The Most Important Part of the Budgeting Process

The following is an excerpt from Securing Your Financial Future: Complete Personal Finance for Beginners courtesy of Rowman & Littlefield Publishers. All Rights Reserved.

Get ready: here comes one of the most important recommendations in the whole book. It is a trick that makes your left brain happy by getting the power of compounding working in your favor but slips right by your right brain’s bag of tricks. This recommendation guarantees that you will follow the First Rule, month after month and year after year.

It is called Pay Yourself First.

Here’s how it works: the First Rule requires that you save 10%—minimum—of everything that you ever earn. So first you decide what percentage you are going to save and then convert that into a dollar amount. Next, make that amount the very first line item in your monthly budget. Think of this savings as a bill that comes to you every month—a completely nonoptional bill that you can’t ignore or delay. Then as soon as the month begins, pay that “bill” first, before you spend any other money whatsoever. The way that you pay the bill is by transferring that amount from your checking account into your savings account. It’s like saying “I know I have to pay my landlord, the electric bill, my phone bill, etc., every month, and of course I will. But I am going to pay myself first.”

This changes your mentality about spending and saving in a subtle but extremely powerful way: you no longer save what is left after spending. Instead you spend what is left after saving. The difference may sound subtle, but its power is profound.

It works even better if you can make it automatic, which I highly recommend. Do this by preauthorizing an automatic monthly transfer, from checking to savings, in the amount that satisfies the First Rule (at least), on the same day that your paycheck is deposited. Your right brain’s preference for the path of least resistance usually hurts you financially, but paying yourself first turns the tables and allows you to use this tendency to powerfully help you instead. The money is out of your account (and your mind!) before you even realize that it was ever there. You’ll never miss it, so it won’t feel like a sacrifice. You’ll be consistently doing the right thing financially, in such a way that it doesn’t hurt a bit. In fact, after you set it up, you won’t even notice that it’s happening. The only time that you’ll notice it at all is when you happen to notice your savings account balance and are surprised by how big it is getting.

By the way, paying yourself first isn’t a secret, and it isn’t new—it’s been around for generations. It’s so well known for its rock-solid effectiveness that it’s the primary technique used by the U.S. government for its own revenue collection. When you get a paycheck from your employer, you’ll notice that an estimated amount for U.S. income tax has already been taken out before you get your hands on your pay. If the IRS doesn’t want to take the chance that it won’t get paid, why should you? Paying yourself first takes the chance out of increasing your net worth and makes it a sure thing. It’s like money in the bank. Wait . . . it is money in the bank!

Getting the Most for Your Money

So far, all of our emphasis in this chapter has been on keeping your total amount of monthly spending under control by using the budgeting process. As long as you do that, you’ll be following the First Rule and your net worth will grow. In addition, the learn step in the budget process will increase your spending skills, and this is important.  Two people can spend the same amount of money in a month, but the one with the superior spending skills will be able to afford more (or better) goods and services for the same amount spent. Alternatively, two people can buy an identical set of goods and services in a month, but the one with superior spending skills will buy them for less, and therefore will be able to save faster.

People who have mastered the art of spending waste less money and get more for the money that they do spend. You’ll learn how to do this yourself as you continue to repeat the learn step in the budget process, but I’d like to give you a head start by outlining some of the key elements of spending skills. Here are seven of them.

1.  Don’t make individual yes/no decisions—prioritize.  The most basic level of prioritization is separating needs from wants. There is no debate that you need a basic level of food, clothing, shelter, and health care. But everything beyond that is a want. What prioritization is all about is ensuring that your needs are paid for before any wants and deciding which of your wants you want the most. Because you are committed to staying within a fixed amount of spending each month, every time you say yes to a want, you’re saying no to other ones. Your goal at the end of the month is to look back and be satisfied that you got the most for your money—that you spent it only on your needs and your very highest-priority wants.

