Money Basics - What is a Budget?

Courtesy of New York Foundation for the Arts
New York Foundation for the Arts

A budget is simply a plan for how you earn, spend, save and invest your money. Creating your budget is one of the first things you should do as you begin to organize your personal finances.

Why? Because having a budget is the key to making your money work for you. Until you actually calculate how much money you earn after taxes - and until you figure out how much money you spend every month - it's impossible to establish a savings or investment plan that will work.

The goal of every successful budget is really quite simple: To have enough money to cover your expenses, with money left over to save and invest and plan for your future. If your costs exceed your earnings, however, having a budget will help you identify where you can cut costs and trim your debt in order to save for a future financial goal.

Don't be too hard on yourself if your budget is lost somewhere in a jumble of bills, receipts, tax returns and hot stock tips you've stuffed into a bedside drawer. And if you frequently say, "I don't know where it all goes", join the club. The National Center for Financial Education estimates that millions of people routinely waste 20 to 30 percent of their money because they have no idea how, when or where they spend it.

So let's get started. It's important to realize that successful budgets are based on a few money principles developed over the years by financial planners, advisers and bankers. Let's review three of them:

  • Save as Much as You Can, as Soon as You Can: There's no magic formula to determine how much of your earnings you should save. While many suggest saving 10 percent of your net income, others may decide that saving 20 percent will help them reach their financial goals sooner. No matter how much you save, this much is fact: Saving and investing should begin as soon as possible in order to give your investments time to make money for you - a concept known as the power of compounding. With compounding, you earn interest on the money you save and on the interest that money earns [See special section on The Compounding Factor]. Plus, if you are saving for retirement in an employer-sponsored retirement plan like a 401(k) or a 403(b),remember to put in as much as you need to qualify for the employer's contribution. Your employer's match is like found, free money - so take advantage of it.
     
  • Just-In-Case Emergency Fund: Set aside three to six months of income. What would you do financially if you suddenly lost your job? If your house needed a new roof? Before you save for any other goals, set aside enough money to cover emergency expenses for several months. Keep this money in a safe place (like a savings account or money market account or a short-term certificate of deposit (CD) where you can get to it quickly and without penalty. That way, when emergencies come up, you won't resort to expensive credit card debt or high-interest loans to cover your expenses.
     
  • The 20/30 Rules: Don't let your short-term debt (credit cards, car payments) exceed 20 percent of your monthly income, and don't spend more than 30 percent of your monthly income on mortgage or rent. It may be tempting to break these rules, but they are standard measures to help you avoid being "house poor" or saddled with too much high-interest debt.

How Much Money Do You Earn?

To begin to establish your budget, let's start with Cash Flow. Like the words suggest, your cash flow is determined by how much money is flowing in and how much money is flowing out.

First, let's determine how much money flows in, how much money you earn. Let's look at your pay stub - electronic or paper.

  • Gross Income is the total amount of money your employer has agreed to pay you.
  • Adjusted Gross Income (AGI) is the figure used to determine your federal income tax. That's your gross income minus allowable pre-tax deductions such as contributions to retirement funds, medical savings accounts, and flexible spending plans.
  • Disposable Income is the money you deposit in your bank account each month after all of your deductions, taxes (federal, state and local), and Social Security payments are taken out. This is the figure you need to use as you establish a budget - not your gross income figure.

Next, consider other possible sources of income:

  • Married (include your spouse's salary)
  • Bonuses
  • Commissions
  • Year-end return from flexible spending accounts
  • Alimony
  • Investment income
  • Interest income from banking accounts (checking and savings)
  • Rental income
  • Pension or retirement plan income
  • Trust fund income
  • Other?

Examining the money flowing in will help you add up your various income sources to determine your total monthly and yearly income.

How Much Do You Spend?

Second, let's follow the money that flows out. How much do you spend each month? Armed with your personal records, your checkbook and your recent banking statement, you can determine your monthly expenses.

You'll quickly see that your spending breaks down into two categories:

  • Fixed Expenses: These expenses are often difficult to reduce or change. They include monthly mortgage payments or rent, car payments, insurance costs, taxes and utility bills.
  • Flexible expenses: Expenses that can vary, month-to month. These include eating out, entertainment, travel, clothes, and variable credit card payments.

Now, subtract your expenses (your cash flow out) from your income (your cash flow in). The balance is called your Net Income - the amount of income that remains after you've paid your bills.

Now that you've documented your Cash Flow, you're one step closer to establishing a budget and a personal finance.

How Much Money Could You Save?

If you make more money than you spend, you obviously have money to save without making any changes in your spending patterns. Financial analysts often recommend that you save 10 percent of your disposable income. If you saved all of your excess cash, what percentage of your income would you be saving? Try the How Much Could You Save? and Simple Savings Goal calculators.

But if you spend more money than you make, it's time to cut back and examine your spending patterns. Financial planners often recommend that you keep track of your expenses for a month in order to see exactly how you're spending your money. Include every category - cash, credit and check - and record every expenditure, no matter how great or small.

