Maybe you’re interested in pursuing FI but are unsure where to begin. If you read “Welcome to Financial Minimalist” then you know it starts with a mindset and a good budget. I’ll admit that delving into the world of finance can be overwhelming at first. Since it is not often taught in schools we have to rely on other sources. Doing a google or book search for personal finance brings thousands upon thousands of results. With so many options it’s easy to see why people become unsure how to proceed.
Budgeting is important because it helps us understand how our money is being allocated. If we spend more than we make it leads us into debt. However, if we track our spending then we can cut down on excess and make our money work for us (through the magic of investing and compounding!).
This post will give you an idea of where to begin.
Have a Commitment Mindset
The first step is to commit to the process and have the desire to want to do this. You can spend the time creating a budget but the time is wasted if you choose not to follow it. To ensure success, think about what you want your future to look like. Do you want to be stuck working a job you hate, buying things you’ll probably never use and then discard? I doubt it. Have clear, concise goals written down that you can refer to.
The second step is to create a better understanding of your current financial situation. The only reliable way to track your income and spending is by knowing the numbers. Thankfully, I have outlined how to do this below.
- Know your Net Income. How much money do you bring home in a month after deductions? If you’re an hourly worker you might have been hired at $15/hr, but after deductions, you actually make less. The same goes for salaried employees. The amount you bring home after taxes, social security, etc. is known as your net income. In this day-and-age, it’s the amount deposited into your bank account.
- Choose how you will budget. Chances are your bank already has a tool for you to budget. If not, or you don’t find it useful enough (I didn’t), there are plenty of services floating around the web to assist. I have not used any of them so I cannot recommend one over another but a quick google search will find some prospects. Because of the ability to link accounts between some of these services it is great for those who want a fast, automated approach to budgeting. For those who prefer more control, I highly recommend Microsoft Excel (or alternatives such as the free Open Office). I have been using Excel for the past few years to budget and the flexibility makes it worth not having the automation of online platforms. Manually updating the spreadsheet also keeps me focused on my goals.
- Track expenses. Start by listing expenses that recur monthly. These are your fixed expenses and account for the rent/mortgage, utilities, cell phone bill, internet, etc. It’s important to know how much this consumes from your net income so you can try to cut back if possible. As you go through the month, list your variable expenses (groceries, gas, entertainment) as well. These will change month-to-month and is where budgeting is critical. It is easier to reduce spending on variable expenses than on fixed.
- Set realistic goals. What are you hoping to accomplish within 6-12 months? 5 years? Maybe you want to get rid of debt and start investing for your retirement. To do so you will need remaining income after you subtract your expenses (fixed + variable) from your net income. This will be used to pay off debt, add to savings, or invest. Here we see the importance of reducing our spending.
- Plan. How much will you spend on groceries this month? On entertainment? Set reasonable figures and don’t be discouraged if the numbers don’t line up the first few months. This is not to say that you should intentionally overspend, but after a few months, you will have a clearer idea of where your money is going and can adjust from there.
- Revisit & Revise. A budget is continually changing based on what is happening in your life. Every month I recommend revisiting it and revising it as necessary to coincide with new developments including a raise, changes to fixed/variable expenses, etc. By keeping it updated it will also keep you on track towards fulfilling your goals.
After following these steps a basic budget will look like this:
Over time you might decide you want to track your expenses further. For example, how is money under “Entertainment” being spent? You can use this information to cut back on spending in specific areas.
A Note on Saving & Investing
Once you know how much you tend to spend in a given month you should multiply it by X and save that amount (where X is the number of months you feel comfortable having saved). The conventional wisdom is 6 months so that if you were to run into hardship (i.e. job loss) you would be okay for a time while searching for another. However, you have to decide for yourself what your comfort range is. For some people, it means having 12 months of expenses saved.
As an aside, over time this amount will depreciate because inflation outpaces the interest gained from savings accounts. It’s a small price to pay though for freedom from worrying about not having a cushion to fall back on if needed.
To outpace inflation we have to invest and I recommend starting this as soon as you have saved the amount you’re comfortable with. I’m a fan of low-cost index investing through the group that started it, Vanguard. For more information on this, J. L. Collins wrote a great book on the subject called “The Simple Path to Wealth: Your road map to financial independence and a rich, free life.” As of now, it is the best book I have found for a newcomer to begin learning about investing.
Bonus: Free Budgeting Spreadsheet
Bonus: Determining Net Worth
Your net worth is how much money you have (or could potentially have) after calculating the sum of your assets (cash, savings, investments) and subtracting it from the sum of your liabilities, or debts (mortgage, loans, credit cards). You want the outcome to be positive. If not, as the old saying goes, you’re in debt up to your eyeballs (and beyond). If something were to happen and you had to repay all of the debt at once, you wouldn’t be able to.