The worst possible way to get that result is to make your spending decisions one at a time, as they come up or as they occur to you, as if every spending decision were completely independent of every other one. Decisions will come at you at disjointed, random times—so you’ll get disjointed, random results. Without prioritization you just spend your way through the month, saying yes when it seems like a good idea, and you run the risk of spending your monthly total before the month is over. (The technical phrase for this is “running out of money before you run out of month.”) The only possible way to end up close to a good prioritization is to look at all of your possible spending alternatives together, at the same time, so that you can compare them against one another. The wrong question to ask is “Should I buy X, yes or no?” The right question to ask is “I can afford to buy X, Y, or Z, but only one of the three. Which one of them makes the most sense for me right now?”

The budget process forces you to prioritize your spending in just this way, in advance.  This kind of “advance comparative thinking” will become a habit and will give you a much higher level of satisfaction with your spending decisions than the “serial yes/no” approach. You’ll become much less tempted to make spontaneous exceptions to your budget, because you’ll know from your own experience that you’ll have to pay for them by doing without something else that you wanted even more.

2.  Be a smart, well-informed consumer. We’re all bombarded by advertising around the clock. This virtually guarantees that we get a constant, unrelenting view of exactly one side of the story. Everybody knows what this side of the story looks like: the benefits of buying are mind-bogglingly wonderful, the price is unbelievably low, you’ll be admired by everyone you know, and unless you act now, you’ll really be missing out. Is that all you need to know, or is there another side to the story?

Of course there is—but you’ll have to do some of your own homework in order to get it. If you put some effort into this kind of homework, I’ll promise this: you’ll be amazed by how much you can save, easily. Become familiar with consumer-oriented publications and forums. Check out user reviews on the Internet. Get educated about the real trade-offs between new vs. used, and about branded vs. not. Ask friends or colleagues who have made similar purchases what they learned in the process. Spend a few minutes looking at coupons in the mail before throwing them out as junk. Learn which things you should never pay the full asking price for. Understand why Homer Simpson says, “Extended warranty? How can I lose?” If you’ve never done this kind of research before, it might sound like a lot of work. But like many other areas that we’ve been talking about, the key is to establish a habit. There is no real shortcut to becoming a smart, well- informed consumer. It takes a commitment to doing the homework, but the payoff for doing so begins early and is well worth it.

3.  Smooth out nonrecurring expenses.  Most of the expenses in your budget come to you in relatively predictable monthly amounts. But some of your expenses won’t follow this kind of monthly pattern. You might have some that are once a year, like membership fees, holiday gifts, or annual vacations. Others might be one-time expenses, like purchasing a major appliance, a new computer, or a training course.

This is where your emerging habit of long-term thinking can come into play to improve your financial life. The idea is to begin planning for these expenses early, well before you need the money to pay for them. How do you do that? By including them in your budget, in small, regular monthly amounts. Similar to paying yourself first, you simply transfer these amounts to savings each month, where they’ll earn interest in the meantime.

Financially speaking, not every month is the same. But the trick is to use your budget to make every month seem roughly the same. When it’s time to pay the nonrecurring expense, since you’ve saved for it in advance, your monthly process won’t skip a beat. For those without budgets—or who don’t use their budgets to anticipate these kinds of expenses—financial life can be a chaotic series of up- and-down months. Smoothing out your nonrecurring but perfectly predictable expenses frees you up from all of this unnecessary stress. This feeling of being in control of your monthly expenses is one of the more immediate benefits of budgeting; you’ll be surprised by how easy it is once you’ve gotten the hang of it.

4.  Plan for unplanned expenses.  Your car needs new brakes much sooner than expected, your doctor prescribes some new and expensive medication, or your microwave blows up and needs to be replaced. All kinds of things like this invariably pop up, and the one thing that they have in common is that they weren’t in the budget. We’re not talking about huge financial emergencies here—we’ll cover those in a later chapter. Instead we’re talking about those bothersome, unplanned expenses just big enough to put a painful dent in this month’s budget. That means that you’ll have to scramble to find the money by doing without some other things that you’d been planning on. Unless, that is, you’ve taken some precautions.

