Today’s blog post is a part of Bridgeworth’s year-long series on Financial Well Being. The first in the series, Four Steps to Making Your New Year’s Resolutions Last Past Valentine’s Day, was published in February.
I’m often asked what is the best financial planning advice I can give. You can tell this question is asked with the hope of a complex tax loophole or a secret investment strategy. Surely the key to building wealth is complicated, right? But my answer is almost always “spend less than you make and save more than you think you need to”. Building wealth isn’t complicated, but it is hard. It is hard to be consistent and disciplined about your spending.
What you spend is one of the most important factors in building wealth. Long-term changes in how much you spend can have huge ramifications on your ability to plan for financial goals. Not only that, but it is one of the only things you actually have control over in the financial planning process. (For example, you don’t have control over what investment returns you get, but you do have control over how much you save and spend). And how much you need to save is directly related to how much you spend! The higher your standard of living (or the more you spend) the more money you will need to save to retire.
Before you can make any changes around your spending, you have to know where your money is going. Write down all of your fixed expenses. These are things like your car payment, mortgage/rent, insurance premiums, cell phone bill, etc. While some portion of your spending is fixed expenses, you will also have a portion that varies month to month. To get an idea of these expenses, you may need to track spending over the course of a few months. If you run everything through a credit card or debit card, there are often reports available that categorize where money is going. In addition to your fixed and variable expenses, hopefully, you are able to save some amount on a regular basis. This needs to be factored into your spending plan as well.
The traditional thought is that budgets help you to be disciplined about your spending. This is mostly true. Budgeting can provide structure, consistency, and accountability with how you spend money. I emphasize can because far too often people create budgets but fail to stick with them. This is because budgets that are overly optimistic don’t necessarily help change behaviors. More important than developing a budget is developing a way to systematize spending that will influence behavior and develop good habits. We’ll call this a spending plan.
A Spending Plan vs. A Budget
What is a spending plan and how is it different than a budget? I describe a spending plan as giving every dollar a job and making sure it’s doing that job each month/pay period. To do this, I find it helpful to use a “three buckets” mentality. Think about categorizing each dollar into either “past obligations”, “current expenses”, or “future goals”. Past obligations are your fixed, reoccurring expenses. Future goals are things that you want to do or need to do someday. This means saving for retirement or college or that dream vacation. Current expenses are your variable expenses that can differ on a weekly basis. These are things like groceries, gas, home depot trips, eating out, etc.
Now that you know what a spending plan is, let’s talk about how to set it up. The key is to automating transfers and limiting your control over spending decisions. As counterintuitive as it might sound, limiting the control you have over spending decisions will keep your spending on track. So how do we accomplish this? With multiple checking accounts, savings accounts, and automatic transfers. Here’s how:
Step 1: Create a checking account that all money flows into. This is where your paychecks should be deposited. We’ll call this the Bills Account. All of your “past obligations” will be paid from here. Set up automatic drafts for these bills to come out of this account on a monthly basis (or whatever frequency is required). Don’t carry a debit card for this account as you should not be spending from here.
Step 2: Create a savings account for each of your “future goals”. This would be things like that trip to Europe or saving for a down payment on a house. It could also be to build an emergency fund. Again, you want to set up automatic transfers to go into these accounts on a regular basis. Most of the time people try to save whatever is left over (pro tip: this doesn’t always work out well), but we want you to be disciplined about setting aside money for these goals.
Step 3: Create a checking account for all your weekly variable spending. We’ll call this your Spending Account. This should be the money that is left over in your paycheck after your fixed expenses and savings amounts. You should set up a monthly/twice monthly/weekly transfer from the Bills account to the Spending account. Since this amount varies from month to month, it may take a few months to get this amount right. This is the only account you should carry a debit card for.
One of the reasons that this system works is because it helps break down your paycheck into smaller portions that are easier to manage. If you are a two-income household and get paid once a month, you may have A LOT of cash hit your account at once. The temptation when we see those big numbers is to not worry as much about spending extra on a trip to Target or date night because it doesn’t seem like a big a deal. But in reality, much of your income is already spoken for (or in the case of savings, should be spoken for). Paying yourself a spending allowance helps keep spending in check because that amount is likely a much smaller number than your total pay.
In our house, we’ve tried everything from traditional budgets to cash envelopes, but this is our favorite method. We “pay ourselves” into the Spending account twice per month. Then throughout the month, I can pull up our banking app to see how much we have left until our next spending allowance deposit. If we are running low, I know I should skip the Starbucks drive-thru or avoid buying an extra item at Home Depot.
Whether or not you choose to implement this spending plan, the important thing is to find a way of managing your spending behavior that works for you.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Bridgeworth, LLC is a registered investment advisor.