To reach any financial objective, whether it be to reach financial independence, get rid of debt or simply plan to save a specific amount to pay for a big expense like a trip, down payment on a house or other, the first step is to establish a realistic budget.
When I was less efficient at planning my expenses and still working on paying off my student debt, I often prepared unrealistic budgets. As a result I would end up missing my objectives of paying down my debt or worse, would need to borrow more money on my credit margin in order to pay a bill. Eventually I understood that to plan a realistic budget, I would need to track my expenses rigorously and over a long period of time, since some expenses only comes once or twice a year. Furthermore, this technique allowed me to be aware that there are periods of time when it is essential for me to have more cash on hand for occasional expenses such as when it is time to pay for our driver’s license.
The exercise of tracking our expenses is also highly beneficial in identifying problem areas where there is too much spending. Even a small $2 on a coffee on your office break could seem insignificant but when you add that amount over a month then over a longer period, we realize that we just spent $520 on coffee over a year. If we take that $520 and invest it in a savings account yielding a very conservative 3% over a monthly basis, this daily $2 of coffee becomes a nice amount of $6061.28 after 10 years, of which $861.28 would have been generated interest (the equivalent of 430 cups of $2 coffee).
Here are the steps I take to plan a realistic budget:
1. Track our expenses:
There are many ways to track your expenses, it could be done the old fashion way by keeping all your receipts and adding them up by category at the end of the month or it could be done with one of the many software and website at your disposition, which allow most of this task to be automated. Since I am always looking to simplify things and free my time, I opted for the second option by using mint.com to track all of our expenses. It is a fantastic website that is simple to use, but unfortunately for the people that read this blog in french and feel more comfortable in that language, there is no francophone version of the site however they do indicate that they are working to get full french language support so that could be something interesting in the future.
The site compiles all transactions we have done on our credit and debit cards, and I can select in which category the expense should be added. I can even add transactions manually, such as when I would purchase something with cash, and am also able to add expense categories. I visit this website at least once per week to make sure that all our recent transactions have been classified in the correct categories, a task which takes me a few minutes and is easy to do if done regularly since the expense is fresh in my mind instead of having to try to remember what we bought at Walmart a month ago for say $13.97.
This site offers a ton of other functions and I probably only use a few of the features since I prefer to record the totals in an excel sheet at the end of the month in order to track my expenses on the long term. The reason why I complicate my life a bit by doing that is that I am more comfortable with excel to analyze numbers on a longer term and I find that it allows me to better compare my expenses on a month to month or year to year basis. I also find it is easier to use the excel sheet to track recurring expenses that only come a few times a year instead of on a monthly basis.
2. Compiling our monthly expenses on an annual basis with our budget in mind:
The first week of the month (more precisely around the 5th day in order to make sure that all the expenses of the previous month have been correctly entered), I open the ‘’Trends’’ page in mint and I choose to classify my spending by category for the last month.
Example from the Trends page on Mint
The total expenses are sorted by category. I make sure I did not forget any expense and then I manually enter all my numbers per category in my excel sheet, making sure every category in my excel sheet is covered. Once those steps are completed, I verify what my new monthly average of spending is per category.
Here is an example of a section of my excel sheet with fictitious numbers:
My sheet contains little customizations like subcategories from my totals in mint, it all depends on what I consider is important to track separately. It’s up to you to choose which category you feel might need a bit of extra tracking.
By having a full year of expenses with each month side by side, it is often quite obvious when there is excess spending in one category, for example I am always surprised by how my ‘’gift’’ category goes up in December no matter how much I try not to go crazy with gifts.
3. Create our budget based on the monthly average from my tracking sheet and on our spending objectives.
The monthly average of our spending is then a very useful tool to prepare a budget. By analyzing the numbers in each category, I can identify realistic limits to our expenses based on what we actually spent in the past year or months per category. These limits can then guide me when I track our new transactions in Mint. You even have the option to set limits directly in Mint which can then send you notifications when you are heading over that limit for the current month.
When preparing a budget, it is important to keep in mind any financial objective you have. In our case, our main goal is to reach financial independence as soon as possible therefore I want a budget that allows us to save as much of our money as possible. I’ll look at our net income on a monthly basis (the actual paycheck we receive in our account after all the deductions and costs), then I will look at how much money we should have after all the expenses I estimated in our budget. If we do not reach our objective in terms of amount saved, I will choose to lower our limits in certain categories of our budget.
4. Continue tracking our expenses and adapting our budget
Our budget is always a work in progress since our needs change through time. Sometime we have unplanned expenses, for example a mechanical problem with our car therefore our budget needs to be adapted in order to face these circumstances. Sometimes we find new ways to spend less in a specific category and choose to adjust our spending limit in that category to a lower amount. The important thing is to remain constant in the tracking of our spending in order to reach our objectives.
The longer you track your expenses, the better you will get at planning them and get control of them. By regularly identifying problem categories where you tend to spend more, and by constantly lowering the limit of spending in those categories, it will become like second nature to spend in a more reasonable way.