3 Budgeting and Personal Financial Statements

Why Budgeting and Personal Financial Statements Matter

Understanding your current financial situation is the first step in financial planning. The path to your financial goals is akin to embarking on a journey – you can’t get where you want to go without knowing where you are!

To gain a comprehensive understanding of your finances, you need to take a detailed inventory of your income, expenses, assets, and debts. By understanding your current financial situation, you can identify areas where you may be overspending, pinpoint opportunities to save, and develop a realistic budget that aligns with your financial goals. Remember, knowledge is power, and when it comes to your finances, understanding your starting point is the first step towards achieving financial success.

You also need a road map for your financial journey so you do not get lost along the way. Therefore, the second step is to create a budget, which serves as a tracking tool to monitor your progress and determine if you are on track to meet your financial objectives. By adhering to your budget and regularly reviewing your financial situation, you can make informed decisions about your spending habits and investment options.

Common Emotional Barriers

We introduced how psychology and money are interlinked in Chapter 1. Many people find budgeting a stressful activity. This stress can stem from a variety of reasons, with four primary factors standing out.

• Fear: Some people associate fear with money and feel anxious about it. This fear may stem from their family of origin where money was the cause of disharmony. Research has found that financial disagreements were the strongest predictor of divorce^[1]. Media and news stories on personal financial tragedies may also contribute to this anxiety.
• Guilt: Budgeting requires individuals to closely examine their income and expenses, which can be an uncomfortable experience. It may expose overspending habits and debt accumulation. This confrontation with reality can be a source of stress and anxiety.
• Unwillingness to recognize financial constraints: Budgeting can be perceived as restrictive, limiting one’s ability to spend freely. This can lead to feelings of deprivation and anxiety about insufficient income to meet desired lifestyle choices.
• Feeling overwhelmed: Financial matters can seem complex and daunting, especially for those unfamiliar with financial management. Tracking expenses, categorizing spending, and making adjustments can be perceived as time-consuming and complicated.

These four main factors can contribute significantly to the stress associated with creating a personal budget. However, it is important to remember that budgeting can also be a powerful tool for achieving financial goals and gaining control over one’s financial life. With the right approach and support, it is possible to overcome these challenges and make budgeting a less stressful and empowering experience.

First, accept the truth that facts do not change even if you do not look at them. Avoidance will only make a bad situation worse. If the word budget causes anxiety, use a different name, e.g. wealth building plan or financial stress reduction tool. Second, you now have the tools provided in this book to guide you through the budgeting process step-by-step. You do not need to tackle everything all at once.  Break down the tasks into smaller, manageable steps. Take one step at a time. You will gain confidence as you complete each step. Reward yourself for your accomplishments. Many people find having a supporting community helpful. If you are taking a course in financial planning, collaborate with your classmates. There are many online communities and forums devoted to personal financial planning. You should not disclose details about your finances online but you will find support to help you take positive steps.

Understanding Cash Flows

A cash flow statement tracks the money coming in (cash inflows) and the money going out (cash outflows) over a period of time. Comparing your cash inflows and outflows enables you to track your spending and determine how much you can allocate toward savings or other purposes. The personal cash flow statement also serves as the foundation for building a personal budget.

Types of Cash Flows and Their Impact on Financial Stability

Essential (non-discretionary) Cash Outflows: These are essential expenses that are necessary for maintaining a basic standard of living and meeting legal obligations. They typically occur on a regular schedule and are relatively fixed in amount, making them easier to budget for but also harder to adjust quickly in response to sudden financial challenges.

• Examples:
  • Housing: Rent or mortgage payments, property taxes, homeowner’s insurance, and home maintenance.
  • Utilities: Electricity, water, heating, phone, and internet services.
  • Transportation: Car payments, auto insurance, gas, vehicle maintenance, and public transportation fares.
  • Groceries: Food and essential household supplies.
  • Healthcare: Health insurance premiums, prescription medications, and necessary medical treatments.
  • Debt Repayment: Student loans, credit card payments, and other loan obligations.
  • Taxes: Income taxes, property taxes, and other government levies.
• Impact on Financial Stability: Essential cash outflows are crucial for maintaining basic needs and fulfilling legal obligations. However, high levels of essential expenses can significantly limit financial flexibility and make it difficult to save or invest for the future. It is of utmost importance to manage these expenses carefully and prioritize needs over wants to ensure financial stability.

