Guide to Personal Budgeting
"You cannot manage what you do not measure". This applies as much for one person's or a couple's financial budget as it does for big business. Simply, if you do not know how much money you have and how much you are spending, you do not know whether you are getting yourself into serious financial difficulties, or how to get out if you are already there.
Most people or couples would never have prepared a proper budget. Many people are not sure how to do so, and a lot of the ones that know believe that it is too hard and probably not worth the effort. Some people just do not want to know what their financial position is, as they know they are living beyond their means but do not want the bad news.
Couples should prepare a joint budget - even if they wish to separate some of their expenses. Both parties in the relationship should be aware of the couple's and the other person's financial position. Financial surprises (or shocks) do not help relationships.
To prepare a useful budget you need to calculate four amounts:
(i) How much money you make;
(ii) How much money you need to spend on Fixed items (like your mortgage);
(iii) How much you spend on living (for food, entertainment, etc.); and
(iii) What debts you must service and eventually repay.
Once you have those amounts you will be able to determine your current financial position and start getting out of debt - even if dramatic changes are necessary in your spending habits to avoid long term and serious financial consequences.
Money Coming In
Step One - Calculating the amount of money you make
This is generally the easiest step. Employees can use their regular pay slips to calculate their annual and monthly incomes. The figure that you need for your budget is income after taxes have been deducted. Taxes in most cases will be deducted from income before employees receives it. People who are self-employed will have to calculate their net of tax income and allow for the payment of taxes.
Annual net income can be turned into monthly net income simply by dividing by 12. Why do we use monthly when some people are paid weekly or fortnightly? Most expenses need to be paid monthly (e.g. telephone and credit cards) and the others will need to be budgeted for on a regular basis. Monthly is a convenient time period.
One off items - like tax refunds - are not regular income and should not be included in a budget. They should be considered windfall gains when they are received, not relied upon to solve financial problems.
Once you have calculated your monthly net income, you can start calculating how this amount must be spent.
Example of Net Monthly Income Calculation
| Source | Gross Annual Income | Net Annual Income |
|---|---|---|
| Person 1 | $67,000 | $43,770 |
| Person 2 | $46,800 | $42,950 |
| Total Net Annual Income | $113,800 | $86,720 |
| Total Net Monthly Income | Annual/12 | $7,226 |
Our example couple is taking home $7,226 after superannuation and taxes each month. This amount now needs to be allocated to expenses, debt repayment etc.
Money Going Out - Fixed Costs
Step Two - Calculating fixed costs
Almost everyone will have some necessary expenses. These will usually relate to accommodation (in the form of mortgage payments or rent) and transport (in the form of a car loan or other transport costs). These are not 'consumer' items and usually cannot be varied easily. For this reason I have called them 'fixed'.
You will also have to include other costs that are necessary to have and use these items. These are generally insurances and rates on property, and insurance and registration on motor vehicles. The important figure is the total necessary monthly payments to maintain these items, but you should find out what amount is owed and what interest rate you are paying on loans. That information may become important later.
Example of Fixed Cost Calculation
| Debt | Amount Owed | Interest Rate | Monthly Payment |
|---|---|---|---|
| House Mortgage | $300,000 | 9.5% | $2,500 |
| Insurance, rates etc each month | $235 | ||
| Person 1 Car Loan | $30,000 | 10.5% | $500 |
| Person 2 Car Loan | $20,000 | 10.5% | $400 |
| Car Insurance etc | $150 | ||
| Total Monthly Fixed Payments | $3,785 |
Our example couple has $3,441 left ($7,226 - $3,785) to live on after allowing for fixed expenses each month. All living costs must be paid from this $3,441.
Money Going Out - Variable Costs
Step Three - Calculating what you currently spend
It is pointless determining what you need to spend each month without firstly determining what you do spend each month. This is the step that requires self-honesty and may cause a few surprises. This is where you find out how much money is being spent (wasted) on 'crap'. It is also where a lot of people find out where their money is going, and importantly, where they can stop the spending and start the savings.
The aim of this step is to determine where your money is being spent, so all of your spending must be included. This is also the part that requires the most work and where some people give up. DO NOT GIVE UP. This process may be very eye-opening.
