Three Parts of a Practical, Effective Budget

Many times I've recommended creating a personal budget to help you meet your financial needs. It doesn't sound too difficult, does it? Believe it or not, the hardest part is finding the discipline to stick with it and give it the care and feeding it needs to be effective. It's easy to add up your income and divide it across all of your expenses/savings goals. But budgeting is more than that. In this post, I'll tell you the three important items that you'll need to have an effective budget: a Budget "Thermometer," Running Total Tracker, and Cash Planner.

1. Budget Thermometer








Here is a sample of my budget thermometer for September. It is simply a screenshot from my favorite free personal finance software, mint.com.

Coming up with categories and their monthly allowances is an important first step and the part of your budget that you will pay the most attention to on a daily basis. Mint.com not only allows you to create your budget, but it will show you a daily thermometer to display how well you're adhering to your plans. Because it's integrated with your bank and credit cards, each day it will classify your spending transactions and tell you whether or not you're on track to meet your monthly goals. If you spend half of your grocery budget by the 5th of the month, Mint will alert you so you can rein in on your shopping until you're back on track. As you spend money in a category, your little "thermometer" will fill in. Its color will change if you're on pace (green) , not on pace (yellow), or over your monthly budget.

I can't tell you how to split up your income each month, but here are some tips:

- Before creating your categories and their associated monthly allowances ($500 on groceries, $200 on restaurants, etc), take a look at where you currently spend your money and don't just pull the numbers out of thin air. If you're using personal finance tool like Mint, Quicken, or Money, you should be able to see a pie chart that shows you how you've spent your money in the past. But make sure your past transactions are classified correctly!

- Next, establish new goals for each of your categories. It's OK (and encouraged!) to spend less each month in certain categories than you have in the past. If you spent $400 last month at restaurants and want to bring that down, this is the perfect time to set those goals. Make sure you're using reasonable and achievable estimates for everything, but don't be afraid of a challenge.

- Don't forget about your savings goals! If you're saving up for something specific like a vacation or an engagement ring, start implementing those goals into your budget as categories after you've figured out what you'll have left over. Whether it's $10 per month or $500 per month, it's important to put money away for the things you'll need in the future.

- Don't budget down to your last penny. We're dealing with your personal finances; you're not an accountant. I like to leave out 2.5% of my monthly net income (after-tax pay) unaccounted for. There's no doubt that at least one of my expense categories will go over one month (as you can see above), so it's nice to have a little buffer for such an occasion without throwing off my other goals.

- If there are expenses that aren't incurred monthly, like car insurance or, in my case, my dog's annual vet visit, split them up in terms of months. Divide your six-month premium by six and use that as your monthly budget. This, of course, means that you'll be under budget some months, and over budget the months that the expense is paid. This point illustrates the need for the other two pieces of an effective budget: a Running Total Tracker and a Cash Planner.

2. Running Total Tracker
Unless you're an incredibly disciplined, you're not going to spend exactly the same amount of money each month on all of your categories. Certain things like your car payment, mortgage, etc are fixed, but other expenditures like groceries, clothing, and utilities will vary a bit. This is why it's important to track running totals.

Mint does not have running total tracking functionality, so I do it myself once a month in a spreadsheet. Two of my columns are identical to my categorical budget columns that are tracked by my personal finance software. One column has the identical category and the next has the monthly budget. Each month, I evaluate my monthly adherence to my budget and note the amount that I was over or under for each category in a new column; I have columns for each month that I have been using the spreadsheet. If my restaurant budget is $140 and I only spend $90 in September, my September column would have a green "$50" because I spent $50 less than budgeted. If I had spent $150, my September column would have a red "$10" because I spent $10 more than budgeted.

Next to the first two columns that display spending categories and their monthly allowances, I have a third column with a number that is either red or green. This number represents the sum of all of the monthly over/under amounts, which I call the "running total."


The running total is important for me to know how well I'm adhering to my budget over time. Also, it keeps track of the balances of certain non-monthly expenses and can help when you create next year's budget. If you see that you're constantly spending more than your budget on gas or groceries, you might need to rethink your amount.

Additionally, the running total column can indicate whether or not my wife or I can afford greater than normal spending in a certain category. Recently she said she wanted to go clothes shopping. We hadn't spent any money on clothes in a few months, so when I checked our running total for clothing, I saw that we were about $123 in the green. Because we hadn't spent our $50 clothing budget in a few months, she was able to go and spend more money on clothes this month. When I update my spreadsheet next month, the running total will be back to zero.