Look at it this way. Even though events like these are rarely planned, what is the probability that your car will never need an unexpected repair, that you’ll never get sick, or that a household appliance will never need replacing? What to do? Build a contingency fund into your budget, that’s what.

Let’s say that your goal is to do a little better than the First Rule minimum, and you intend to save 15% of everything you ever earn. The way that you plan for unplanned expenses is to put a line item in your budget called “contingency fund.” If you budget for 3% of your earnings on that line, all of your other—planned—spending will be set as if you were planning on saving 18%. The difference between the 15% and the 18% is a pool of excess savings that you can draw on when these unplanned expenses occur. At the end of the year, if it turned out that you needed the 3%, you’ve got it—and you still achieved your goal of saving 15%. If it turned out that you didn’t need the 3%, then you’ve saved more than you planned and your net worth is increasing faster than you’d planned—oh, darn!

5.  Avoid using currency.  There are many forms of what economists call cash and cash equivalents—we’ll learn more about them in upcoming chapters. But probably the most familiar of all the forms of cash is currency—coins and bills—whether in your pocket, purse, wallet, piggy bank, or between the cushions on your couch. Do you understand now what I mean by currency? Good. Now, stop using it.

When you spend coins and bills, they leave no trail. Unless you want to collect paper receipts all month, or keep some kind of transaction-by-transaction record, using currency short-circuits the compare and learn steps in the budget process. It’s like mystery spending—who knows where, when, or how it was used? All you know is that it’s gone.

When you spend with a debit card, a credit card, or by check, you leave a specific record of what the purchase was for, which greatly facilitates the budgeting process. The best approach of all is to select just one of those three (debit card, credit card, or check), and use that for every transaction. (We’ll cover which one of the three is best a few chapters from now.) That way, the results for the entire month are available online, all in one convenient place, in downloadable form. This makes the compare step a snap, and you can spend more time in the learn step.

Yes, there are exceptions. It may not work particularly well to pass your debit card down the aisle at a baseball game to a hot dog vendor or to write a check at an automated turnpike toll booth. But the more you can avoid using currency, the smoother your budget cycle will be.

6.  Small transactions repeated a large number of times add up. Sounds obvious, doesn’t it? But this is one of the most common spending traps that those who don’t budget fall into. Why go to the trouble of bringing your lunch to work? It’s always easier to go out; bringing your lunch might only save $5 or $10. The key is to understand that it is not a $5 or $10 decision—multiplied by 200 lunches a year, it is a $1,000 or $2,000 annual habit. Maybe those lunches are worth that much to you, or maybe they’re not, but the point is to make the decision consciously, prioritizing the lunches against other things that you could spend that same amount of money on.

Budgeting forces you to look at the small-dollar, high-volume transactions and see them realistically. Operating without a budget, or letting these kinds of expenses escape scrutiny by using currency to pay for them, will allow you to be lulled into thinking they’re much smaller than they really are.

7.  Beware of the subscription effect. Many service providers charge for their services on a regular monthly basis. Often it is convenient for both you and the service provider to set up an automated payment scheme, which calls for you to preauthorize payment from either your bank account or a credit card. Examples include services like cell phones, cable or satellite television, club memberships, and insurance coverage. If you are completely certain that the monthly amounts will never change and that the duration of the agreement cannot be extended without your explicit permission, then you are on safe ground. But if the monthly charges are subject to variation, or if the agreement can be automatically extended or renewed automatically, then watch out! This situation leaves you vulnerable to what is sometimes called the subscription effect, and it is financially dangerous; you might end up paying much more, and/or for a longer period of time, than what you had originally preauthorized. Here’s how it works.

