The Simple Budget

For many people, the idea of creating and following a budget may seem difficult, time consuming or restrictive. There is a better and simpler way to manage your money and still stay on track with both your short-term and long-term financial goals.

Introducing The Simple Budget. A different approach to budgeting which focuses on the big picture view of your finances rather than the line item details. Instead of putting the primary focus on your spending and expenses each month, you examine how much you are saving and investing first by establishing a “financial priorities” fund.

It is the perfect budget for those who don’t necessarily like budgets as well as anyone serious about becoming financially independent as quickly as possible. By maximizing your savings while keeping your expenses to a minimum, you no longer have to keep track of every single transaction and then stress over whether or not you are staying within budget in one particular expense category or another. Through the use of automation and paperless billing, you can ensure that your essential living expenses are always paid on time and no longer have stacks of bills to deal with, freeing you up to focus on managing a much smaller portion of your expenses each month.

Saving Over Spending (SOS)

The SOS approach to managing your finances puts a greater emphasis on your ability to save and invest before you begin to worry about what you spend each month. Your priority is to “pay yourself first” by setting aside a certain percentage (20% or more) of your monthly net income right from the top of every paycheck. And you do this automatically so you don’t have to think about it.

As you get the hang of it and your income increases over time, you can even adjust these percentages to increase your savings percentage up to 50% or more (yes that is possible) of your net income. This does not mean that you have to be super restrictive with your living expenses either. It just means that as your income goes up you would apply the additional earnings to your “financial priorities” fund first until you reach 50% or more of your net income. Anything beyond that would then go towards your regular living expenses.

Taking this approach encourages you to reduce unnecessary expenses and wasteful spending in favor of reaching financial independence sooner. Throughout this process you are changing your relationship with money, being more intentional with how you use it, while also putting more of it back to work through your savings and investing. Eventually the money that you prioritized above your spending begins to earn enough money (thanks to compounding interest) that you can completely replace your need to work to earn an income.

Going Paperless

Setting up paperless billing (when possible) reduces clutter (and stress) by not having to deal with all of the extra paper that comes along with paying your bills (not to mention all the wasteful trash it generates). Most companies offer a paperless billing option and will let you access several years of previous statements online (and print them off if necessary). If you need to retain a copy of these files, you can usually download and keep a PDF version of each statement on your computer. It is recommended that you organize these by year, then by month to make them easier to find. Be sure to backup your files regularly!

Automation is Key

All of your essential living expenses should be setup to be paid automatically each month on (or just before) their due dates. This includes your mortgage (or rent), all utility bills (water, electric, gas, etc.), Internet and phone services and any other regular reoccurring monthly living expense. Using options such as electronic bill pay or setting up automatic payments directly with a company you are paying, you are no longer having to worry about remembering (or forgetting) to pay something on time and can avoid unnecessary late fees.

For expenses that may occur annually, semi-annually or quarterly, you can set these up to be paid automatically as well, but you will need to make sure you leave enough money in your bank account to cover these each month. For example, if you have a car insurance bill that you pay twice per year (semi-annually), then you will want to take the total of that bill and divide it by six months and make sure you are setting aside that amount monthly to cover the bill once it comes due.

This can be done with any expense that you know will come due at least once (or multiple times) per year. It is recommended that you keep these extra funds in a separate high yield savings account (not the same one you use for an emergency fund) until you need to pay a bill so you aren’t tempted to spend it. By using automation you can have the amounts that you set aside automatically transferred to and from a savings account based on the known due dates of these bills.

Saving Money While Paying Off Debt

A question that often gets asked is if you should you pay off all your debt first before you begin to save money? The answer is that it depends on your income and current interest rates as well as what your financial priorities are. If you have credit cards or student loan debt and the interest rates are very high (anything over 3% to 4% is high), you should consider paying those off first (or at least refinance them to a lower rate).

If you have no debt or the interest you pay is low (like 0%), then your priority would be to establish at least a $1,000 emergency fund in a high yield savings account in order to help you break the cycle of going back into debt by giving you some money for unexpected repairs, medical bills or other expenses.

Once you have that emergency fund established, determine what the debt you owe (if any) will cost you per year and compare that with what you could be earning by investing the extra money instead. For example, if you have some credit card or student loan debt and the interest rates are low (3% to 4% or lower), then you might want to put the majority of your money (after paying at least slightly above the minimums due on all your debts) into your retirement savings first where it could be earning 10%-12% (or more) during that same period of time (more than making up for the small amount of interest you are paying). Instead of investing it all, you could also divide it up and put a portion in your high yield savings account to increase your emergency fund up to 3 to 6 months of living expenses.

This does not mean that you should not try to pay off all your debts as quickly as possible however. The idea is that if you were going to make extra payments, consider which would yield a higher return in a given period of time as well as help keep you from going back into debt in the future. This is the opportunity cost that you have to consider. It is possible to pay down debt and simultaneously save and invest, even if it takes a bit longer to do so.

As your debt gets lower (or is eliminated completely), it frees up even more money to save over time. If you wait to save anything until the debt is paid in full, you are missing out on valuable time that the money has to compound and grow. There is also the risk that if you failed to save an emergency fund, that you could go right back into debt.

