Some people dream that they are wealthy, but they don’t know how to get riches or where to begin. A good way to start is by creating a budget. Budgeting is critical because it will give you a clear picture of where your money is coming from and where it is going, therefore, you’ll be able to control it. You can improve what you control and you can control what you measure. People who do not know how to control their expenses will slowly fall into debt every year. You can use this planning process to give priority to the things that matter the most and start the path on becoming financially free. The main purpose of a budget is to take control of your financial situation. It will help you determine your cash flow by making an outline where your income and your expenses are clearly stated. The result from the difference between your income and your expenses will tell you if you have a positive or negative cash flow and will help you determine the best strategy when saving and investing. It is important that you set your financial goals in order to keep motivated during the saving process.
Let’s use the previous example of the road trip. Imagine that you prepare everything you need for the trip: your luggage, a map, some food for the road, and you pack it in the car. You turn on the engine and hit the road but then you realize that you don’t know where you are going. Even with a map, if you don’t know where you want to go, it will be useless. The same applies to personal finance. You can have the perfect budget and stick to it the seven days of the week but if you don’t know why you are saving for, it will be pointless.
Imagine that you want to take an amazing vacation to the blue waters of the Caribbean beaches for a whole week and you estimate that it will cost you around $5,000 all included (round trip, food, hotel, etc.). You earn $3,000 each month as a result of your full-time job and, after expenses, you manage to save $500 each month. That means that you will have to save all your remaining money for ten months if you want to enjoy this vacation. This is just to give you an example of how a budget can be useful in meeting your financial goals.
Other examples of financial goals are buying a new home, buying a car, saving for an emergency fund, investments, and anything you would want to save for. My goal with this book is to help you get some financial education, so my advice on a good financial goal would be to save for investment. Rich people save to invest in assets which will then generate positive cash flow that will help them meet their financial goals. Let’s use the previous example of the vacation at the Caribbean beaches. You know you can save up to $500 every month and that you need $5,000 for your vacation.
Now, instead of working for ten months and then spending it all in one week, you can save for some more time to make the down payment of a little apartment that you can rent to someone. With the rent money, you can continue paying the apartment and you can save what is left to take your vacation. By doing this, you will find yourself taking a refreshing piña colada in the blue waters of the Caribbean Sea knowing that when you return, you will have that long-term, extra income that you can later use for future investments. I know, it implies a lot more work, but you will have to do it if you want to become financially free and dedicate your life to what you truly enjoy doing.
Starting to live on a budget
As you may guess, starting to live on a budget is not easy. It implies many changes that may take a little effort at the beginning but, with time, you will get used to them. You will have to adjust your expenses which will translate into lifestyle changes. There are two main ways in which you can stay on track with your budget.
The first one is by taking up the practice of saying “no” to yourself and your family, as you strive to justify spending money on “desires” that you are trying to transform into a “need”. Learn to live without these little sweets and indulgences that you have lived with over the years. If you concentrate on negatives it will be hard to stay on track on your budget. But that is why it is important to focus instead on the positive side. The second way, and my favorite one, is not to close yourself to the possibility of getting the things that you want. Instead, you should ask yourself the question “how can I afford that?” As I mentioned before, this will boost your mind on finding ways to generate money and get everything you want. This, in the long-run, can generate multiple income streams and lead you to become financially free and improve your quality of life.
Benefits of budgeting
Up to this point, we have had an introduction to what a budget is and what you can achieve by effectively staying on track. Now, we will clearly state some of the benefits that you can have if you continue applying these good financial practices.
Avoid unnecessary expenses
When you feel that you do not have control over your money and always worry where it went and what has happened to it, budgeting will give you a hand. You can determine where your money needs to be spent, monitor spending, see how you do, and know when you need to stop. This is a huge opportunity to improve your financial future and gives you the potential to change now. Checking your budget every day or week will allow you to track how you are doing and prevent excessive expenditure.
The improvement in your spending habits can be a difficult task, but budgeting will allow you to make small, far-reaching improvements. Slowly you will begin to see changes in how you think about spending and how you spend your money. You will see results and will be able to reward yourself for sound financial practices. In the end, you will be able to easily distinguish between what you want and what you need in order to save more than what you spend.