You will need all of your bank statements and credit card statements (and any other documents that show the spending of money) for a period. The amount calculated will be an average over a number of months. At least three months should be used (six would be better) to smooth out any peaks or troughs in your spending pattern. The total of each category is simply divided by the number of months used to get a monthly average.
You want to classify the money you spend over a range of categories. What categories you use is variable. Some common ones are listed below, but these should be expanded to cover any major areas of spending. For example, if you buy a lot of books or music, these should be put into a separate category.
- Telephone bills, etc
- Food
- Restaurants (Eating out)
- Entertainment (Movies etc)
- Alcohol
- Hardware
- Cloths
- Transport (Petrol etc)
Do not include any payments from the Fixed costs area. These will be added on to the list shortly.
There are three categories that should be included in your list:
General Expenses - these are the costs of health insurances, electricity etc that are payable monthly, quarterly or yearly (that are not already in the fixed cost area). If they are paid yearly, the appropriate portion of that amount should be included in this calculation.
Bank Charges - these amounts can be material if bank accounts are overdrawn from time to time, cheques are dishonoured, or non-bank ATMs are used for cash withdrawals.
Cash Withdrawn - this is the cash that is withdrawn from the bank. They are not included on credit cards and generally cannot be classified into separate areas.
If the amount of money that you spend is greater than the amount of money that you have available, it is inevitable that your level of debt will rise in order to meet the shortfall - and this will usually be high interest debt on credit cards. Left unchecked, that level of debt could rise significantly, especially when compound interest is considered. If the amount being spent is less than the amount available, the surplus can be directed to savings and debt repayment.
Example of expenses list
| Class of Expense | Average Monthly Spend |
|---|---|
| Telephone bills, cable TV, etc | 280.00 |
| Food (eaten at home) | 535.25 |
| Restaurants & Take-Away Food | 575.45 |
| Entertainment (Going Out) | 465.00 |
| Alcohol | 224.65 |
| Clothes | 425.00 |
| Music (CDs etc) | 85.25 |
| Transport (Petrol etc) | 440.00 |
| General Expenses (Health Insurances, power, etc) | 225.25 |
| Bank Charges | 90.00 |
| Cash Withdrawn | 325.00 |
| Total Expenditure | $3,670.85 |
Our example couple spends $3,670.85 on average each month, overspending their available money by $230, and this does not take into account money for savings (they have none except superannuation) and debt repayment.
Debts
Step Four - Adding up your debts
The obvious statement is that most people in financial difficulty spend more than they make. That shortfall is made up by debt - whether that debt is on credit cards or personal loans. That debt will keep growing if they continue to spend more than they make, and over time - and sometimes short periods of time - that debt and the interest payments due on that debt can become unmanageable.
When this occurs most of a person's income may used in making small payments of these cards or loans, and the available balance created in that facility is then drawn upon to live for the next month. This cycle never reduces the amount owed on these debts, which suits the finance companies as they are being paid a high rate of interest on the outstanding amount.
Step four is listing all of your debts. This step may also be an eye-opener as many people know that they owe money, but never have added the amounts together to get a total. You will also need to find out what interest rates you are paying on this debt. Some debt has very high interest rates and these rates should be used to consider which debt should be paid out first. You want to include all credit cards, personal loans (even non-interest bearing loans from friends and parents) and any other amounts that are owed.
This list should also include money owed under store promotions - the "1000 days interest free" type promotions - that are common for furniture purchases. Work on the basis that 'if you have to pay it back at some time, even some years in the future, it goes on the list'.
The last piece of information is the monthly payment, which may be the minimum payment necessary on credit cards. Personal loans will normally have a required monthly payment.
Example of debt list
| Debt | Amount Owed | Interest Rate | Minimum Monthly Payment |
|---|---|---|---|
| Credit Card 1 | $10,000 | 17.5% | $200 |
| Credit Card 2 | $12,000 | 14.5% | $300 |
| Consumer Loan - TV | $4,000 | 16.5% | $300 |
| Consumer Loan - Holiday | $6,000 | 12.5% | $250 |
| Loan from Family | $10,000 | 0% | $0 |
| Total Monthly Payments | $42,000 | $1,050.00 |
Our example couple has a number of credit cards and other loans, including a loan from one of the parents. They should be paying $1,050 as minimum payments off these loans (which will hardly reduce the actual debt as most of that amount is interest). But they have spent all of their available money.
