Budgeting

I’m going to go out on a limb here and say that most people hate budgeting. In fact, it can be a real point of contention in many married households with shared finances. But the reality is that budgeting is a crucial financial tool. Understanding that level of detail in your finances is one of the fundamental tools to maximize your financial potential. The key is moving through the four stages of budgeting to fit the current stage of your life.  And the more diligent you are in the early stages, the quicker you’ll be able to progress through to the final stages.

The first stage: Detailed Budgeting

This is the first stage of budgeting, where everyone must start, hopefully while you’re still in school. At this stage your net worth is likely very low, or negative, due to student debt. You’re forced to budget – not because you want to, but because you have to. Your focus is on paying the bills for essentials, like tuition, rent, and sustenance and living within your means. Minimizing housing expenses and even eating PB&J for lunch every day is not out of the question. At this stage it is crucial to avoid the trap of credit card and other debt. The good news is that those who diligently budget at this stage will quickly graduate on to the other stages of budgeting.  For those who’ve never mastered this stage, regardless of age, it’s never too late to start!

While there are a number of budgeting tools available, some better than others, in our office we provide all our clients with access to an online client portal that allows them to aggregate their various checking, savings and credit cards to simplify the budgeting process.  Over the years, I’ve met with people who have diligently kept written or excel based records of their expenditures, but this is rare, and for good reason! The process of manually tracking all your expenses is extremely time intensive. Having your expenses electronically tracked and categorized for your budget saves hours of time every month and allows you to focus on far more important things while still maintaining detailed and accurate monthly budgets.

This is the stage where my wife and I started when we were first married, and we probably stayed at this stage for about a year before beginning to transition to the Awareness stage of budgeting.

What’s interesting is that I sometimes see clients go back to this first stage of budgeting in the years immediately preceding retirement. Of course, if you’re already tracking your expenses electronically using our client budgeting tool, going back to create more detailed budgets is very easy.  If you’re not already tracking your expenses and would like to begin doing so, feel free to reach out.

2. Awareness

This is likely the stage you are in if you have already established good budgeting habits and no longer need to watch the details as closely. You’ve likely been earning a good income for a few years, made good progress on paying down student debt and are enjoying small financial triumphs…like not having to check your checking account balance every time you write a check or withdraw cash.

There’s still value in budgeting, but it’s use is now more as an awareness tool. If you see you’re overspending in one category of expenses, you can still pay the bill that month (by borrowing from another category) and then make small adjustments to manage that expense better in the future. At this stage, you can dabble in “luxuries” from time-to-time, like expensive dinners or vacations. You’ve made strides to plan for your future, like developing an emergency fund, paying down student debt, and contributing regularly to your retirement account. Most people in this category have made some of their first big life purchases, such as a home.

Budgeting still plays a role here, but this group no longer wants to focus on every penny in-and-out. The important thing is to review your finances and ensure you’re optimizing your budget. You can do so by asking questions like, “Is the deductible for your car insurance too low?” Perhaps you can afford to increase it, thus reducing your monthly expenses to apply those funds elsewhere, such as your mortgage. The other key is coming to terms with the debt-versus-savings issue; some people become so hyper-focused on putting all their funds toward paying off their mortgage that they overlook the importance of contributing to their retirement savings accounts. The relatively low contribution limits on these tax-advantaged accounts often means that the value of contributing is greater than paying off a low interest mortgage. There is also value in establishing the habit of savings, even if it is a small amount.

3. Prioritization

This is where most mid-career families reside. They are successful in their career and earning a good income. They still have a lot of expenses, perhaps mortgage debt, a growing family, perhaps private school tuition… and while they may not feel they are “rolling in the dough” per se, they do have some money to splurge on luxuries they might value. They can afford a nice lifestyle and no longer have to focus on day-to-day spending as it pertains to their financial needs. However, they still have to prioritize their financial wants. They might pay a bit more to upgrade to a nicer house or luxury car. However, maybe that comes at the expense of dialing back their vacation budget for the year. They’ve also developed substantial financial assets outside of their retirement savings, meaning they either have a substantial amount of cash sitting around that they don’t know what to do with, or they’ve already started investing.

The important thing in this stage is thinking through financial priorities and coming to terms with what you truly value and what type of lifestyle you can afford given your current budget.  A common saying that could be applied here is “You can have anything you want, but not everything you want.”

4. Goals-based Planning

The final stage is goals-based planning.  It’s difficult to say how long it takes to move through the previous three stages as this will vary considerably from person to person.  While this is rare, some people may even be fortunate enough to be in this stage shortly after finishing school, by developing good personal finance habits early and with the help of financial support from family.

For most people this stage corresponds with when they are close to hitting the peak of their earning potential. They are realizing that there are significant complexities surrounding their wealth, such as the need to plan around their taxes, business, debt, estate, etc. Their real concern is not “How am I going to manage my budget today?” but rather “Am I saving enough to ensure that I can support my lifestyle when I retire?”

At this stage, you move away from the focus on funding your daily expenses to the other end of the budgeting spectrum by focusing on funding your goals. Having a plan in place for meeting your long and short-term financial goals provides the freedom to no longer need to pay attention to everyday living expenses. Making the funding of these goals a top priority, including taking proactive measures such as automating your savings, gives you the confidence to know that your future goals will be met.  Your key focus is on optimizing the use of your income, savings, and assets to meet the specific goals you’ve set as efficiently as possible.

What does this mean for you?

Remember the key point of budgeting is to make the best financial decisions possible.  If you should be focused on goal-based planning, it is an inefficient use of your time and energy to focus heavily on detailed budgeting – the tools we provide to clients make this process easy, helping you accelerate into the next stages of budgeting.  As a reminder though, jumping to stage 4 when you really need to be in stage 1 will only lead to frustration and failure. As a result, I see many people who have been in stage 4 revisit earlier stages as they approach retirement and are re-assessing their budget.

In order for budgeting to be truly effective, you need to first determine what stage you’re in and what the best process is to meet your needs and goals for that stage so that you can quickly graduate to the next stage. Despite everyone’s dislike for budgeting, these stages provide a roadmap for moving beyond the detailed budgeting that frustrates so many people (to an extent that almost no one budgets at all) and into the freedom that comes with having established goals that are being funded out of a values-driven budget that requires very little ongoing oversight beyond the regular, perhaps even automated, funding towards your financial goals.

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