How many nights you were not able to sleep well because you did not know how you were going to pay the bills? People who lose their sleep because of financial problems allow their money to dominate them. You must take control. If you make a wise budget, you will never lose sleep again thinking about your financial problems. Whenever you want to change your financial practices, you need to prepare and execute a strategy. A plan without action means nothing. By budgeting, you learn to make wise spending choices while also saving.
More Comfort
Just because you budget your money, it doesn’t mean you can’t spend it. One part of the budget is to prepare big expenses and splurges. Just because you’re good with your money doesn’t mean that you have to stop spending some of it. You can afford to spend a little extra on certain things, without feeling guilty or bad about it, through budgeting. Your budget allows for a few high price products now and then, without negatively impacting your monthly expenses.
Paying your bills on time
Late payments are never a positive sign. Paying late could lead to debt default and then to major financial problems. Budgeting will allow you to prevent missing payments on essential bills as you have already put the money aside. Your budget should ensure that every bill is paid on time because it is a top priority in your plan.
Achieving your goals
Attaining and achieving your goals can be a very satisfying and rewarding process. Having a clear and concise budget plan will ensure that you reliably and routinely achieve your objectives. You will accomplish the goal of saving for a car or enjoying a lavish holiday because you have planned on it. You can enjoy the results of months or years of hard work.
Building a rainy day fund and an emergency fund
Another benefit of living on a budget is that you will able to build a rainy day fund and an emergency fund. The difference between these two types of funds is that, typically, a rainy day fund contains between $500 and $100, while an emergency fund contains somewhere between three and six months of expenses. A rainy day fund will allow you to make little unexpected payments without having to use your credit card and pay interest on small expenses. You don’t know when it’s going to rain and how hard the rain will be. An emergency fund will help you deal with a bigger crisis such as a job layoff or an economic crisis.
50/30/20 rule for budgeting
If you want to become financially free, you have to look deep into how you spend your money. Does that mean that you have to give up your coffee in the morning or curb your addiction to sweet candles? It’s not really important. You can spend fun money, but there’s a limit. This is a simple way to classify your money into three types of expenditure.
- 50% of your income should be aimed at your needs. It covers housing expenses, food, transport, childcare, and so on.
- 30% of your income should be destined to pay your debt, saving, investments, and emergency funds.
- 20% of your income should be used to pay for things that you want, such as restaurants, entertainment, and luxury products.
Four steps of the 50/30/20 rule
Step 1. Calculate your post-tax income after deducting your taxes, Medicare and Social Security expenses.
Step 2. Restrict your requirements to 50% of your income
Your first step is to reduce the costs, which ensures that your needs are less than 50% of your after-tax income. They include such things as…
- Rent or mortgage payments
- Auto loans and storage expenses
- Assurance rewards, food, and household supplies
- Cell phone bills
- Vital clothes and shoes
- Minimal credit payments
Step 3. Destine 30% of your income to save, pay a debt, investments and emergency funds.
This part of your after-tax income should be to pay down debt, save money, and invest. As your minimum debt payments are managed in the category of needs, creating an emergency fund is necessary as soon as possible. Use this 30% of your income to reduce your debt obligations once you have established an emergency fund. When the debt is gone (despite mortgages and car notes), resist the urge to spend 30% more. Save in a low-risk savings account, invest in your financial education so you can learn how to properly invest your money and get the best returns.
Step 4. Limit your wants to 20% of your income
Your last step would be to limit your desired expenditure. They include comfort and luxury items or products like:
- Luxury clothes and accessories
- Restaurants and food
- Holidays
- Phone arrangements
- Personal care
- Gadgets Toys
You cannot understand the value of a budget if you do not comply with its laws. The easiest way to stick to a budget is when you earn your money. Use it immediately to fund your needs (50% of your revenue) and your savings (30% of your income) after you obtain your paycheck.
Example 50/30/20 budget
Let’s presume that every month your family receives $5,000 after taxes. Following the 50/30/20 rule, you could spend up to $2,500 in your monthly expenses, $1,500 should be put aside for saving, investment or paying off debt. The remaining $1,000 are available to spend as you wish. This rule is a good plan for those who don’t want to follow a strict budget, but it’s essential to remain consistent. You spend every month responsibly, giving you the freedom to enjoy yourself later in life.