Optional (discretionary) Cash Outflows: These are expenses that are not essential for survival or meeting legal obligations but are incurred for personal enjoyment, convenience, or lifestyle choices. They are typically more flexible and can be adjusted based on income and financial goals.

• Examples:
  • Leisure and Entertainment: Movies, concerts, sporting events, streaming services, and hobbies.
  • Dining Out: Restaurants, take-outs, and food delivery services.
  • Travel: Vacations and weekend getaways.
  • Personal Care: Haircuts, salon services, and cosmetics.
  • Clothing and Accessories: New clothes, shoes, and jewelry.
  • Electronics and Gadgets: Smartphones, computers, and other devices.
  • Gifts: Presents for birthdays, holidays, and other occasions.
  • Charitable Donations: Contributions to non-profit organizations and causes.
• Impact on Financial Stability: Discretionary cash outflows can enhance quality of life and provide enjoyment. However, excessive spending on optional items can lead to financial instability, debt accumulation, and difficulty achieving long-term financial goals. It is crucial to strike a balance between spending and saving to ensure financial well-being.

Recurring Cash Inflows: This is income that is received regularly and consistently, often on a weekly, bi-weekly, or monthly basis. It is predictable and can be relied upon for budgeting and financial planning.

• Examples:
  • Salary and wages: Compensation for employment, usually paid on a regular schedule.
  • Investment Income: Dividends from stocks and mutual funds, interests from bonds and savings accounts, and rents from rental properties.
  • Pensions or social security benefits: Retirement income from employers or the government.
• Impact on Financial Stability: Recurring cash inflows provide a stable support for essential expenses and optional expenses. Having sufficient recurring cash inflows is critical to long-term financial stability.

Non-recurring Cash Inflows: This is income that is received irregularly and unpredictably, making it difficult to anticipate and incorporate into long-term financial planning.

• Examples:
  • Bonuses: Performance-based payments from an employer, often awarded annually or quarterly.
  • Commissions: Sales-based earnings, typically paid as a percentage of sales revenue.
  • Gifts: Cash or other valuable items received from family, friends, or others.
  • Tax Refunds: Money returned by the government due to overpayment of taxes.
• Impact on Financial Stability: Non-recurring cash inflows can provide a temporary boost to finances but should not be solely relied upon for long-term financial stability. They can be used to pay off debt, make investments, or occasional optional expenses

Cash surplus or deficit: When your cash inflows exceed your cash outflows, you will have a cash surplus, i.e. you have money left at the end of the month. When your cash outflows exceed your cash inflows, you will have a cash deficit, which means drawing on your savings, unpaid credit card balance, or the need to borrow money on short notice. Obviously it is better to have a surplus. Developing and adhering to a budget will significantly reduce the likelihood of not having enough money to pay all your essential bills. Figure 3.1a shows the relationship between cash inflows and cash outflows when there is a surplus and Figure 3.1b shows the relationship when there is a deficit.

Creating a Personal Cash Flow Statement

A personal cash flow statement is a historic record of your cash inflows and cash outflows. The first step in creating a personal cash flow statement is to collect data on incomes and spending. Using data over an entire year will smooth out seasonal variations. The primary source of data include bank statements, credit card statements, and mobile payment records. Almost all these financial services companies provide a way to download historical transactions.

The second step is to determine the categories of cash flows. The last section provided examples for different types of cash flows. You can use them as inspiration. The appropriate number of categories depend on your personal need and your willingness to devote time to this process. A larger number of categories will provide a more detailed picture of your spending habits. For example, you may want to separate eating out from other entertainment and leisure activities to better keep track of where your money goes. On the other hand, too many categories will make the information harder to interpret and you will lose sight of the forest for the trees. For those new to personal financial planning, fewer categories may make the process easier to get started. As they gain experience and as their finances become more complex, they can increase the number of categories to meet their needs. Figure 3.2 shows two sample systems of classifying cash flows. Income related cash flows are colored in blue. Essential expenses are colored in red, and optional expenses are colored in red.

