Budgeting Basics - How to Budget using Cash Envelope System

I have been intending to do this post for a long, long time now... I am going to ramble here a little. You have been warned!

If you'd rather go right to the points, scroll down to the bottom of this page for the cheat sheet ;)

How the journey began

Money came into my life long after I reached my 20s and started working full time. But to be frank, even after I started earning for myself, I knew precious little about money matters. My financial skills were limited to writing down my daily spends.

I used to note down meticulously each and every rupee spent. However I was not savvy enough to tally up the total amount spent in different categories or anything. But, I did know that, on average, I would need to spend at least such-and-such amount each month. Slowly, I realized that I could just withdraw this amount all at once when the month begins and forget about it until the next month.

As time went on, I wanted to give a part of my salary to my parents and save another part. I also wanted to donate some amount to charity ( Maybe my parents suggested this one, I sure hadn't read up on this then...). Roughly, this was the pattern I followed - 5% Donate, 20% Parents, 50% Savings, 25% Spend. I was, for the most part, living with my parents, and as such, my living expenses were mostly nil.

Life goes on

And then, I married and soon, my little girl was born. And I was suddenly(!) conscious of my responsibilities towards the little angel snuggling in my arms. That was when I started looking up personal finance. It is sad that we are not taught these basic life lessons at school or anywhere else, for that matter.

And now, saving took on a new meaning altogether. I now had GOALS! And I bought a car on a loan, too. So now, I had GOALS and LOANS! And I was no longer living with my parents anymore. I had a baby to take care of. There was also a longer commute to my workplace from my new home. So now, I had GOALS, LOANS and LIVING EXPENSES! Hey, I still wanted to continue contributing to society. So to make a long story short, I had GOALS, LOANS, LIVING EXPENSES and DONATIONS! to handle.

How I budget

I was already using a free software Money Manager Ex to keep track of my income and expenses. It is a freeware that is also available on the android platform. I have used it for years and it has helped me track expenses very effectively and I would highly recommend it to anyone interested in getting serious about their finances. Nowadays I use Money Lover for keeping track of my daily expenses. Knowing how much you spend and what you spend it on is the first baby step towards better finance management.

I did not consciously look up this topic online or research extensively, but as they say, "When the student is ready, the teacher will appear". While aimlessly surfing online, I clicked on one link, and that led me to another and that led me to another... and I was redirected to Dave Ramsey. Dave Ramsey has, since then, taught me a lot about how to manage my financial life more simply, more efficiently, more sensibly. I think I was subconsciously money-savvy, but I certainly learned the whys and hows and whens from the Dave Ramsey blogs, videos and talks.

I follow what Dave Ramsey calls the Zero Balance Budget. To rephrase a favorite quote, "Tell each dollar where it should go (at the beginning of the month) instead of wondering where it went (at the end of the month)". That is, every single rupee that comes into my hands is assigned a place in any one of the following four categories:

1. Sharing (Giving)
2. Settling (Loans)
3. Saving (Goals)
4. Spending (Living expenses)

... in that order, always!

Sharing

Now I use the term Sharing. It is known as daanam in the Hindu way of life, tithing in Christian belief, zakat in Islam and so on... I personally consider this more of a social responsibility than a religious practice.

I do not necessarily always give to the temple either; I occasionally do. I also give to charitable organizations, non-profit organizations, to acquaintances, friends, family - any one, really. The concept I have embraced is to give, and to give unconditionally to any one. 

I try not to over complicate this category; I keep it simple: Give away, without any expectations, whatsoever.

Settling

This category covers any loans that you might have taken. Dave Ramsey cautions against taking any loans at all.

The ideal method is to purchase only those items that you can afford right now. If you cannot spare that much money at present, save for it little by little every month, every windfall that comes your way; and then buy it.

That said, you might have already taken up a loan, as of today. Pay it back in full as early as you can. Ramsey suggests that AFTER saving for your emergency fund, eliminating debt should be your NEXT MOST IMPORTANT priority.

This is one category you should not need at all one day. Work hard at eliminating this one!

Saving

Here I set several goals that I am saving for. Most of them are long-term, some are short-term, a few are both/neither. Consider these categories for saving:

Emergency (Short Term Goal) 

Make sure you fill up this fund fully first before moving on to the others.

The idea is to have at least six to seven months of expenses in an emergency fund. This is to ensure that if, God forbid, you are left without any source of income for a while, you ought to be able to tide over it smoothly. This should give you a decent time frame to look for another job without stressing yourself crazy. DESPERATE is worst way to go job hunting!

This fund should hence include monthly expenses, as well as any repayments that you may be expected to make during those months. You must also revisit this fund once a couple of years to make sure that your current expenses and current debts are fully covered.

Retirement (Long Term Goal)

This, I have learnt since, is the most important one as it allows one to live life with dignity at an age where dignity is most craved for.

There are many online calculators that help you get to the right amount that you will need in retirement, and the amount you'll need to save each month, starting today! Carry on!

New Car (Short Term Goal)

All right, so this one is almost a no-brainer. Everyone has a car, everyone needs a car. If you can do without, that's what I would suggest. If you can't, I would suggest saving up for it first and pay in full (No loan!).

I shall let Dave Ramsey do the talking for me on this point. He has a nicely illustrated video explaining why it is incredibly foolish to be taking out a loan for something that loses 40% (or more) of its value the moment it is driven out of the showroom! Please visit this link to watch the video: https://www.youtube.com/watch?v=BKyV8CTHeJ0

Home (Long Term or Short Term Goal)

Now here's another very, very important goal. I'm not sure whether you can really buy a house, or build one, entirely with your savings. Anyhow, save up for a sizable initial down payment.  

