Let’s look at financial basic #2: Spend less than you make

How does one go about doing this? It’s easy, right? You just make sure you don’t spend more than you make. Simple enough.

The reality is, if you don’t have a system to plan your spending, your spending will more than likely plan you. Odds are, you will spend more than you make until you exceed what I call your debt comfort threshold. That’s the point at which you no longer feel comfortable that you will be able to recover from the level of overspending you’re currently engaged in.

For many of us, planning our spending, and then sticking to that plan is something we all know we should do, but few of us actually do. In a study done in 2013 of the American population the results were that 32% prepared a monthly detailed budget. That means that the vast majority (68%) do not.

As a reformed non-budgeter, I know the reasons why we didn’t do it. One of those I’m sure relates to my engineering background, which expressed itself in the form of analysis paralysis. In my early attempts to budget I would try to allocate every line item on our bi-weekly paycheck to the proper category in Quicken, so that I could be accurate to the penny. Federal taxes, state taxes, medicare, medicade, medical insurance, life insurance, 401(k), etc. Very tedious! I don’t recommend that. Despite my multi-year efforts at acquiring and keeping the data accurate, we never got to the point of planning our spending. All I did was use hours to track where our money was going, in order to have good data for when we did start to plan, which never happened.

STEP #1 Forecast your income for the next month

The first step in establishing a monthly spending plan (some people call that a budget, but that has a negative connotation for so many, that I prefer to use the term spending plan), is to forecast as accurately as possible (without the analysis paralysis part), how much income you expect during the coming month. I no longer worry about all of the automatic withholding that comes out of my check for things such as taxes, insurance, 401(k), etc. when I forecast our monthly income. Rather, we create our monthly spending plan based on our net monthly take-home pay. This simplifies the process greatly.

This doesn’t mean that we don’t pay attention to the tax withholdings, the insurance costs, etc., but it doesn’t need to complicate your monthly spending plan. Don’t let that be a reason you don’t make one!

Once you’re armed with the how much you have available to spend during the next month, you can create your spending plan.

STEP #2 Plan your spending

Here are the planning numbers that I recommend, as percentages to use for your budgeting process. Depending on where you are with your current financial situation, it may or may not be the right starting point for you, but these should be the minimum targets as a percentage of your expected income:

10% — Give to charity

10% — Invest actively

10% — Invest passively

70% — Live on what’s left.

Let’s look at each of these categories for a minute.

Give 10% (minimum) to charity

I sought out a mentor not long ago. The was a man who had retired from a large company as a Vice President. I had known him from our church when we lived in Michigan. He was kind enough to share advice with me via a phone call years later. Among the advice he gave, and he said, “This will seem counter intuitive, but one of the principles of wealth is to give.” We have had the practice of donating consistently to our church and to other charitable entities, and occasionally to individuals in need, but after that conversation, I have made a more conscious effort to give to people and organizations in need, or that do positive charitable work more consciously and consistently. As he said, it does seem counter intuitive, and I have no explanation as to why it works, but living this principle will help you in your personal finances. (When I have greater insight as to why, I’ll write a blog post about that).

I have often had reservations about donating to organizations that spend so much money on mail campaigns. How do you know if your money is going to help the advertised target recipient, vs. pay for more envelopes, return addresses and coins to hot glue onto the letter asking for help? Last Christmas I discovered a non-profit organization that ranks non-profit charitable organizations. If you are interested in finding out how your favorite charity stacks up, or if you want to look for an organization that truly uses the donated funds well, I invite you to visit CharityNavigator.org

Actively and Passively Invest 10% (each or 20% total)

The active and passive portions of 70/10/10/10 budget model are the two components that will guarantee you become wealthy, or at a minimum, much more financially secure than if you choose to ignore those categories. You won’t get rich overnight, but over time, you will become financially unstoppable. So what is the difference between an active and a passive investment?

Active investments are those that require your time and effort to manage or make work. They are things that can bring you a return on your investment (ROI), but which require a higher level of focus and effort than a passive investment.

Examples of Active investments would include a home-based business, acquiring rental properties, private investment opportunities, etc. I have a couple of investment brokerage accounts and purchase individual company stocks. I consider those active investments, because they require more oversight than say, a mutual fund investment.