Once you have decided on the categories, assign each transaction to a category. Compute the total for each category and enter them into the personal cash flow statement. To better illustrate this process, let us look at the example of Maya and Isis.

Example: Maya and Isis – Downloading and Classifying Transactions

Figure 3.3 shows the downloaded transactions for one of Maya and Isis’s credit cards for the billing period from July 12 to August 12. The first four columns were from the credit card company. Maya and Isis classified these transactions into their chosen categories in column five.

After classifying the transactions into their categories, Maya and Isis computed the subtotal for each category.

The personal cash flow statement has three main sections. The first section contains cash inflows. It includes take-home pay, which equals gross income from salary and wages minus deductions, and all other income such as bonuses, gifts, and interest income. The second section includes cash outflows. It is useful to divide the second section into two subsections: essential expenses and optional expenses. Total cash outflows equal the sum of total essential expenses and optional expenses. The last section computes the cash surplus or deficit, which is the difference between cash inflows and cash outflows.

• Net (take-home) income = Gross income – deductions
• Total cash inflows = Net (take-home) income + Gifts and other income + Investment income
• Total essential expenses = sum of all essential expenses
• Total optional expenses = sum of all optional expenses
• Total cash outflows = Total essential expenses + Total optional expenses
• Cash surplus (or deficit) = Total cash inflows – Total cash outflows

Example: Maya and Isis Personal Cash Flow Statement

Maya and Isis downloaded and classified all their credit card, bank, and mobile payment transactions for the entire year. They entered the annual total for each category into their personal cash flow statement (Figure 3.4).

Tools for Keeping Track of Incomes and Expenses

Cash inflows are relatively easy to track. Employers routinely provide earning statements (paychecks) with information on gross pay and deductions. Figure 3.5 shows a sample earning statement. The Year-To-Date (YTD) values of the last paycheck in December will contain the annual gross income and total deductions. Common deductions include federal and state income taxes, Medicare and Social Security taxes. Your entire gross income is subject to federal and state income taxes and Medicare taxes. There is a maximum amount of income subject to Social security. We will discuss tax planning and tax calculation in detail in the Chapter 4. Other deductions may include health insurance and contributions to retirement accounts such as 401k. Dividends and interest incomes are provided by banks, brokerage, and financial services firms.

Collecting and categorizing cash outflows are more time consuming. There are three main approaches to collecting and keeping track of expenses:

1. A do-it-yourself (DIY) spreadsheet,
2. Tools from banks, credit cards, and mobile payment services,
3. Third party apps.

The factors to consider when choosing a particular approach include ease of use, privacy, security, reliability, and costs. A DIY spreadsheet is free and as long as you adopt good cybersecurity practices, offers the most privacy, security, and reliability. It requires more effort, especially when setting it up for the first time. Using a DIY spreadsheet requires you to download transactions from multiple sources, including banks, credit cards and other payment services. You have to assign each transaction to a category manually and create subtotals for each category. Once you have set up the spreadsheet, future updates can be done on a monthly basis and the task becomes very manageable.

Another option is to use free spending analysis tools offered by banks, credit cards, and other financial services. Usually these tools automatically assign pre-specified categories to transactions and provide monthly, yearly, or year-to-date (YTD) summaries. For example, Chase offers the Chase Spending Planner which classifies spending into 17 categories and American Express generates year-end summaries with 9 categories. One advantage of these tools is their relative ease of use because you do not have to manually assign each transaction to a category. The drawback is that you cannot customize categories to your own needs and you do not have control if the company decides to change categories or discontinue the service. You still need to combine information from multiple sources to get a complete picture of your spending. Financial services companies such as banks usually have strict cybersecurity and privacy practices, especially those with a long history. After all, these companies already possess sensitive information such as account numbers and your personal data that you need to protect. They are also likely to be reliable because bank failure is a significant event. We will discuss factors to consider when choosing a financial services firm in a later chapter.

