the streets or highways. Even the maps don't have street names - just straight and squiggly lines that show where the unnamed roads are. And bizarro world also has no GPS, Google Maps or Waze. If you want to get to a destination in an unfamiliar area, you'll have to look at the old-fashioned map and plot out in advance how to get there. But even after you've plotted out your route, since there are no street signs, you have to keep looking at your map to make sure you are going the right way.
Just like you have to look at the map and plan how to get to your destination, you need to look at the map of your finances and plan how to reach your financial destination [goals].
If you have no financial goals, then hurray! - you don't need a budget. You're not trying to go anywhere, so you don't need a plan for how to get there. Just follow the golden rule of personal finance and you're good to go. (Although, for many folks, just trying to follow the golden rule of personal finance requires a plan).
If you have financial goals and you make a budget, but never look at it, it's just like plotting a route to get to your destination and then never looking at the map again. And if you never look at that map again (and you're going to an unfamiliar neighborhood), you're probably gonna get lost.
If you have goals and a budget and categorize your spending and compare your spending against your budget from time to time, that still may not be enough. That's like tracking where you are on the map and where you're supposed to be. That might show you how much you veered off-route but doesn't necessarily get you to your destination.
So, how are you supposed to use a budget?
If you are driving, your route tells you how far to drive and when to turn. You continually check where you are against the route and if you happen to veer off course, you recalculate and make a new route. And that's exactly how you should use a budget.
If a budget is a roadmap for how to spend, then you should be consulting your budget whenever you make a spending decision. When you spend money that wasn't in your plan (making a wrong turn), you need to go back to your budget and make adjustments.
Practically, there are a few things that fall out of this paradigm.
- There is no need to have a million budget categories. That just makes the part where you check against the plan a lot more complicated. If it's too complicated, you're likely to eventually give up tracking it. And does it really matter if you overspend on 'Eating Out' by $50 and underspend in Entertainment by $50?
- Make categories based on what you need to track. Because a budget is goal oriented, I create my categories based on what is non-negotiable (like rent), what helps my goals (like savings) and then 'everything else'.
- Don't dwell [too much] on the past. I don't bother much with categorizing every expense and looking at how well I stuck to the budget in the past. When you're driving, it's less important to keep track of every wrong turn you already made, but rather what turns are ahead of you. Also, dwelling on past mistakes will just discourage you from looking at your budget.
- Budgets are always changing. Most folks I know don't have the same expenses every month. There are always things that come up, such as traveling for weddings, unexpected illness, something breaking down or having to relocate. Rigid plans that don't account for those ups and downs tend not to be too helpful.