Depending on your own feelings towards the subject, you may or may not be surprised to hear that two thirds of Americans don’t budget. For many people, budgeting conjures up images of painstakingly tracking every nickel and dime.
However, different circumstances call for different measures, and different approaches to budgeting. The reality is that budgeting can and should be relatively painless. Depending on your financial situation and habits, your needs should be met with one of four budget types. It’s time well spent because budgeting – and ultimately spending less than you make – is the foundation for achieving financial freedom.
So let’s look at each of the four types of budgets, along with tools to help you regardless of your situation.
1. The Survival Budget
I grew up in a middle class family, living in a middle class neighborhood. My step-father worked at the gas company. My mom did too until she quit to raise my younger brother and sister. Due to a failed business venture, we hit hard times when I was about 12.
I recall vividly my mom sitting me down and explaining that we had to move. We couldn’t afford the mortgage, and the bank was taking back the house. It was sheer luck that kept us in that house. But for a long time we lived paycheck to paycheck. A few days before each payday there was little food in the house. The electricity and gas were shut off from time to time.
We used what I know call the Survival Budget. It’s the budget people need just to survive month to the month. Savings and debt are secondary at this point, because what you have available is whatever’s in your purse or wallet. My mom used the envelope budget, and she had one envelope. When it went dry, we waited and longed for payday.
The Survival Budget isn’t what I’d call fun. Pure survival rarely is. But it gets the job done until you get back on your feet.
- Paper and pencil, because it’s fast, cheap and simple
- A spreadsheet, such as the free Google Docs spreadsheet
2. The Debt-Free Budget
If you’ve got a little more breathing room, then the Debt-Free Budget is where you assert more control over your finances. You’re no longer worrying about how to get to the next paycheck, and you start making plans for the future. The focus is to get out of or avoid debt, by spending less than you make.
For this budget, it’s not necessary to go to the effort of tracking everything. You’ll get a lot of benefit by simply figuring out the two or three areas that are causing most problems. Many people have a few areas where the spending is often discretionary yet has a disproportionate effect on their finances. Common examples of problem spending categories include eating out, buying clothes or gadgets, or expensive vacations.
Budgeting here means setting a maximum amount that you want to spend that month on each of those problem categories. Over time, you ratchet down that amount, spend less, and direct the extra money into paying down debt or building up savings. You may be surprised how big a difference you can make simply by tracking just two or three expenses.
Some people use the old school “envelope system” for this budget. You put the dollars you want to spend on a category into an envelope, and when you’ve spent it, you can’t spend any more until the following month.
- A dedicated budgeting tool such as YNAB (You Need A Budget)
- Financial dashboard app such as Mint that can download transactions from your bank accounts and help create a budget
- Detailed planning app such as Quicken or similar desktop application
- A spreadsheet, such as the free Google Docs spreadsheet
3. The Financial Freedom Budget
When you’re planning for the longer term, you can develop a Financial Freedom Budget. You’re able to save a significant portion of your income, perhaps into a 401k, IRA, or taxable account (or all three!).
In the Financial Freedom Budget, you pay yourself first. That means you set aside a certain amount of your income, whether it’s 10% or 50%, and then spend sensibly whatever is left. The easiest and most effective way to do this is to automate your finances. For example, pay into a 401k straight out of your paycheck, or set up an automatic transfer into a taxable account.
There’s no requirement to focus on individual spending categories or to track every bill. That said, if you’re finding it very easy to live on the remainder, you might want to consider increasing the percentage you are saving.
If you’re able to spend and save appropriately, achieving financial freedom is a highly desirable goal. Financial freedom means achieving a level of financial independence where you have choices for how you live your life. For example, you can choose to continue working, take a few months off to travel, or try a different career altogether.
- Personal Capital. This free tool gives you great insight into both your cash flow and investment portfolio. Particularly helpful is the 401k fee analyzer and its new Retirement Planner tool.
4. The Planning (Retirement) Budget
Ultimately, you want to know whether you’ll be able to afford to stop working. You can look at this at any age, by estimating how much it’ll cost per month to live the life you want, then comparing it against your expected income, such as from investments or social security.
It doesn’t just mean retirement in old age, which might be very far off. It also doesn’t have to mean retirement at a young age, like the 30-year old Mr. Money Mustache. It’s knowing you have the means to do what you want because you’re in control of your finances.
I’ve found that the best way to do this is to go back to the types of categories you may have used in the Debt-Free Budget, but this time at a much higher level. Expenses fall into two buckets:
- Fixed expenses or monthly bills. Categories might include taxes (e.g., property, real estate), insurance (e.g., homeowners, health, life, car), and utilities (e.g., gas, electricity, garbage, water, internet).
- Discretionary spending. Categories might include eating out, clothes, entertainment, travel, maintenance (home, car), and groceries (although you could argue some amount of this is in fixed expenses).
In the Planning Budget, you build up a model of your expenses using these categories. You’re not tracking every penny, but you are scanning your monthly bills for areas you could improve on. These can be either in the fixed or discretionary buckets. For example, if your cable bill looks high, talking to your provider about a lower rate, or switching to a different provider.
At the end of the day, the goal is to get comfortable with your rate of expenditure, such that you could cover it comfortably with your available assets.