If the above two options do not meet your needs, you can consider a third party financial management app. The biggest advantage of these apps is that they are designed to be user-friendly and have a large number of features. These apps can collect data automatically from your banks, credit cards, and other financial services and generate a complete spending report. However, you will need to provide them with your login information to your banks and credit card companies and allow them access to your financial accounts. The cybersecurity and privacy practices of these apps vary and are not always transparent. Many of these apps are start-up companies and the products may disappear if they do not have enough funding to keep the business going. Some of these apps are free and some charge a monthly fee. Security, privacy, and reliability can be a concern, especially for free apps.

The most important consideration is to choose a tool that you will use. If you prefer a DIY spreadsheet but find that keeping track of 15 categories is too overwhelming, reduce the number so it is manageable for you. You could use 5 categories of essential expenses: debt, housing, utilities, transportation, groceries, and medical and group all other expenses as optional. You could enter total deductions instead of recording each one as a separate category. That way you only need to keep track of 5 types of expenses.

Understanding Assets, Debts, Net Worth, and Personal Statement of Net Worth (Personal Balance Sheet, Personal Statement of Financial Positions)

A personal statement of financial positions is also known as a personal balance sheet or a personal statement of net worth. It provides a snapshot of your financial health at a specific point in time. It lists all assets and debts (liabilities) and computes the net worth, which is determined by subtracting debts from assets.

A positive net worth means the total value of assets is greater than the total value of debts. A negative net worth means a person owes more than they own and selling off all their assets will not be sufficient to pay off all their debts.

A personal statement of financial positions is an important element of a financial plan. Updating the statement on a regular basis enables you to monitor how your financial health improves or deteriorates over time and whether you are on track to achieve your financial goals. A personal statement of financial positions is required in some financial or legal activities such as applying for a mortgage or a car loan, or establishing a prenuptial agreement.

Types of Assets and Liabilities

It is useful to classify assets and liabilities based on their liquidity or duration. For assets, liquidity refers to how quickly and easily it can be sold for cash without significant loss of value. Cash is the most liquid asset, while real estate or collectibles are considered least liquid. For liabilities, short-term liabilities are debts that are due within one year and require cash available to pay them off. Credit card balance is the most common form of short-term liability. Each month when the credit card company sends out the monthly statement, you must pay off the entire balance. Otherwise you will be charged interests and sometimes late fees. It is important to view the entire balance as your obligated payment, not the minimum payment amount. Long-term liabilities are debts that will be paid over a period beyond one year. Interests will be charged on the outstanding balance until the entire loan is paid off. Common examples of long-term liabilities include student loans, car loans, and mortgages.

Understanding the liquidity of assets and liabilities allows individuals to manage their cash flow effectively, ensure they have enough cash to meet their short-term obligations, and make informed investment decisions. Another important concept is market value versus historical value. Market value is how much you can sell an asset for today. Historical value is how much you paid when you purchased the asset. Many assets depreciate in value over time. Automobiles are a prime example. A new car loses value the moment you drive off the dealer’s lot. Personal items, such as clothing, lose so much value once used that banks do not consider them valuable assets to be included at all. When creating a personal statement of financial positions, you should use market values. Lastly, it is useful to distinguish between real assets and financial assets. Real assets include items that have a physical form, such as houses, cars, boats, phones, artworks, or appliances. Financial assets do not have actual use except to be converted into cash when needed. These include cash, bank accounts, stocks, bonds, mutual funds, investment accounts, or retirement accounts. We will discuss financial assets in detail in later chapters.

• Assets:
  • Highly Liquid Assets: These can be converted to cash quickly and easily, typically within a day or two. Examples include cash, checking accounts, savings accounts, and money market funds.
  • Moderately Liquid Assets: These take longer to convert to cash and may incur some transaction costs or loss of value. Examples include stocks, bonds, and mutual funds.
  • Illiquid Assets: These are difficult and time-consuming to convert to cash and often involve significant transaction costs or loss of value. Examples include real estate, collectibles, art, and retirement accounts.
• Liabilities:
  • Short-Term Liabilities: The entire balance of these debts is due within a year and requires cash to be available in the short term. Examples include credit card debt and short-term loans.
  • Long-Term Liabilities: The balance of these debts are due in more than a year and they usually require regular monthly payments. Examples include mortgages, student loans, and auto loans.

