After evaluating your spending history and committing to tracking your spending, the next step is to create a surplus. By this I mean, find a way to spend less than you earn.
This step must be taken even before you start saving for an emergency fund or start investing. Skipping this step is like trying to fill a bucket with holes in it. This step is the equivalent of plugging the holes so that your bucket can fill (with sweet, sweet money).
The point of this step is not necessarily to optimize your spending and your budget, but to stop accumulating debt and create a little surplus so that you have some extra money each month to save or pay down debt.
Create a Budget That Reflects Current Spending
Don’t get scared by the “b” word! Budgets are not as complicated as people make them out to be. In fact, I can make it really easy.
The first step is simple: make a budget which shows your current spending levels (which you already did, if you followed the steps in Part 1 of Evaluating Your Status). You can make a Personal Capital, Mint, or Hi Charlie account. Or, you also have the option to do this manually if you’re a nerd like me.
Don’t worry about what you think you should be spending in each category, and don’t worry if your expenses are more than your income. Just look at what your average spending a month currently is (or look at an average month in one of the spending trackers).
Compare Your Current Spending to Your Current Income
Now, things get real. Figure out your monthly income (the spending trackers should tell you, or you can look at your pay stubs or account where it’s direct deposited).
Then, determine which number is larger: your income or your expenses. If your income is larger than or equal to your expenses, you’re already in a decent spot. If your expenses are larger than your income, it’s time to stop the bleeding.
It’s time to set your budget, which is simply, what you think you should be spending in each category.
Mint and Hi Charlie have options to set a budget by category, and they will keep track of your spending in each budget category for you. Hi Charlie will even warn you if you’re getting close to your month’s limit.
Personal Capital is a little lacking in the budget category. You can set an overall monthly amount you don’t want to exceed, and it will show your actual spending by category, but you can put budget limits on each individual category.
I made a spreadsheet that’s easy to fill out and tweak the numbers until you hit your target savings rate.
Here’s how it works:
- Use your paystubs to fill out your salary, 401(k) & HSA/FSA contributions (if any), taxes, and health insurance on an annual/bimonthly basis. Note: This budget assumes you are paid twice monthly. If you are paid every other week, you’ll have to adjust the bi-monthly numbers to bi-weekly by dividing annual numbers by 26 and vice versa (instead of 24 for twice monthly).
- Fill out any debts, the total amount and minimum monthly payment for each (except for your mortgage, which I incorporate in your monthly expenses).
- Fill out your monthly expenses. This should come from your budget.
- This step is where you account for anything you have to save up for over time. They are things you generally need to put aside money every month to be able to pay them in a lump sum whenever they’re due. For example, if you wanted to save $4000 a year for travel, divide that by 12 months and include here. Or if you pay for any subscriptions or insurance in a yearly lump sum, divide them by 12 to account for them monthly. This is also where you would track after-tax investments, such as a Roth IRA.
- Finally, analyze your results (this part should automatically be calculated). You’ll see income, expenses and amount going toward investments. If your company provides 401(k) or HSA/FSA matching, you will have to update the company match manually since they differ from company to company. The calculation I have in the spreadsheet currently assumes a 5% match on income (make sure you stay long enough at your company to become vested, or “earn,” this match).
Finally, your savings rate is shown. This is simply all your investments and savings divided by income. You want this number as high as possible. The higher it is, the faster you’ll reach financial independence. Strive for at least 10%, but many people seeking fast financial independence find ways to get it to 50 – 75%. I’ll talk about those strategies in future articles.
Don’t worry about getting this exactly right, and don’t worry if your savings rate isn’t where you want it to be yet. You can adjust and tweak it over time.
Cut the Easy Things
We’re going to start by trying to cut your expenses such that you have 10% of your income leftover each month. If you’re already contributing a percentage to a retirement account like a 401k, you can subtract that. For example, if you currently contribute 5% to your 401k, try to make your budget so that you have 5% of your income left over each month.
Take baby steps as you prune your budget—you don’t need to cut it all, just start with the easy things. I promise that by saving a little now, the growth and progress you see will be addicting. Before you know it, you will be saving more and more, you’ll be finding creative ways to cut expenses, and you will be wealthy.
Some easy things to cut here could be: subscriptions you no longer use, cooking more instead of eating out, get rid of cable, shop for cheaper phone or internet plans. Usually, people find that they are spending money they don’t even remember or realize. Cut those things out here.
Cut the Things You Don’t Value
First, remind yourself of your “why” and imagine what your ideal financially free life looks like. This should give you an indication of what your values are (family, hobbies, cooking, etc.). Now look at your budget, and cut the things that don’t align with your values.
For example, I recently cut my budget for clothes by about $100 per month. I realized I don’t value them that much, I don’t even wear most of them, and they won’t be really important to me in the future.
Once you are spending 10% less than your income, you are on your way to financial freedom! You have stopped subtracting from your net worth and are instead adding to it. Next, we’ll talk about where to put these savings.