Many, if not most people, start off the new year with new goals and dreams for the upcoming year that include budgeting and financial goals. When it comes to personal finance, that is the easy part. The hard part can be following that plan during the course of the year. Now that we are several months into the new year, we can look at our budget performance and see if we are sticking to our plan. We can compare our financial goals and corresponding budget to our actual spending. Simple enough. Then we can make adjustments, if needed, to keep on track on meeting those goals.
But there is another budget exercise that is also worth doing. How does that saying go: “A manager makes sure things are done right, but a leader makes sure we are doing the right things?” So it might make sense to spend some time making sure that we not only are staying on budget but to make sure we have a good budget in the first place. What is a good budget? In fact, let’s go one step further. Let’s look at the budget through the lens of financial freedom. Let’s make a budget that not only makes sure the bills are paid and our goals and dreams are being funded, but is also optimized to let us experience ongoing financial freedom, and eventually, financial independence. It may sound complicated but it is not if you have the discipline to stay the course!
Budget: A Dirty Word
Let’s just put it out there. For some people, a budget is an awful thing. It is hard to make, confusing, very confining and seems to steal joy from life. But let’s start by change our perspective on the budget for this discussion. A budget is simply a tool to help us meet our goals.
“The budget is a plan for our money so that it goes where we want it to go, instead of getting to the end of the month and wondering where it all went.” Dave Ramsey
Don’t think of it as constraining or difficult math, but simply as a useful tool. A good budget can be as brief or detailed as you need to meet your goals and experience the financial freedom you want.
Financial Freedom: What is it? Why Do We Want It?
If a budget is a tool to help us meet our financial goals, then what is the overall purpose of having financial goals? Is it simply just to afford more stuff? Or to be rich? No, the purpose of having financial goals and a good budget is to achieve financial freedom and hopefully, financial independence. Financial freedom is discussed a lot but what is it?
“Our definition is having the attitude and resources to live abundantly in each stage of life, free of worry and free to completely live out the full purpose and goals of one’s life.”
This freedom allows peace of mind, security and choices, which usually result in a fulfilling life. So let’s get started to define a good budget that can get us on our way to financial freedom.
Typically, a good budget has four characteristics:
- The budget has clearly defined goals
- The budget funds those goals
- The budget has margin, breathing room, to account for emergencies, opportunities and life challenges, in general
- The budget defines and prioritizes needs over wants
It Starts With A Prioritized Set Of Goals
Before we start talking about making a good budget, we need to define our financial goals. Goals should be the priority in your budget. They should be funded first. Goals should include responsibilities, short and long term plans, life goals, passions of the heart and family goals. Common goals include:
- Home ownership
- Financial security or financial independence
- Large expenditures: cars, vacations, travel, furniture, etc
- Kid’s education/college
- Hobbies/side businesses
- Bucket list items
Make a list of your goals. Then ask yourself: Am I willing to fund these goals at the expense of other possible uses of my money? If not, drop them off your list and go through the process again until you have a set of goals that you are excited to pursue AND are willing to fund. Here’s a sample list of 2017 goals with dates and amounts:
- Max out 2017 401K retirement savings, to support a 2020 retirement from full time work. $18,000 this year
- Family reunion vacation in July. $3,000
- Braces for our teenager in June. $3,200 out of pocket (Insurance pays the rest)
- Tithe, charitable giving, to my local church. $9,000 a year
Needs vs Wants: Knowing The Difference
One more step before we start making our budget. We need to know the difference between needs and wants, and make sure needs are funded before any budget money is used on wants. A need is something required for basic living. Needs usually fall into six basic categories:
- Housing and utilities
- Reliable transportation
- Groceries/basic food needs
One more thing on needs. What you need to spend is just the amount for basic living so as to keep you safe, secure and functional. Anything more is a want that will be discussed later. An example of a need versus a want: The transportation need for a family might be a basic four door sedan or SUV, but a transportation want might be an expensive European sport car.
Margin Means Freedom: What Does It Look Like In A Budget?