Balancing the Budget
A sound budget has more money coming in than going out, and that surplus of money is used for debt repayment and savings. Whether your budget is balanced is determined simply by deducting what you spend from what you make. This is why we spent so much effort getting reliable figures. Your surplus or shortfall of money is determined by:
Monthly Net Income
less Fixed Costs
less Variable Costs
less Debt Repayment
Our example couple's budget is:
| $ | |
|---|---|
| Net Monthly Income | 7,226.00 |
| less Fixed Costs | 3,785.00 |
| less Variable Costs | 3,670.00 |
| less Debt Repayment (Interest) | 1,050.00 |
| Balance | - $1,279.00 |
Our example couple has financial problems. They are over-spending by more than $1,200 a month, or over $14,000 a year. They will have to take steps to correct this problem or their debt will continue to grow. Over time they will end up with an unmanageable debt load and risk bankruptcy at some stage in the future.
Standard Budget
Many financial advisors and commentators say that a well-formed budget has the following parts, made up of percentages of net income.
| Percentage of Net Income |
Our couple's Expenditure |
Percentage of couple's Net Income |
|
|---|---|---|---|
| Accommodation Costs | 35% | 2,735 | 37.8% |
| Car or Transportation Costs | 15% | 1,050.00 | 14.5% |
| Savings | 10% | Nil | Nil |
| Debt Repayment | 15% | 1,050.00 | 14.5% |
| Living Costs | 25% | 3,670.85 | 50.0% |
Either our couple's expenditure needs to be reduced, or their income needs to increase, or both.
Our couple earns $7,226 per month, but they are actually spending $8,505 on average each month. Their actual spending and recommended budgeted spending is listed below, along with the dollar differences.
| Actual Cost | Budgeted Cost | Difference | |
|---|---|---|---|
| Accommodation Costs | 2,735 | 2,529 | over by $205 |
| Car or Transportation Costs | 1,050 | 1,084 | under by $34 |
| Savings | Nil | 720 | under by $720 |
| Debt Repayment | 1,050 | 1,084 | under by $34 |
| Living Costs | 3,670 | 1,806 | over by $1,864 |
| Total | 8,305 | 7,226 | -1,279 |
Long term savings, in the form of superannuation, is considered so important that the law says that it must be deducted from employees' wages before they get it - as is the case with our example couple. Self-employed people should provide that some of their monthly income be directed to long term saving. This provides for money after retirement, but people also need to save for things that they will want before retirement.
Short term savings should be made for things like holidays, larger purchases (furniture, etc) and emergencies. Some people decide to delay saving to meet debt repayments. But once debt repayments are under control, people with a sound budget will recommence short-term savings.
What can our example couple do?
A review of our example couple's budget indicates that their mortgage and associated costs are slightly more than the recommended level - but not much. That overspend is partially made up by an under spend on Transportation costs. Their minimum debt repayment is also slightly less than the highest level but what they repay off loans needs to be increased - more on that below. They have no short term savings - but saving is not possible when you spend more than you make.
Their problem area is their living expenses. They spend almost twice as much as they have available. The first thing that our couple needs to do is to decrease this variable spending to bring it in line with their level of income. That is, they have to cut their spending by $1,864, and the place to start is with variable spending. Our couple could decrease their variable spending to:
| Class of Expense | Current Monthly Spend | New Monthly Spend |
|---|---|---|
| Telephone bills, cable TV, etc | 280.00 | 280.00 |
| Food (eaten at home) | 535.25 | 450.00 |
| Restaurants & Take-Away Food | 575.45 | see Entertainment |
| Entertainment (including eating out) | 465.00 | 200.00 |
| Alcohol | 224.65 | 50.00 |
| Clothes | 425.00 | 50.00 |
| Music (CDs etc) | 85.25 | 40.00 |
| Transport (Petrol etc) | 440.00 | 440.00 |
| General Expenses (Health Insurances, Power, etc) | 225.25 | 225.25 |
| Bank Charges (through better money management) | 90.00 | 40.00 |
| Cash Withdrawn | 325.00 | 100.00 |
| Total Expenditure | $3,670.85 | $1,875.25 |
This means that our couple's new budget looks like:
| $ | |
|---|---|
| Net Monthly Income | 7,226.00 |
| less Accommodation | 2,735.00 |
| less Transportation | 1,050.00 |
| less New Variable Costs | 1,875.00 |
| less Current Debt Repayment | 1,050.00 |
| Balance | 516.00 |
By simply decreasing the amount of money spent on 'extravagant' living (living beyond your means is by definition extravagant) our example couple have created a budget that does not increase their debt. The surplus of $516 each month should really be allocated to saving. But our couple may, and probably should, decide to use part or all of that money to pay down debt as quickly as possible.