A good example of this is if you were considering paying off your 15 or 30 mortgage early. If you have a low interest rate on your mortgage of 4% or lower, then instead of making extra payments to pay off the house early, you would be better off investing this money first, so it can earn a higher return (10%-12% or more in the right index fund or ETF). Besides, unless you plan to live in that house forever, you will likely sell it at some point and move (paying it off early anyway). If you must pay your mortgage off early, consider doing so once you have become financially independent (all your living expenses are covered by your unearned investment income) and can direct your entire earned net income to paying it off quickly.

How to Get Started

Step 1: Know Your Income

You need to know what your total monthly income is for any given month. If you have a fixed salary you take your net income (after taxes and benefits are withheld) and use that number. This is usually what ends up being direct deposited into your checking account. If you have variable income or are self-employed, you will have to determine what the average income you earned over the past sixth month to a year (or couple of years) has been minus any taxes you had to pay and use that number.

Step 2: Determine Your Financial Priorities

Once you know your total income you now just need to grab a calculator and multiply your income by .20 to get the amount you should using for your “financial priorities” fund and then take your total income and multiply by .80 to get the amount you have left over to pay your living expenses (all your bills). For example, if your total monthly net income was $3,500, you would assign $875 of that towards saving and investing or paying debt and leave $2,625 towards paying your living expenses.

If the math doesn’t add up and your living expenses still far exceed 75% of your income, you may want to consider reducing some those expenses as much as you can or trying to increase your income some. If you have done all of that and still can’t make it work, just adjust the percentage for your “financial priorities” fund down to 15% (which is the normal recommended savings rate) leaving you 85% for expenses.

Optionally you can take the Ramp-Up Investing approach if you need more time to increase your earnings and reduce your expenses. This is where you start by saving just 1% of your net income and slowly increasing this amount each month (or each quarter if needed) by another 1% until you eventually reach 20-25% (or more) of your income. This gives you more time to increase your monthly income and reduce your expenses while still letting you save and invest and earn compounding interest.

Step 3: Develop the Plan

Now that you know how much you have to put towards your financial priorities and your living expenses, it is just a matter of assigning each dollar a job to do and automating it as much as possible. When you assign each dollar you are creating a plan for how that money is going to be used (which is essentially what a budget is). This doesn’t have to be done on paper or a spreadsheet, but while you are setting it up it doesn’t hurt to have a notepad, pen and calculator handy to make sure everything totals up correctly.

Start with your financial priorities, dividing up the available funds to put towards saving your emergency fund, investing for retirement or paying off your debts (or a combination of all three). Determine what is the highest priority here by calculating the opportunity cost. If you have debt with a high interest rate (over 4%), you should get rid of that first, then put money into an emergency fund in a high yield savings account to get at least $1,000 saved and finally the rest should go towards retirement investing in a 401(k) and a Roth IRA.

For your remaining living expenses, make a list of everything you spend money on each month, quarterly, semi-annually and annually. Prioritize your essentials such as housing, food, transportation and utility bills and automate payments on them as much as possible. Take irregular bills and divide them up into monthly amounts. For example, take an annual expense and divide it by 12 to get your monthly amount. A semi-annual expense would be divided by 6 months and a quarterly expense would be divided by 3 months to get the amount you should be setting aside monthly. Once you have all of the amounts listed for the month, total them up and make sure they still fit within the 75% of your income that you allowed for them. Set this money aside in a separate savings account so you don’t accidentally spend it and then only transfer what you need back to your checking account to pay your bills right before they are due using automation.

After you have done all of that then you should only be left with a small portion of your expenses to actually manage each month. This usually includes money that you would spend on things you want but really don’t need. Sometimes this is referred to as blow money or fun money. The amount you have is really determined by how much you have left over once your financial priorities and living expenses are taken care of.

Example Budget Scenario

John earns a salary of $62,400 after taxes and benefits are withheld each year. This gives him $5,200 of net income each month which is $2,600 per paycheck. John still has some debt ($3,100 on a credit card) he owes but is wanting to make sure he puts money towards an emergency fund and an earlier retirement.

He decides based on his current spending he can afford to cut back in a few areas and establish his financial priorities as 20% of his net income. So John will take $5,200 and multiply that by .20 to get $1,040 to put towards his savings, investing and debt. This leaves him with 80% (or $4,160) for his living expenses.

Next John determines that his financial priorities are to first establish an emergency fund which he will be able to do after just two months by applying half of the $1,040 (which is $520) towards his debt and the other half to a high yield savings account. Once he has that established he will then put $500 of the money towards investing while the other $520 will go towards his debt to pay it off in six more months. He knows once that debt is gone he will then have the full $1,040 to save and invest after that.

At this point since since John has a solid plan for his financial priorities fund, he totals up his essential living expenses (including those which are set aside for annual or semi-annual expenses) and total came to $4,020 per month. This leaves John with $140 left to actively manage each month because he was able to automate the payments for everything else. He can now use that money (or save it up) for anything he wants without feeling guilty for overspending. If he were to overspend on one or more of the expenses covered under his living expenses, he would use some or all of the $140 he had left over to cover it.