Margin, or breathing space in a good budget, is fundamental for financial freedom and usually takes two forms:
- An emergency fund (usually between 3 to 6 months of expenses saved for emergencies)
- Adequate insurance that usually includes: medical, property and long term disability insurance
The amount of money in an emergency fund varies depending upon your situation and risk-adverseness level. Once you reach your goal, you do not need to keep contributing to it but each time you use money from the emergency fund, the money should be replaced for the next emergency. What constitutes an emergency? Job loss, auto repairs, housing repairs, deductibles for medical issues and such.
Many people working full time today have medical, dental and vision insurance (medical) through their employers, but one way or another, we need to have medical insurance to have financial peace. The same is true with insurance for our large pieces of property (home and auto) and with employment insurance (long term disability). Note: Short term disability insurance can be your emergency fund.
One more note on having margin in our budgets. We know each year that we have seasonal expenses coming, like presents at Christmas time and for birthdays. We should budget for them. You might say, what’s the big deal about birthdays? But if you have an 8 year old, that is in a class of 21 students, and has the same school invite policy as our school, you know that you are required to invite all classmates to your birthday party AND you should expect to be invited to ALL 20 of the other classmate birthday parties too! That could be $400 or so of presents each year you should be setting aside for financial freedom in your life.
Pressing The Information Into A Good Budget
Let’s recap: We know what our goals are and how much money they require. We know what margin in our budget looks like and we’ve identified what that costs. Also, we defined our basic needs in our budget and classified everything beyond those needs as wants that should be funded last, if money is available. Now we can start allocating money to make a budget.
Where to start. A GREAT place to start when forming a budget is to use tools by successful organizations who specialize in budgets and budget allocations. Two such tools are made by Dave Ramsey, http://www.everydollar.com, and Crown Ministries, http://www.crown.org, that provide guides as to how much money should be allocated to each budget category. Here is a great starting point for each budget category:
Take your net income (net pay after taxes) and allocate as such:
Budget Category Percentage of Net Pay Description
Charity (tithe) 10%
Savings/Investment 15% Retirement, emergency fund,
Total Housing 30% Mortgage, taxes, utilities, cable, HOA, insurance, repairs
Auto 12% Car payment, gas, repairs, insurance
Food 14% Groceries & eating out
Entertainment 6% Recreation, pets, travel, gym, gifts
Household 6% Clothing, phone, beauty, services (lawn, cleaning, etc)
Children 4% If no children, go towards savings or a college fund
100% of net pay. Can’t be more than that or we have an unbalanced budget (Read: debt!)
What Makes For A Good Budget?
What makes this budget any good? First, it funds our financial goals (In this case, retirement, travel, children’s needs and entertainment). Second, this budget amply provides for all our needs (housing, food, transportation, insurance and clothing) and many of our wants (cable, eating out, etc). Third, this budget provides savings for an emergency fund and prevents the accumulation of credit card debt, which is the biggest wealth stealer around. Notice what this budget doesn’t have in it? It doesn’t have debt payment as a line item, consumer debt that is. That is because consumer debt is not a financial freedom maker, it is a financial freedom stealer. So pay off your credit card in full each month, while sticking to your budget. It also doesn’t have any money that is not allocated in the budget. Unallocated money usually results in mindless spending. In fact, in 2016, Fidelity reported that 22% of all discretionary money is spent on items we don’t remember just 24 hours after the purchase. Mindless.
Recap A Good Budget
Let’s go through our “good budget for financial freedom” checklist:
- Our budget clearly funds our current goals, In this case retirement, travel, children’s needs and entertainment). Check
- Our budget has margin built into it in the form of an emergency fund and insurance. Check
- Our budget has funded all our needs (basic housing, transportation, clothing and food), all of our goals (previously stated) and some of our wants, like cable TV, pets, etc.
There’s one more important thing our budget provides for and that is charity or generosity. It is the first line item in our budget, because generosity helps us keep money in its proper place as a tool, nothing more, and it is a huge component in financial freedom!
Wait! You say, you have completely different budget needs to obtain financial freedom. Ok. Just re-allocate the money according to your goals and/or lifestyle and as long as you are living within your means, savings for your goals and dreams and have ample margin for life’s challenges, you will be all set.
There you have it. We have a good budget that supports financial freedom. There’s nothing better than that!