Examples of Passive investments would include, 401(k) or IRA contributions into managed mutual funds, bank savings accounts or other low risk investment options that yield a positive return. (Be careful about bank savings accounts, however, as they are currently paying a lower return than the rate of inflation, which may mean that your money is actually losing value sitting at the bank. I keep a relatively small portion in our savings accounts that serves as peace of mind knowing it is secure and easily accessible, if needed. I try to move most of our liquid savings to our brokerage accounts so that it can work harder for us than it would otherwise, sitting in a bank).

Live on your remaining 70%

I can hear the replies now. “What??? Live on 70% of my net income? Are you crazy? I can barely make it on what I’ve got today, and you want me to cut it by 30% or more???”

Yes, I do.

A number of years ago, I chose to change positions with my employer. I knew that the new position paid $20,000 less per year than I was making at the time. That was not an easy financial adjustment, but, because it was something I wanted to do, and therefore, chose to do, we no longer had that $20,000 of salary per year. That’s about $1,700 per month. If you were to cut that much out of your monthly budget today, do you think you would feel it? We certainly did.

I mention this now, because, though it wasn’t without some financial pain and adjustment, we survived the transition. Remember the quote from Financial Basics part 1:

“That what each of us calls our ‘necessary expenses’ will always grow to equal our incomes unless we protest to the contrary.”

If you suddenly had to live on 70% or less of what you’re currently living on, you could most likely do it. It wouldn’t be comfortable, and it probably wouldn’t be easy, but you could do it. If you truly scrutinize your spending, you can find waste, and unneeded spending in multiple places. If you want to take a serious look at where the big expenses come, I refer you to Scott Trench’s book, “Set For Life” where he analyzes “Average Joe’s” spending. (Hint: housing and transportation are two of the biggest consumers of your disposable income).

Once you have the amount of money available to spend for the coming month, you need to allocate your planned spending among your chosen spending categories. Here are a sample of some of the categories we use:

Mortgage/Rent; Charity/Donation/Gift; Auto Insurance; Life Insurance; Gas (Auto); Utilities (electricity, gas, city trash collection, etc); Phone/Internet; Education; Food/Groceries; Dining (Restaurants); Home/Household; Entertainment; Clothes; Miscellaneous

You can choose however many (or few) categories you desire.

Tools for Success in Creating and Sticking to a Monthly Spending Plan

One of the reasons people don’t do the things they know they should is because they don’t know how to do them. I suspect this is a big reason that a lot of people don’t create and stick to a monthly spending plan.

With the advent of technology there are a multitude of apps and software programs that help facilitate the “budgeting” process. This includes both the planning part as well as the tracking part. Here are brief summaries of a few that I am somewhat familiar with:

Every Dollar from the Dave Ramsey Organization

My experience with this is limited. I signed up for a couple of years to test drive it, but didn’t end up using it more than a few times. There is a free version and a paid version, which currently is at $90/year (which equates to $7.50/month). The paid version allows for automatic accumulation of your transactions, by linking your bank accounts. The free version requires that you enter all of your transactions manually, a process that I have found as a large obstacle to any budgeting process, regardless of the system.

YNAB or You Need A Budget

My son uses this system, and likes it a lot. They have a free 34-day trial, after which it costs $6.99/month. He says they have a user-friendly mobile app which is well maintained, and he has used it for a number of years.

Mint, by Quicken/Intuit

This is my personal favorite, for a couple of reasons. One is that it’s free. It has the function of the Every Dollar paid version, but you do get ads. They are usually relevant to your situation, and often can be beneficial opportunities, and I don’t find them intrusive. Mint allows you to link your financial accounts, and automatically imports transactions. For common transactions, it automatically assigns them to the appropriate spending category.

Regardless of the system you use, in order to be successful, you need to plan your spending on a monthly basis, and track your actual spending to that plan on a weekly basis. That, along with following the 70/10/10/10 spending plan model, will ensure your financial foundation much faster than you might think it would take, if you’re not already among the 32% of people that create and track to a monthly spending plan.

In the next post in this financial basics series we’ll look at how you can determine your personal financial score. Until then, to see how you’re doing with the financial basics take this 10-question survey.