It starts with highly visible advertising for a very low monthly rate for a certain set of services. (The rates are often especially low if you are switching over from a competitor.) These low rates are only temporary, but you will only find that out in the fine print. These temporary low rates are called teaser rates. Before long, the teaser rates go up—sometimes very substantially. The seller heavily encourages you to preauthorize an automatic monthly payment, allegedly for your convenience. But the seller’s real motivation is to encourage an “out of sight, out of mind” situation so that you (hopefully) won’t notice when the teaser rates expire and the higher rate takes effect. After several more months, the seller may implement yet another price increase. If you’re notified at all, the communication is usually in the tiniest print available and specifically designed to encourage you to ignore it. A similar tactic may be used when it’s time to renew your agreement; it isn’t uncommon for service providers to automatically assume that you want to renew unless you specifically notify them to the contrary.

Here’s another twist. Let’s say that the seller has three levels of service: red, white, or blue. You sign up for blue. A year or so later, the seller redesigns all their service packages and now has four levels: bronze, silver, gold, and platinum. The seller notifies you of this exciting new development and advises you that “gold” is the closest to what your current “blue” service level is. So, supposedly for your convenience, they offer to make the assumption that your choice is to switch to gold, and if you agree, you don’t have to do anything—they’ll take care of everything automatically! Well, gold may be the closest to blue, but it is a safe bet that gold has a higher price than blue. Unless you are the type to read every line of fine print in what looks like a routine piece of mail, you’ve just “agreed” to pay a higher price—by doing nothing. Suffice it to say that these sellers know all about the paths of least resistance. The idea is that they’ve got a little hidden drain in your financial bathtub, and they want to steadily open that drain up as wide as possible without your noticing a thing.

Your budget process stops this tactic cold. They’re hoping you won’t notice the steady increases, but your budget forces you to notice every increase. Each increase is a trigger for you to reprioritize the spending against all of your other spending and make conscious decisions about whether to accept the increase, downgrade your service level, or cancel it altogether. If it sounds like I’m making a big deal out of one small part of your spending, wait until you set up your first budget. If you’re like most people, you will be surprised by the large percentage of your total spending in the automatic monthly billing category. It is a big deal!

Decision Time

Earlier in this chapter, I noted that many people choose not to adopt a budget process at all because it doesn’t seem like much fun. And even though I’ve done my best to convince you, point by point, of the many advantages of a basic budget process, I’m sure that some of you still aren’t ready to commit to it. I won’t sugarcoat it; even though the budget process eventually becomes a breeze, the first few cycles are likely to be time consuming and maybe a little bit frustrating. That’s because you’re learning lots of very valuable lessons in a concentrated period of time, and I highly recommend that you begin right away.

But for those of you who just can’t stand the idea, let me offer this alternative. Strictly speaking, you don’t have to use a monthly budget process, but if—and only if—you faithfully follow the First Rule (which, as you’ll remember, precludes any form of borrowing whatsoever) and pay yourself first every month without exception. If you follow these two rules, you can just spend each month until you run out of money—and then stop.

If you choose this alternative, there is good news and bad news. The good news is that your net worth will continuously grow—maybe even as fast as it would if you were doing monthly budgeting. You’ll also be able to use every other tool and recommendation in the book; none of them are dependent on your doing a monthly budget. Now here is the bad news: your financial life will be quite chaotic. Especially when you are in any kind of transition (a move, adding a spouse or partner, new dependents, new job, etc.), you’ll find yourself running out of money before you run out of month and having to scramble. And you definitely won’t get as much for your money as if you’d budgeted. Once you’ve had enough of this bad news, you can always change your mind—when it comes to budgeting, better late than never!

The choice is yours: implement the monthly budget process as was just described, or skip it and instead rely only on the First Rule (which precludes any form of borrowing) and Pay Yourself First shortcut.

Before you decide, consider this: would you invest in a company that doesn’t budget, when there is overwhelming evidence that most successful companies do? Isn’t investing in your own financial future at least as important?

Comments

[Sean @ One Smart Dollar]

I agree completely. No matter what I always make sure money each month is going into retirement, savings and other "me" accounts.

