Macro Mondays: Budgets (Part 6 of 8)
Welcome to another edition of Macro Mondays here on GradMoney!
One of the most important parts of creating an effective budget is the process of setting (and following) effective goals and using the budget as a way to achieve these goals. They may be simple, like saving enough money to buy that fancy Kate Spade sweater or saving money for tickets to the baseball game next week, or they may be really big and forward thinking, like "I want to retire at age 55."
Budgeting provides the best way for you to reach your short and long term goals in one place. Investopedia's budgeting lessons provide some useful ideas to help get you there (and hopefully make the process fun at the same time). Be sure to CLICK HERE to learn more on Investopedia's page.
1. Fund Rainy Day Savings
To make sure that unforeseen expenses don’t cause your goals to careen off track, build up some cash reserves. Three to six months’ worth of expenses is a good cushion. This fund will help protect you from a sudden loss of income, an unexpected car repair bill or that unavoidable root canal. It will keep you out of credit card debt when life happens and turn an emergency into an inconvenience.
2. Get Beyond the Next-Paycheck Mindset
When you’re always thinking about the arrival of your next paycheck, that probably means you’re burning up your current paycheck and spending the next one, whether by mentally accounting for where it will all go or by putting purchases on credit cards. If this situation describes you, it’s likely that you’re living beyond your means.
Since no job is guaranteed, and neither is your next paycheck, making it a goal to fit your expenses into your current income is an important one. This way, even if you lose your job tomorrow, at worst you’ll be starting at zero — you won’t already be in a hole. What’s more, getting beyond the next-paycheck mindset is essential to thinking about your long-term financial picture and how you can save for your future goals and expenses.
If you share income and expenses with a partner or spouse, making it a long-term goal to get by on a single income can give you a lot of flexibility if one partner wants to stay home to raise kids, becomes unemployed, or gets sick or injured and can’t work.
3. Substitute for the Short-Term
For a short-term goal, such as being able to afford tickets to a basketball game next month, you may simply be able to substitute one expenditure for another. If you normally go out to eat, maybe you can trade a few meals for a game. If your budget is tighter than that, you may have to take a more drastic measure like cutting your grocery bill by eating lots of pasta- and rice-based dishes and cutting back on more expensive items like meat and cheese.
4. Calculate Your Long-Term Needs
For a long-term goal, such as retiring by a certain age, find a retirement savings app or calculator that allows you to enter variables such as your age, amount currently saved, expected rate of return on your investment and age you want to retire by to find out how much you need to save per month to reach your goal. Online calculators can produce varied results, so it’s best to try several and get a general sense for the amount you need to save. Further, they’ll only give you a general estimate of your retirement needs.
For budgeting purposes, don’t worry too much about calculating exactly how much you need for retirement. Try to establish a general goal to work toward and give it a number to make it more concrete. Then, start considering your retirement savings as a non-negotiable monthly “expense” and adjust your other spending as needed to make room for the new amount. (Try our calculator, How much do you need to save to become a millionaire?) Eventually, you may want to refine your savings plan with a financial advisor.
5. Save for Fun Things
If all your savings goes toward dreary activities like paying off debt and saving for unexpected car repairs and medical bills, your only incentive to save might be the fear of what will happen if you don’t. Fear is a great motivator, but it’s not very fun. So even if you’re in debt up to your eyeballs and are committed to getting out as quickly as possible, it’s a good idea to plan some modest rewards as part of your savings program.
Yes, a $750 annual vacation will set you back, but consider what could happen if you didn’t take that vacation. You might go on a spending binge one day to compensate for how deprived you’ve been feeling under an avalanche of bills, or you might get sick from overwork and stress. Not only might you spend more than you would have on the vacation, but you won’t get the several days of relaxation and restoration that a vacation could have brought. Depending on your financial situation, you might need to pick a less expensive reward, but you should still treat yourself occasionally, within reason. Ideally, find ways to treat yourself throughout the year that don’t involve spending any money, like going for a hike with a friend or hosting a potluck, BYOB game night or movie night at your place.
6. Pay Off High-Interest Debt
Pay off any debt that costs more than you can earn from your investments as quickly as possible. A reasonable, long-term rate of return from buy-and-hold stock market investing is 8%. So if you have a credit card with a 20% interest rate or a private student loan with a 10% interest rate, pay those off before you put more money toward your investments.
What about mortgage debt, federal student loan debt and auto loan debt, all of which generally have interest rates well below 8%? Your money may earn more if you invest it than the savings you’d achieve by paying off the loan early. Also, in the early part of your career it pays to put aside as much as you can so you can benefit from compound interest's ability to make your savings grow over the long period of time before you'll retire.
7. Avoid Useless Debt
Don’t go into debt for things that are not long-term investments (a house or an education that you can reasonably afford). Consumer debt will strike a major blow to your finances. When you finance a car, for example, not only does the asset depreciate every year, cost money to maintain and eventually become obsolete, you’re also losing money on interest every month. But even things like a home and a college degree that people tend to think of as investments aren’t guaranteed to make you more money over time than you would have made without them. It doesn’t make sense to go into crushing amounts of debt to finance them.
8. Save Automatically
If your employer offers direct deposit, you may be able to deposit a portion of your paycheck directly into a savings account. If not, set up automatic monthly transfers from checking to savings. By having money automatically deducted from your paycheck and invested in your company’s 401(k) or 403(b) plan – or by setting up your own automatic monthly transfer from checking to savings or a Roth IRA – the money you don’t need in the short term will be out of sight and out of mind.
For short-term savings, you’ll need to keep the money accessible, but don’t make it too accessible. For example, if your checking and savings accounts are at the same bank, it’s all too easy to rapidly transfer money from your savings into your checking account. If you have these accounts at two different institutions, the transfer will take time, and that time delay may be enough to cause you to rethink your decision if you’re trying to spend your savings on something that isn't worth it. For long-term savings, the money should be somewhere inaccessible, like a retirement account. You’ll usually have to pay taxes and penalties to withdraw retirement funds before age 59½.
9. Use Apps to Hold Yourself Accountable
Remember the budgeting apps we mentioned in section 3? They can help you stay accountable for your spending and saving minute by minute and day by day. They make it easy to track your purchases, see how much you have available to spend by category and overall, and evaluate how you’re progressing toward your savings goals.