3. Cash Planner
Our incomes and expenses aren't always regular and incremental. There are times of the year when we receive bonuses or incur extra costs. The third piece of budgeting is important to help you determine how much cash you'll have after receiving irregular income (possibly after getting your tax refund) and after paying your abnormal expenses (like the January post-holiday credit card bill).

This budgeting tool is also something that I track manually in Excel. Across the top are columns indicating two periods per month -- one ending on the 15th and the other on last day of the month. It's up to you to determine how small your time increments will be. Depending on how often you're paid, you can have columns represent every Friday from this day forward, or simply the end of the month.

For each column, I have a series of rows for my expenses and incomes. My income is a row and my wife's is another. My expense rows resemble my budget categories, but unlike my running total spreadsheet, they don't follow them explicitly. This is because not all of my expenses are paid on the same day of the month. Many of them, like groceries and my XM bill, are put on my credit card. Since my credit card bill is due only once per month, I have a single row for "credit card" that includes many of my regular expenses. Other expense rows include one for my mortgage, my car loan, and my student loan payment.

Two other important rows include "Additional Income" and "Additional Expenses." These will be places where you can input anticipated fluctuations in your income or expenses. If you know you're planning on spending $350 next month on your quarterly student loan interest, you can plan for that. If you're getting a big tax refund in the spring, put that in your April column. Add as many columns as you're comfortable with. If you want to plan out six months ahead, you may. If you only want to plan two months ahead, that's fine, too.

Next, for each period column, I enter the expected amounts for each row (if any) that will be applied during the period. For example, my mortgage and car payment are paid on the 10th of each month. For the column labeled 10/15 (representing the period from October 1st - 15th), I will enter the amount of my monthly mortgage and car payments as well as any income I expect to receive. Since my credit card and student loan payments aren't due until later in the month, those expenses will show up in the second column for the month, 10/31. Similarly, because my wife is paid only at the end of each month, I'll enter her income only for the second period.

At the bottom of each column, I do a little math to estimate my cash balance. I take the cash balance from the bottom of the previous column, add the incomes from the current column, and then subtract the expenses from the current column. This will result in my new expected cash balance for the period. For example if I had $5,000 at the end of the last period, received $1,000 of total income, and incurred $800 of total expenses, my new cash balance would be $5,200.

While the Budget Thermometer and the Running Total tracker are useful for tactical budgeting, the Cash Planner is great for strategic cash management. If you're trying to develop an emergency fund of a few months' salary, the cash planner will give you a good idea of how long it will take to reach your goal.

As you can see, there's more to budgeting than just coming up with monthly allowances for spending categories. To budget effectively, you must have reasonable monthly goals (derived from your past spending), the ability to monitor your adherence to those goals, a willingness to log your monthly adherence (running totals), and a view into the future to know what your financial situation will be and how soon you can achieve your goals.

What are your own personal budgeting strategies?

Prosper.com: Convincing My Wife, Part 2

...she ain't convinced yet.

In my continued efforts to convince my wife that Prosper.com is a good investment, I'll analyze another aspect of the website today. Today I'll study what makes the successful lenders successful, what makes the average lenders average, and what makes the biggest losers, well, the biggest losers. I'll be moving my analysis platform to a fabulous website that focuses solely on Prosper.com lender and loan data, EricsCC.com.

To get things moving along quickly, consider the following graph that shows all lenders' rates of return on a seemingly normal distribution curve (please click any graphic to enlarge it):
As you can see, the majority of lenders are making money, and a significant majority are also earning a higher rate of return than they would earn in a traditional savings account. However, of all the non-average lenders, there are more that are doing exceptionally poor than doing exceptionally well. This indicates that if you do not follow a reasonable, disciplined investment strategy, you are more likely to lose at a high rate vs gain at a high rate. I guess the same could be said about the stock market. Essentially, it's easier to make mistakes than it is to get lucky.

Do you ever watch that show called The Biggest Loser on NBC? Well meet the biggest loser on Prosper.com: scoobydoo. Here is a graphical representation of his investments:
As Antonio from the Merchant of Venice would say, His "ventures are in one bottom trusted." This guy has invested a lot of money into Prosper.com and has given several large loans to people with C-grade credit. If one or two of those loans defaults, his ship will have sunk.