[Old Limey]

I also agree completely. During our working life we followed the article almost completely. Now we are in a position where we don't have to but many of the habits, once formed, become ingrained and are hard to change. We didn't have to read books to know how to manage our money, the knowledge came from necessity and from examples within our extended family when we were growing up.

Unfortunately when I look around at young adults today I see lots of spending in areas that were not part of our lifestyle. For example, we never ate out in restaurants when we were raising our family, we never had expensive family vacations, instead we rented cabins in and around national parks. We also never gave our children allowances, they each had multiple jobs. Our children learned from our example how to be thrifty and now at ages of 48, 50, and 52 they are each in excellent financial shape.

[Catherine]

Maybe it's just me, but I view #5 and #6 as being at cross purposes.

If you use cash and only cash to buy food, when the cash is gone, you can't buy anymore and you are forced to use the bag of rice or can of beans in the back of the cupboard. You are forced to bring lunch from last night's left-overs. When you use plastic, you can make those $5 and $10 purchases that add up to an annual lunch tab in the thousands.

Everyone says they don't spend more even though they are using plastic instead of cash, but all the research suggests otherwise. Most of us spend more with plastic, and we spend enough to offset the cost to retailers for the privelige of paying with plastic.

An aside regarding safety: I no longer 'fill the tank' and rely on a gas pump's auto-shut off. At a full service station, the nozzle once popped out and sprayed fuel all over my car. The pump registerd some thirty gallons before the attendant could get it shut off. Considering I have only a 16 gallon tank, it was annoying to have such a large bill for wasted fuel on my credit card until it could get resolved. Now I buy in $20 increments. The pump is programmed to shut off. When we've used up our gasoline allotment for the month, we walk or take the bus.

It incredibly low tech, but the envelope method of budgeting for food, transportation & entertainment really does work.

[S. B.]

This is actually a really good article. I was skeptical when it started out with "pay yourself first" because that phrase has been so overused and redefined that it is basically meaningless now. Having said that, the article is dead on and the proper meaning of paying yourself first - to prioritize above most needs and wants a certain savings rate - is clearly articulated. The advice about smoothing out expenses is excellent. In my opinion, you absolutely must have some mechansim for accruing expenses. Otherwise, people cherry pick one month of low cash outflows and conclude their financial situation is sound. Then the car breaks down or the roof leaks, invalidating that thesis.

[Elizabeth]

I agree wholeheartedly with this article so much that I copied the link and sent it to my friends.

[Chris Smith]

Catherine, thank you for the comment. As far as the "low tech" envelope method is concerned - it's brilliant! I use it in teaching young adults about budgeting all the time. It's based on the simple idea of deciding - in advance - how much you're going to spend in specific categories, and then stopping when/if you've spent that amount. And that one simple idea is at the heart of ANY effective budgeting process - no matter HOW high tech. Finally, if using real cash in some categories of your spending has been working well for you - by all means, carry on!

Sean, S.B., and Old Limey - thanks for the kind words. And Elizabeth - you are my hero!

[Ruth]

Thank you so much for all of this helpful information. I've been trying to revamp my budgeting strategies and I think you've identified two of my biggest downfalls: making individual expense decisions and not planning for unexpected expenses. Now that I've identified these problems, I'm excited to plan better in the future. This post was extremely helpful; can you recommend any other articles for further budgeting/financial advice? Thanks for your input!

[Chris Smith]

Ruth, thanks, and I'm thrilled that you found the article helpful! As FMF noted above, the article is an excerpt from my book "Securing Your Financial Future." There are two chapters specifically about budgeting, but the book comprehensively covers all the areas of personal finance. So if you want a recommendation for more on budgeting/financial advice - just click on my name!

[Victoria @Lend Not Borrow]

Great information here. Pay yourself first and doing it automatically is probably one of the most important financial decisions one can make. I see your point with step 5 on not spending currency, but I've found that when people spend cash they tend to spend less. While I agree the spending trail may be harder to follow, it is certainly not impossible.

Thanks for sharing!!