Relationship Between Cash Flows, Economic Conditions, and Net Worth

A key characteristic of a personal statement of financial position is that it provides a snapshot of an individual’s assets, liabilities, and net worth on a given date. It offers a static picture that is only valid at that particular point in time. Information provided in a personal statement of financial position changes with the passage of time and changes in economic conditions.

A cash surplus occurs when cash inflows are greater than cash outflows during a specific time period. This surplus can be used to purchase additional assets or pay off existing debt, leading to an increase in net worth over time. Conversely, a cash deficit may necessitate the sale of assets, taking on new loans, or the accumulation of interest due to non-payment, resulting in a decrease in net worth. Effective budgeting and financial planning can help to increase net worth and build wealth over time.

The worth of some assets depends on their age and conditions. For example, the value of a car goes down as it accumulates mileage and years in use, leading to lower net worth. Other assets, such as real estate and financial investments like stocks, bonds, and mutual funds, fluctuate in value due to changing economic conditions. These economic factors include changes in interest rates, inflation, economic growth or recession, consumer confidence, and global events.

During periods of strong economic growth, increase in asset values tends to outpace increase in debts, resulting in higher net worth for many people. The opposite is true in times of recession when asset values decrease, resulting in lower net worth. Figure 3.6 shows the median net worth for U.S. households from 2017 to 2022.

Creating a Personal Statement of Financial Positions (Personal Balance Sheet, Personal Statement of Net Worth)

Similar to creating a personal cash flow statement, the first step when creating a personal statement of financial position is to collect relevant data. Market values for financial assets and liabilities are the current balances in the respective accounts and can be obtained from the financial services firms’ websites or paper statements. Actual market values for real assets are not usually available and must be estimated. Online resources are available for estimating market values of common real assets such as houses and cars. For houses, recent selling prices of similar houses in nearby neighborhoods provide a reasonable estimate. Real estate websites such as Zillow are a good place to start. The market values of cars can be obtained from local used car dealers or websites such as kbb.com. Unique items such as artworks or collectibles require appraisers with expertise to assess their values, which can be costly.

Both assets and liabilities are listed in order of their liquidity on the personal statement of financial positions, beginning with the most liquid asset, cash. Figure 3.7 shows the personal statement of financial positions for Maya and Isis as an example.

Example: Maya and Isis Personal Balance Sheet

Using Personal Financial Statements to Evaluate Your Financial Health

The personal cash flow statement and statement of net worth provide valuable information about your financial situation. You can use them to analyze your spending habits and financial readiness, assess whether you are on track to meet your financial goals, and create a sustainable budget.

Analyze Spending Habits

In general it is easier to change your spending habits than to change your income in the short run. Increasing your income usually requires looking for another job or changing your career completely. Chapter 2 discusses career planning and factors to consider when deciding on a career or changing careers. This section focuses on spending habits. The personal cash flow statement contains a complete picture of historical spending. One useful approach is to convert the dollar values in the cash flow statement into percentages, either as a percentage of gross income, take-home pay, or total expenses. Expressing debt obligations as a percentage of gross income is a common measurement used by banks to evaluate potential borrowers. Translating expenses into a percentage of take-home pay shows where the paycheck goes, including both spending and savings. Using total expense as the basis of the percentage highlights spending patterns. The following example illustrates the process of converting expenses into a percentage of take-home pay.

Example: Maya and Isis – Analyzing Spending Habit

To determine where their money went, Maya and Isis computed each spending category as a percentage of take-home pay by dividing each category by take-home pay. To demonstrate, let us review Maya and Isis’s personal cash flow statement in Figure 3.3. Their take-home pay was $126,000 for the year and they spent $31,694 in housing expenses, which represented 34 percent (0.34 = $31,694 / $126,000). Similarly, they spent $15,423 on leisure activities, which equaled 16 percent (0.16 = $15,423 / $126,000) of take-home pay. Figure 3.8 shows each spending category as a percentage of take-home pay.

