This is part of a weekly series on personal finance and wealth building. If you care to read them all, please click on the ‘Building Wealth’ category on the right.
Most people giving and taking financial advice focus on the budget as the key to building wealth. I disagree, but budgeting is a very important tool in the process of paying off debt, and can play a role in building your net worth by helping you live beneath your means and effectively plan and meet your savings goals. I don’t think having a budget is a requirement if you aren’t in debt; I don’t use one, although I do track some of my spending.
One of the running themes in this series is to keep things as simple as possible to meet the requirements of the process. My approach to budgeting is no different (and if you’ve known me for a while or remember anything I’ve written on lifting, you’ll see some similarities).
To build your budget, you first need to know how much money is coming in during a period of time. Most people use a month, and that’s just fine with me. We discussed how to get a good picture of your income and expenses last week. We also need a detailed list of every bit of spending for the month. It’s a bit of a record keeping hassle, but for this one month, it is absolutely critical that you know exactly how much you spend and what you spend it on. As we get in to budgeting, you’ll find that you spend a lot of money on stuff you don’t need, and you’ll find a lot of waste.
I mean it. Buy a $.25 pack of gum? Record it.
When I was first digging myself out of debt, my now wife helped me through some of this process. One of the things we found were ATM fees. Seems like a little thing, but when you add them all up, it becomes a big thing. I would regularly stop at a foreign ATM and pull out $20-$40, and pay $2-$4 for the privilege. Do that once or twice a week or more (and I was), you find $20-$50 a month that you can eliminate. For you, maybe it’s not ATM fees, it’s your morning cup of coffee at Starbucks, or it’s your stop on the way home for a beer at the local pub. I promise you the effort here will pay off as you will find little things you didn’t realize add up to big things, and many of these things can be eliminated without changing your lifestyle. I was pretty happy to find $20+ a month I could put towards debt repayment that didn’t require a change in my lifestyle.
As you go through the month of record keeping, make sure you track not only every bit of cash that moves and every bill you pay. This is also a good time to put together a list of all your debt. build yourself a list or a spreadsheet, whatever works for you, and record every debt, the minimum payment, the total balance, and the interest rate. This list will become very important in your debt repayment plan.
At the end of the month, compile your list of your income and all of your spending. It should look a lot like your income statement, but with more detail.
Do you have a positive cash flow (more income than spending)? If not, you need to make some pretty big adjustments.
Do you see any spending that is wasteful or unnecessary? Any spending that when you look back on it didn’t really add any value to your life? See anything you could replace with a less expensive alternative (for example, a night out at the bar with friends could be replaced with a night in with your friends… with the added benefit of leftover beer and wine!)
To build your budget for the next month, make those adjustments and come up with the limits of spending for every item. Be realistic and reasonable, but you may have to be willing to make some uncomfortable cuts. The extra cash flow you create is going to go to debt repayment. All of it.
Some “gurus” insist you need an emergency fund before you start working on repaying your debt. They are wrong. You don’t. You need to have enough of a cushion in your checking account to make sure you don’t bounce a check if a bill comes due before a payday or cover some incidentals; I would use a one paycheck buffer as a general guide, but you should use what you are comfortable with. I would not go more than two paychecks. The reasoning behind this is discussed in more detail here, but put simply, it’s not smart to pay interest to keep money you might need when you could use it to pay down debt. Once you pay down the debt, the credit is available on the off chance you need the money. Remember, the emergency fund is just that, for unexpected and unlikely emergencies. It’s not for a birthday present for your mom.
Just to reiterate, you are going to use every bit of the money you don’t need based on your new budget to pay off debt. You are going to keep doing that until all the debt is gone. It’s the surest and fastest way to wealth. Now, if your goals change and you decide you don’t want to build wealth and instead want to have a little fun, or one up the Jones’ with a new car, or whatever, that’s fine. I’m not passing judgment. You can still use these tools to keep your money under control and meet whatever goals you set, but you are not following the plan I’m laying out.
Your assignment this week? You guessed it. Build your budget and create that detailed list of debt. Start thinking about ways you can reasonably save money, and consider our topic for next week, which is the debt repayment strategy.