Let's look at another big loser's profile. How about jasonpeery:
Here's another guy that has a poor, lazy investment strategy. He has invested over $50,000 in Prosper.com listings and has scores of late payments and defaults. This guy has made several individual loans over $1,000, including one that is in default for $11,000! Why in the hell would you EVER loan $11,000 to a person with high-risk credit? And without even asking them a question! I sure hope that jasonpeery is better at personal finance than he is at determining to whom he should lend his money. As Neil Boortz would say, I bet that this guy has a lot of rent-to-own furniture in his house. My guess is that this guy's grandmother died recently and left him a bunch of money. No one that worked for $11,000 and saved it would ever be that careless in giving it to a single high-risk stranger.

One thing to remember about Prosper.com's fee structure is that all individual loan fees are passed along to the borrower except for a 1% loan servicing fee which is paid by the lender. This means that, statistically speaking, there is no reason to invest more than $50 in ANY candidate. Period. If I lend $500 to one person or $50 to ten people, I will pay the same loan servicing fee. And though I may save a little time by investing more money in lower-risk candidates, it's just plain silly to not diversify to the max with sub-prime borrowers.

OK, so let's look at someone with an average return. Consider the portfolio of helpishere777:
Ahh, this is refreshing. This user is right in the middle. He is earning about 11% interest, which takes into account the probability of his late payments going into default. He has invested the same $50,000 that our last big loser had invested, but in a completely different way. Look at the nice even relationship between all of the blue and green lines. Do you know why they're all equal? Because he invested the same $50 into every single loan. He understands that in order to mitigate his risk, he needs to diversify -- especially if he can do it at no additional cost!

Now let's look at the best lender. I'm not going to evaluate the person earning the highest return on his money. Currently that person is DrakeCO, who is earning about 33.6% interest. However, the average length of his loans is less than one month and most of his loans have been large amounts (max of $1,500) to high risk borrowers. Because of the youth of his loans and the nature of his strategy, he is bound to fail. Instead, I'm going to look at someone earning about 20% return with a reasonably large average loan period (if it's not old, the borrowers don't have time to be late!) and a significant amount of money. It looks to me like the golden child of Prosper.com is brother_tam. Here is his portfolio:

brother_tam is obviously smart and probably a little lucky. He has invested a little more than $10,000 in Prosper.com, mostly in $50 increments. Of his 224 loans, he has given more than $50 only 13 times, probably just to spice up his account. As a lender that understands the need to diversify. He is aware that he can invest in lower-credit borrowers because of his discipline. But he doesn't invest in only low-credit borrowers. He has a nice normal distribution of his loans that has a mean slightly on the low-credit side.

To be a successful lender on Prosper.com, you need to stick with a disciplined strategy that is formulated around the values of diversification and a normally distributed loan strategy. When choosing which loans to bid on, consider your current portfolio and establish a quota. "Right now, 75% of my loans are to high-risk borrowers. I should invest in some low-risk borrowers."

Remember: there is no penalty for investing the minimum amount in a person. And with more than 2,300 active listings, you shouldn't run out of people to lend to.

If she's still not convinced, I'll have to write more tomorrow.

Debunking Dave Ramsey's Snowball Plan for Debt Reduction

A reader recently commented on my site,  suggesting that I check out Dave Ramsey's website and learn about some of his suggestions for getting out of debt.  This morning, I performed a detailed analysis of his debt reduction plan which he calls the "Snowball Plan."

First accumulate $1,000 cash as an emergency fund. Then begin intensely getting rid of all debt (except the house) using my debt snowball plan. List your debts in order with the smallest payoff or balance first. Do not be concerned with interest rates or terms unless two debts have similar payoffs, then list the higher interest rate debt first. Paying the little debts off first gives you quick feedback, and you are more likely to stay with the plan.

I should mention that Mr. Ramsey is a faith-based financial advisor and regularly takes into account more than just the numbers.  When speaking on personal finace, he focuses on the "personal" just as much as the "finance."  Though his system has proven to be effective for some, it is not my style.

He urges his readers and listeners to build momentum when reducing their debt and try to feel a sense of accomplishment.  But let me warn you: those senses of momentum and accomplishment may not come cheaply.  Essentially, by "feeling good" about paying down debt, you risk taking more time to do it and thus wasting more of your money on interest payments.