By computing percentages, you can get a clearer picture of where your money goes and be able to focus on areas of concern. For Maya and Isis, housing was their largest expenditure, which was common for many people. According to the U.S. Department of Housing and Urban Development (HUD), households are considered cost-burdened when they spend more than 30 percent of their income on rent or mortgage payment. In 2023 nearly half of renters in the U.S. spent more than 30 percent of their income on rent (U.S. Census 2024). The housing burden for Maya and Isis was 34 percent, leaving them with less money for other things. Housing and groceries represented a large percentage of their income and were essential expenses, therefore difficult to adjust in the short run.

The areas an individual has the most control over are optional expenses. Let us look at the example of Maya and Isis again. Their second highest spending category by percentage was leisure activities such as movies, games, travel, and streaming services. Last year they spent 16 percent of their take-home pay in this category. They also ate out quite a bit, spending 7 percent on restaurants. In addition to looking at spending as a percentage of income, it is also useful to convert the annual total to a monthly amount (divide the annual amount by 12). The average monthly total is also a good starting point for creating a budget. As shown in Figure 3.9, Maya and Isis spent $6,812 last year on eating out, which equals to $568 per month, or over $140 per week. These two areas would be easier to cut back if necessary compared to essential expenses.

Example: Maya and Isis – Monthly Personal Cash Flow Statement

How do you know if you need to change your spending habits? An obvious red flag is low cash surplus or cash deficit – a situation a good financial plan seeks to avoid. Instead of waiting until a financial disaster hits, a proactive financial planning process includes analyzing an individual’s financial readiness and identifying necessary changes. Lastly, when comparing your current financial positions and your financial goals you may realize changes to spending and/or income are needed to meet your goals. We will discuss these two topics next.

Analyze Financial Readiness and Gaps to Financial Goals

Financial readiness refers to your ability to meet unexpected changes in your personal circumstance or to the overall economy. For instance, you or a family member could become ill unexpectedly and you are unable to work, or your car suddenly breaks down and needs major repairs. Having an emergency fund is a good way to prepare for unforeseen events. The rule of thumb is to have three to six months’ worth of essential expenses in a readily accessible account.

Another useful indicator of financial health and readiness is the debt-to-income (DTI) ratio, which is computed as monthly debt payments divided by gross monthly income. In general, a DTI ratio below 30 to 35 percent is considered good. Keeping borrowing in check is important not just for the individuals but also for the overall economy. Excessive borrowing by consumers was one of the causes of the 2008 financial crisis, which led to losses of billions of dollars and millions of jobs (Born, 2011). A large number of consumers who borrowed excessively (i.e. beyond their ability to pay back using their income) were victims of predatory lenders.  These predatory lenders intentionally misled consumers into taking out loans they could not afford. The Consumer Financial Protection Bureau (CFPB), which was created after the 2008 financial crisis to correct some of the mistakes, established standards for lenders to avoid excessively risky loans. One of these standards requires the borrower’s DTI ratio to be 43 percent or less (CFPB 2020). If your DTI ratio is too high, you will not be able to borrow from conventional lenders to meet unexpected financial needs.

If you discover that you do not have sufficient emergency funds or have too high a DTI ratio, you will need to consider changes to your spending habits to put your finances back on the right track. In addition to financial readiness, you also need to determine whether continuing on your current course will achieve your financial goals. To assess if there are gaps, compare current financial positions shown on the personal statement of net worth to the financial goals. If you find significant gaps, you may need to change spending habits or to revise your financial goals or both.

By analyzing the personal cash flow statement and the personal statement of net worth, you can gain valuable insights into your spending habits, savings progress, and debt management. This information can empower you to make informed decisions about your finances, set realistic goals, and take control of your financial future. Chapter 1 suggested regular review and adjustment of your financial plan to adapt to changing circumstances. Remember, financial planning is a dynamic process.