Clearly, your first target for cutting back will be your flexible expenses - discretionary expenses that can fluctuate on a whim. How often do you eat out? Do you really need another cashmere sweater? Just one cup of gourmet coffee a day can cost you around $2.00 - which adds up to $730 a year. Is it worth it?

But don't overlook your fixed expenses, either. They often have some give and take and you may be able to reduce these expenses. If mortgage rates have dropped, should you refinance to lower your monthly payment? Are you using the least expensive long distance telephone service? And are you properly insured, or do you pay for too much home, car or personal life insurance?

As you trim your expenses and look for ways to save, remember your first savings goal: an Emergency Fund. Financial experts recommend that you save enough to cover three to six months in living expenses - though you may decide that this is a little more or a little less than you feel comfortable saving. It might be tempting to shove your Emergency Fund into some high-flying technology stocks with the hopes of fast appreciation, but that move would break another long-established financial planning rule: For funds that you might need quickly, keep them deposited in a safe place with easy access. That means a savings account, certificate of deposit (CD) or a money market account.

And now there's one last step before starting your savings plan: a quick review of assets and debt.

Who Let the Dollars Out? A Look at Assets and Debt

Before you can plan for your future financial goals, it's a good idea to review where you stand right now. And that means looking at assets and debt, and figuring out your net worth.

Net worth is a summary of how you're doing financially. It's the difference between how much you own (an asset) and how much you owe (a debt). To determine your net worth, you simply need to add up the value of all of your financial liabilities, and subtract them from the value of all of your assets.

Financial Liabilities
Mortgage
Home equity loan/line of credit
Personal loans
Car loans
Additional installment loans
Student loans
Credit card debt
Loans against investments or Life insurance policies
Unpaid taxes
Deductions for automatic savings
Alimony/Child support
Medical bills

TOTAL:

Assetts
Equity value of house
Checking account balance
Savings account balance
Cars/Boats
Real estate/land
Money market accounts
Certificates of deposit
Mutual funds
Pensions and retirement funds (include cash value of company pension, 401(k), IRA or KEOGH, SEP, Roth IRA, IRA rollovers)
Stock options
Furnishings
Jewelry
Equity value of business

TOTAL:

Now, subtract your liabilities from your assets. That's your Net Worth.

Often, people are surprised at the size of their net worth. Remember, however, that your net worth does not always reflect liquid assets, butrather assets like a house or a retirement account that cannot be realized or accessed for many years. Your net worth should be used as another financial tool to help you plan for your financial future.

Notice that your list of financial liabilities includes a regular savingspayment - to yourself. One of the basic rules of saving is "pay yourself first." How?

  • Arrange for automatic payroll deductions from your paycheck into a savings or investment account. That way, you won't be tempted to spend the money on other expenses.
  • Invest your raise. Before you get used to a new level of income,save it.
  • Turn your bonus, tax refund or gift into savings, not spending.

Many people look at their debt as a percentage of their total financial picture called a "debt ratio". Financial planners suggested that an individual's debt ratio be no more than 38 percent.

To estimate your debt ratio, you need an accurate list of your monthly payments; the total of these payments is your currently monthly debt.Then, take your gross monthly income (income before taxes are deducted) and divide it by the monthly debt amount. This number should not be more than 38 percent.

Financial Goals: Both Short-term and Long-term

You are now well on your way to understanding your financial picture.

You have a list of all of your assets and liabilities, and you have calculated your net worth. You have a pretty good idea of how much money you earn, how much you spend, and how much you are able to save. In fact, you may be working to trim your expenses so you can save more. With your financial picture in focus, it's time to think about your long and short-term financial goals.

Your goals will vary, depending on such factors as your age, financial status, marital status and timetable for reaching your goal.

A short-term goal may be saving for a vacation, or a special entertainment center for your home, or a home-remodeling project. A long-term goal may be to buy a house, save for a college education, or provide a comfortable retirement for you and your spouse at age 65.

Our array of investment calculators can help you determine how much you need to save each month - and at what interest rate - to meet your goal. And our personal financing calculators can help you determine how long it will take to save for a major purchase, such as a car. In addition, there are special sections on saving for college, buying a home and planning for retirement.

It's important to remember that short-term and long-term goals also require different investment strategies. Let's look at saving versus investing.

  • Saving money means accumulating and keeping it safe for upcoming expenses or emergencies. If you are saving for a short-term goal, you should save your money in a safe place or product such as a savings account, checking account or a short-term certificate of deposit. You'll have easy access to your money, and it will earn a low fixed rate of return.
  • Investing means taking a risk with your money in exchange for the chance to realize higher long-term returns. Investing works best for long-term goals like saving for retirement or planning for college when you are seeking long-term capital growth and returns that are greater than inflation. Investing in stocks, bonds or mutual funds, however, also brings greater risk than saving your money in a saving account because your investments could decline in value. As a general rule, long-term investing requires a five-year commitment.

This article was originally created for TheArtBiz.com. It appears on NYFA Interactive courtesy of the Abigail Rebecca Cohen Library.

It appears on CAR courtesy of New York Foundation for the Arts, www.nyfa.org

Published by CAR_admin on Tue, 01/08/2008 - 12:22am
Updated on Tue, 11/05/2013 - 12:47pm