Consider this analysis:

Let's say you have two loans: A student loan for $25,000 and an auto loan for $10,000.  The student loan has an interest rate of 8% and regular payments of $227 for 200 months.  The auto loan has an interest rate of 6% and regular monthly payments of $304 for 36 months.  In addition to your regular payments, let's say you have $100/month extra that you can apply to whichever loan you're currently paying and that once it is paid off, you will take the normal payments of it and apply them toward the other loan until it is paid off.  In this scenario, with minimum payments of $227 and $304 and extra cash of $100, you will be paying $631 per month until both loans are paid off.

Because the length of the student loan is much longer than the auto loan, even if you decide to apply the extra money to the student loan first, by the time it's paid off the auto loan will have been long-since paid off.  The total you will have spent on interest over the life of the two loans will be $10,603.  If you had decided to pay off the smaller auto loan first and then send all of your debt-reducing cash to the student loan, you would have saved $2,262 in interest.  In this case, Dave Ramsey's strategy works.

But let's look at another scenario.

Let's say you marry your college sweetheart.  After the wedding, you decide to merge your individual finances and adapt a joint financial strategy that works for both of you.  Let's say that you have a student loan of $30,000 at 9% for ten years.  Your spouse has less: only $15,000 at 6% for the same 10 years.  Like the previous example, you can pay an extra $100 each month toward the principal on whichever loan you're paying down first.

The terms (length) of the two loans are the same, one is twice the size of the other, and the smaller loan carries a smaller interest rate.  Dave Ramsey would tell you to pay off the smaller $15,000 loan first.  By doing that, you're costing yourself $1,534 in unnecessary interest.  If the difference in the interest rates was greater, this wasted amount would be even larger.  Let's say your loan carried 10% interest and your spouse's carried 5%.  You would then waste $2,058 in additional interest by paying the smaller loan first.

Let's tweak the numbers one more time: Assuming the same rates and balances,  a change in terms so that the smaller loan lasted for 15 years instead of ten would result in a waste of $2,656 in unnecessary interest payments; just because you listened to Mr. Ramsey.

As you can see, there is not a definitive high-level strategy that can accurately determine the order in which you should pay off your loans.  Mr. Ramsey tries to justify his financially flawed plan by adding emotion and human perception to the equation.  Here is my solution:  When considering the order in which you pay off your loans, crunch the numbers.  Once you prove which will save you the most money, set up a regular payment with your bank and forget about it.  You should find satisfaction in the fact that you're paying off your loans in the smartest, cheapest way possible.  Maybe it means paying off the smaller loan and maybe it doesn't. 

Setting long-term financial goals

I've been a long-time proponent of creating a budget and setting short-term financial goals. As a recent escapee of credit card debt, short-term goals have been the best tools to dig myself out of that hole. But during dinner last night, my wife and I were talking a little bit about our retirement and I realized that I had no idea when we could retire. All I knew was that we make decent money, don't waste too much on frivolous things, and try to pay cash for as many big-ticket purchases as we are able. Given our current situation, can we retire at 65? 60? 50?!?!

Because I'm no expert, I won't try and tell you how specifically to plan for your retirement. But I will share some results of exercises that I've been going through this morning. Ideally, I'd like to retire at age 50. And according to some initial calculations, I'll need to save a significant percentage of my income to retire at that age, assuming that I do not receive any social security. Of course, my lifestyle during retirement will affect the amount of money that I need to save. Assuming the following lifestyles (% of my current annual income, adjusted for inflation, that I would like to withdraw during each year of retirement), I will need to save the following percent before tax (assuming 8% growth before and during retirement):

• 70% of income: 32% savings
• 80% of income: 37% savings
• 90% of income: 42% savings
• 100% of income: 46.5% savings

Of course, those numbers assume that I will retire at age 50 and will receive no social security (mainly because the system is in the toilet and I don't want to rely on it). If I assume that I will receive social security benefits, my income/savings percentages change significantly:

• 70% of income: 23.5% savings
• 80% of income: 28% savings
• 90% of income: 32.5% savings
• 100% of income: 37.5% savings

One important thing to consider about these numbers is that they all reflect the minimum percent savings required to ensure that the money won't run out by age 90. Each percentage will result in a near-zero balance by age 90. However, by saving approximately 4% more than the minimum savings percentage required for my desired income, I will be able to draw from the account annually without decreasing the principal balance. Essentially, by saving for an 80%-income lifestyle and actually living a 70%-income lifestyle, my account balance will continue to grow indefinitely. Assuming that I save enough to live off of what is today $42,000 per year (70% of 60,000), saving an extra 4% annually will give me an account balance at age 90 of about $1.5 million. Not saving the extra 4% annually will leave me with a balance by age 90 of about zero dollars.