Budgeting

A budget is part of a financial plan that helps you manage your income and expenses, achieve your financial goals, and build healthy financial habits. If you are someone who does not like budgeting there is some great news. By completing a personal cash flow statement you have tackled the majority of the work involved in creating a budget. There are only a few steps left.

Creating and Maintaining a Budget

The personal statement of cash flows you created can be used to project your future income and expenses. There are a few key factors to remember. First, analyze your spending patterns from the past 12 months to account for seasonal variations in your expenses. Second, convert annual income and expense values into monthly figures for easier budgeting. Third, round income and expense figures to the nearest 10s or 100s to simplify calculations and make the budget easier to work with. For example, round $1,358 to $1,400. This revised monthly version of the statement of cash flows is the foundation of the budget.

The next step is to update the budget to incorporate any new information that may impact income or expenses. This includes changes in income sources and new essential expenses.

The most important step is to make necessary changes to make the budget work, which means having sufficient cash inflows to pay all budgeted expenses and allocate cash surplus towards short-term and long-term financial goals. This could involve reducing optional spending, increasing income by working more hours or taking on a side hustle, or exploring new borrowing options. Creating a workable budget often requires multiple rounds of adjustments. Be realistic when you make adjustments. Extreme changes may backfire if you cannot adhere to the budget. Remember that while frivolous spending due to unhealthy psychological triggers are harmful to your financial and emotional health, appropriate optional spending to maintain healthy friendships, social bonds, and personal wellness are important parts of life. In some cases, you may need to make changes to both spending habits and financial goals. Perhaps instead of renovating the kitchen in 5 years, it will take 7 years to reach that goal.

The biggest challenge to budgeting is perhaps adhering to a budget. Chapter 1 describes some psychological triggers such as peer pressure, fear of missing out (FOMO), or retail therapy, that often lead to impulsive spending. Consider setting up automatic transfers at the beginning of each month to move surplus cash into designated investment and savings accounts before temptation to spend beyond the budget can take place.

Method of payment may also affect spending habits. Studies found that consumers were willing to pay a higher price and more likely to spend when using credit cards, debit cards, or mobile payment compared to paying with cash^[2]. Using cash only is one potential strategy to help someone adhere to a budget. It is sometimes called “envelope budgeting”. At the beginning of each month, put the amount of cash budgeted for each category into separate envelopes. When an envelope is empty, stop spending in that category. There are a number of advantages to this method. Cash is tangible and provides a visual cue to alert you when an envelope is getting thin. Seeing cash leftover at the end of the month feels great. If you stick to what you withdrew, you cannot overdraw your bank account or build up credit card debt. In today’s world of online banking, credit cards, and mobile payment, it is unrealistic to use the envelope method for all spending categories. However, it can be very effective for just one or two categories, such as eating out, that an individual finds especially challenging to stick to the budget. You can also use a prepaid debit card in place of a cash envelope to limit spending in specific categories.

Instead of an envelope you can use online tools or mobile apps offered by credit card companies, banks, and mobile payment services to set spending alerts and monitor transactions. This allows for quick identification of any areas where spending is exceeding the budget. These alerts may not be as effective as the cash envelope method because it is easier to dismiss alerts. Setting up alerts is better than doing nothing. A more recent study found that the effect of higher willingness to pay has reduced overtime, perhaps due to increased popularity of credit cards and mobile payment^[3]. Unfortunately, a new form of payment option, Buy Now Pay Later (BNPL), has been shown to entice consumers to purchase more than they usually do^[4].

To avoid impulse buying, use a list before going shopping and stick to it so you will not be tempted by “sales”. Many retailers have recurring or annual sales and you can plan your purchases to take advantage of them for things that you need. Do not let payment options such as BNPL affect your purchase decisions. Would you still purchase the item if you were paying cash? If the answer is no, then do not buy it. Shopping and resisting buying can be stressful. A very powerful tool is the ability to pause and create space for you to make decisions. Use a 72-hour or a 7-day rule. Before making a non-essential purchase, wait 72 hours or 7 days. If you still want the item after the waiting period and it fits into your budget, go ahead and enjoy the purchase.