Our couple's accommodation expenses are slightly higher than the recommended level. If this difference was significant, or could not be covered by reallocating some of the money that would be saved or increasing income - our couple may have to look at selling the property. But that drastic step is not required here. In their case they may decide to allocate some of their 'savings' money to keep an asset that should increase in value over the years.
Our couple also has the option of consolidating their debts onto their mortgage - assuming the bank or finance company will allow them to do so. This could lower the interest paid each month and the debt repayment amount ($1,050 plus part or all of the $516 surplus) would be directed at the mortgage. (See below for a few words on Debt Consolidation.) If they do not consolidate, our couple should concentrate their debt paying money on the debt with the highest interest first. Once that debt has been paid off, use that money to pay off the debt with the next highest interest.
It may be possible for our couple to increase their income (by working overtime etc) to make up any small shortfall. If our couple could increase their net income they could repay their debts faster. Once their debts are paid off they could use part of the 'debt repayment' money for saving and some for increased living expenses - but living without the debt that went with it previously.
The important factor is to create a budget that you can live with. It is pointless paying most of your money off debt, if you will need to draw down on that debt in order to live. It is also pointless denying yourself everything to pay off debts super-fast. The important word in 'Balancing the Budget' is balance.
A few words on:
Marginal Propensity to Consume - Economist have a principle called the 'Marginal Propensity to Consume' which essentially means that people will spend whatever they make, regardless of how much their incomes increase. This - very real - principle means that increasing income alone will not solve a long term financial problem if bad spending habits are not also addressed. Making more will just result in spending more - which is why people with large incomes also become bankrupt.
Debt Consolidation - Debt consolidation can be a great idea. It is essentially grouping all of your high interest bearing debts into one lower interest rate. Usually people draw down on their mortgages (which should be one of the lowest interest rate loans that a person has) and uses the money to pay off credit cards and consumer loans.
There is a catch! Once credit cards are paid off, there is available credit on those cards. Some people will again run up credit on these cards ending up with the same amount of high interest debt on the cards, plus an increased mortgage from the consolidation of the past debt. Once credit facilities are paid off from a consolidation, they should not be used again. The consolidation loan is meant to get rid of these loans, not provide more money to spend.
There is a second catch! Some people consolidate and draw down on their mortgage, but then drop their repayments to the minimum amount possible, paying the consolidated amount back over 20 or 30 years. Consolidations of loans are best used when the repayments are kept at the highest level (under a balanced budget) and the amount saved by the reduction in the interest rate is used to repay the consolidated loan principle. This makes people debt free as soon as possible.
Bankruptcy - Sometimes people just cannot create a balanced budget and their financial position continues to get worse. This is usually because they have a very large amount of debt, and the accumulating interest and repayments do not leave sufficient monies on which to live. In that case - and usually only as a last resort - they consider bankruptcy. This is the legal process where a trustee is appointed to administer a person's affairs so as to provide a fair distribution of that person's assets to their creditors. Most debts are then forgiven and a personal can financially start again.
Summary
Budgeting can be an eye-opening experience. It takes some work but it is necessary regardless of whether you think that you are in financial difficulties or not. Remember: "You cannot manage what you do not measure".
Disclaimer
The enclosed information is of necessity a brief
overview and it is not intended that readers should rely
wholly on the information contained herein. No warranty
express or implied is given in respect of the information
provided and accordingly no responsibility is taken by
Worrells or any member of the firm for any loss resulting
from any error or omission contained within this
fact sheet.
Last Updated: 9.3.2010