What I have learned from my research is this: I should figure out what kind of annual income I would like to have in retirement. Next, I'll save enough to make that goal, plus at least an additional 4%. It is that relatively small extra savings that will determine if I die rich or poor.

With a simple routine comes comfort and ease

There was a point in my life, particularly in college, where I didn't exactly trust myself. From time to time, I promised myself lots little things that I would do to better myself: reading, writing, and exercising more, eating right, etc. I'd usually stick with it for a couple of days -- a week at most -- before slipping into my old habits again. I'd always seem to find a good reason to put the book down, stop writing, sit on my butt, or drive to Hardee's. Maybe I had writer's block; maybe I had to get up early that morning and just wasn't feeling up to exercising; maybe I was starving and had nothing in the fridge. Whatever it was, I compromised, and with each compromise, the next one became easier...and easier...and easier until there was nothing left to compromise; I had given up.

When I consciously compromised my behavior, I felt a little guilty. When I had given up on the goal of the week, I was no longer compromising and therefore never really felt guilty. As a result, I spend a good couple of years without doing many of the things differently than I would today. Watching TV instead of reading; speaking my thoughts instead of writing them down; sleeping in and sitting around; eating lots of fast food. Because I hadn't set any goals for myself (or a plan to achieve them), I wasn't viewing these behaviors as destructive.

Eventually I grew up a little bit and decided it was time to make a few changes. But how would I stick with them after having trouble in the past? I was the king of excuses, and I had been excusing myself for too long. So how did I fix it?

I could always find a legitimate reason to justify a decision to not do something constructive, so I took the whole 'deciding' part out of the equation. I came up with a daily routine and a small, achievable set of rules. In the past, though I always came up with achievable goals, they never materialized because I never enabled myself to achieve them. By establishing a routine -- a daily itinerary -- I was able to achieve my simple personal goals and improve the quality of my life.

By setting a few simple rules and establishing a routine, I began writing every day, finishing books on a weekly basis, losing weight, and lowering my cholesterol. Whenever I was presented with options related to my goals, instead of making a decision on the fly, I consulted my newly established routines and guidelines. Here are some examples:

• Each morning for breakfast, I will eat a bowl of oatmeal
• I will not eat fast food
• I will go for a long walk every day (which eventually turned into a jog)
• When I have free time and am considering turning on the TV, I will pick up a book instead
• I will write every day
  

By setting these guidelines, I took the decision out of decision-making in my weakest areas. Also, I set up allowances for most items, which was a key to changing my behavior. The allowances kept me sane and flexible. But it was important for me to define them, almost as I defined items in a budget. Examples are:

• I would allow myself to not eat oatmeal if I was traveling and it was unavailable (instead eating something else that was healthy)
• I allowed myself to eat an unhealthy breakfast twice a month
• I would skip the walk if it was raining all day (but if I anticipated rain in the evening, I would try and walk earlier in the day)
• I could skip reading two days per week
• I would write every day, unless I decided ahead of time the length of my hiatus
• I still would not eat fast food
  

By being mindful of my goals and their allowances, I changed my daily routine to something that I was comfortable with. Every morning, without thinking about it, I eat a bowl of oatmeal. Because it was sometimes hard to find time to write, I would get up early and write before starting my workday. Because I know I sometimes get writers' block, I'm always jotting down ideas for tomorrow's post. During my lunch break, I take the dog for a long walk around the neighborhood. After dinner, I sit down and read, unless there is something else pressing (hey, life happens); if I'm busy for a few nights straight, I try and play catch up.

Of course, I'm not perfect. My writing hiatus for my wedding was longer than expected; I sometimes skip the walk if my to-do list gets the best of me; and just the other day I caved and watched three back-to-back episodes of The Office instead of finishing my book. And that's OK -- that's life. We're human and we sometimes need to take time for ourselves and be lazy and forget about doing something constructive. But what we can't do is forget that we define our personal goals for a reason. We define them to better ourselves and enable ourselves to live fulfilling lives. We define them because we recognize our own weaknesses and maybe want to turn them into strengths. We define them because we need to take control of the only life we can control...our own.

The ability to set and achieve personal goals is an important component of our confidence and self esteem. For me, the easiest way to better myself has been to define my goals, come up with a plan, and establish a simple routine.

What works for you?