It is important to regularly review the budget, spending, and saving patterns on a consistent basis, such as monthly or quarterly. Compare the budgeted amount versus actual spending. This helps to ensure that the budget remains aligned with financial goals and allows for adjustments as needed. Regular reviews also provide an opportunity to identify and address any potential financial problems early on. Remember, personal finance is a journey, not a destination. By understanding your financial situation, creating a budget, and tracking your progress, you can take control of your finances and build a secure future.

Example: Maya and Isis – Budgeting

After completing their personal cash flow statement and personal balance sheet and identifying actions needed to reach their financial goals, Maya and Isis began the budgeting process. They expected their income to increase by 5 percent next year based on the new union contract for Isis and historic trend for Maya. They included the estimated change in income and rounded other cash flows to 10s or 100s in their first round draft budget (Figure 3.10).

The first round draft budget showed a cash deficit of $35, which was not acceptable to Maya and Isis. There were no funds available to contribute toward any of their financial goals. Significant changes were needed. Maya and Isis knew this and were willing to make changes to their lifestyle after they purchased their house. They just had not done so. The budgeting process opened their eyes to the importance of making the changes sooner rather than later. They knew there were limited actions they could take regarding essential expenses. Nonetheless, Maya and Isis were able to get cheaper auto and house insurance after shopping around. They decided to cut back on optional expenses, especially eating out and leisure. They cancelled all but two streaming services and bought a bike stand and free weights to replace their gym memberships. Instead of traveling for vacations, they joined a local hiking club. Replacing air travel with hiking and backpacking actually aligned with their environmental values and they felt great about the decision. They increased their food budget and reduced their restaurant budget. Their second round budget (Figure 3.11) showed a cash surplus of $1,595, a huge improvement. They reduced optional expenses to just 9 percent of take-home pay.

In the round 2 budget, Maya and Isis planned to allocate $300 per month toward their emergency funds and contribute $1,200 toward their retirement accounts. Unfortunately, these actions would not be sufficient for them to reach their current financial goals and there were no other immediate changes to their spending that they could make. Isis decided to work over the summer, which would earn approximately $5,000 in take-home pay each year. With the additional income, they would have approximately $18,000 in emergency funds in two years. Maya and Isis revised their short-term goal to have 3-months of essential expenses in an emergency fund. They decided to postpone their kitchen renovation goal until they paid off their student loans. Even though they were not meeting their goal of contributing 15 percent of gross income toward retirement, they contributed $1,200 per month, which represented 11 percent of gross income ($1200/$11025 = .11), an excellent start. Through the budgeting process, Maya and Isis were able to improve their spending habits and revised their financial goals to be more realistic.

How well did Maya and Isis adhere to their budget? They prepared a personal cash flow statement the next year and compared their actual incomes and spending to the budget (Figure 3.12). Overall, Maya and Isis did a great job. They increased their income with Isis’s summer job and were able to follow their budget in general. They spent more than budgeted on restaurants but more than made up the difference by spending less on leisure and clothing. They were able to put all the extra surplus toward their emergency fund and were very close to achieving their revised short-term goal in one year.

The term zero based budgeting has entered popular culture in recent years. It originated in the business world in the 1960s and was briefly adopted by the government in the 1970s. Zero based budgeting regained popularity following the 2008 recession. The central idea behind zero based budgeting is that instead of assuming you will spend the same amount as previous years, each year you re-evaluate how much to spend in each category. This is a good idea, especially for discretionary non-essential items. An example is subscription services, which usually automatically renew each year. A zero based budget mindset requires you to evaluate each service before renewing. As noted in this section, good budgeting practices include regular review and assessment and are therefore consistent with the intent of zero based budgeting.

Organizing Your Financial Records

Maintaining organized financial records is essential for effective budgeting and financial management. Most financial records can be stored electronically. For security, perform regular backups and use encryption. Some documents require physical copies, such as birth certificates, car titles, social security cards, or wills. Store these in a fireproof safe or safety deposit box. Here is a guideline on what to keep and how long to retain financial and personal documents.

Types of Records and Retention Periods