To own a neat, lovely house, without having to take on a huge, enormous loan (and spend the rest of your life paying back almost double the amount) - is a worthwhile goal indeed.

Children's Education (Long Term or Short Term Goal)

A book I found incredibly interesting is "The Millionaire Next Door" by Stanley and Danko. In this book, the authors note that one common trait of millionaires is that they invest heavily in their children's education. To be wealthy, do as the wealthy do. Educate your children, educate them well.

And that's where this category comes in. I do not believe in student loans at all. They just make the kid desperate to land a job even before he/she is out of college. And as you already know, DESPERATE is the worst way to go job-hunting, right?

Children's Wedding (Long Term or Short Term Goal)

In Indian culture, this is THE BIG EVENT. So you could save for this too; though, in these changing times, I often wonder...

Any other ideas? Drop me a comment!

Spending

And at last, we come to the final, totally unavoidable and usually most interesting category. It is here that you get to decide what to spend on and how much to spend on. It becomes easiest if you have been regular in noting down your expenses for the last month.

Beginning from today, write down how much money you have spent and how much you have earned for each day of the month. At the end of the month, you will have a fairly accurate idea on the average amount you will need for each expense category. Ideas for spending categories are:

1. Monthly Spends
1. Petrol/Gas/Commute/Transport category
2. Household Purchases/Grocery Shopping category
3. Bills/Services/Utility Payments category
4. Rent/Apartment Payment category
2. Occasional Spends
1. Holiday Gifting - Onam, Christmas, Ramzan...
2. House Maintenance/Repair
3. Vehicle Maintenance/Repair
4. Clothing/Accessories Shopping
5. School Fees/Back-to-School Shopping

Any other ideas? Drop me a comment!

Once that is done, you need to set aside the amount required for each month. And for this, I use the Envelope System.

What is the Envelope System?

This is a method that was devised during the World War II, when people were struggling to make the ends meet. This is how it works. At the beginning of each month, you set aside into one envelope a certain amount to spend on a particular category of expense. And each time you need to spend in that category, you take the amount from that envelope only. If the cash in the envelope runs out before the month is over, then, too bad!, but you don't spend any more in that category until the next month. Harsh? Maybe yes, but during the Depression, this was probably the only way to ensure discipline in spending habits.

I have modified the original method to suit my purposes. So here's my take on this classic method:

Save for the month after next, not for the next month.
Let us assume you are usually paid on the 30th of every month. And you have some mandatory payments on the 2nd of every month.
Scenario 1: This March 30th, you expect to receive the money for the expenses of April. And you have the payment coming up on the April 2nd. For some reason, this month your company was unable to pay you on March 30th and pay day was extended. This puts you in a real fix. You don't have the money for the payment!
Scenario 2:  This March 30th, you expect to receive the money for the expenses of May. And the company announces that pay day is extended. Note that last month, you have already saved for April. So come April 2nd, you already have the money for the mandatory payment. Finally your company pays the salary on Apr 10th. Now you refill your envelope with the money allocated for the month of May, no hurry!

This simple tip ensures that you have the time for a breather at the beginning of the month and are not stressed about delays in pay crediting.

Give, Give, Give
The more you give, the more you'll receive. Have a separate envelope for giving. Set aside a percentage of your monthly income for sharing - I suggest five to ten percent of your income, for starters.

Pay yourself first
Always save before you spend. Have envelopes for saving goals too, especially the short-term ones. You can set up envelopes for all your saving categories. Here are two important ones I have:

1. Fixed Deposit (FD) Envelope 
2. Recurring Deposit (RD) Envelope

All the money saved in the FD envelope go towards the long-term savings. I have a pre-calculated amount that intend to save for each goal. I allocate the certificates among these goals until each goal receives the intended amount.

For purpose of instruction only, consider these long term goals:

Retirement goal - 7 lakh rupees needed

House Purchase - 10 lakh rupees needed

Each month I save 10,000 for FDs. After 5 months, I'd have 50,000 in the envelope. This would be used for a new Term Deposit earmarked for retirement. After another 5 months, I'd have another 50,000 which would be used to begin another Term Deposit earmarked for House Purchase. The process would continue until the desired amount is reached.

It would be handy to keep a list of all the FD certificate numbers and the goals they are allotted to. And, never withdraw the interest. Just let it all accumulate and when the term expires, renew the entire amount for another term. Let all the compounding work its magic! 

All the money saved in the RD envelope go towards the short-term savings. Once established, an RD loop helps in achieving short-term plans. So this is what I call the RD loop.

Why do I use Recurring Deposits/RD Loop?
Every year in January, I begin a new Recurring Deposit (RD) for a time period of five years. RD is a scheme offered by banks, post office etc... in which you deposit a small amount each month and at the end of the tenure, you receive the entire amount plus the interest.

Starting a new RD each year continuously gives a great advantage. Assuming you start in 2005:
Start a new RD in 2005 which matures in 2010.
Start a new RD in 2006 which matures in 2011.
Start a new RD in 2007 which matures in 2012.
Start a new RD in 2008 which matures in 2013.
Start a new RD in 2009 which matures in 2014.
Start a new RD in 2010 which matures in 2015... and so on.
If you keep this up, you are assured of getting a good sized lump sum amount at the beginning of each year from 2010 onward.

You could also have a Gold Savings envelope, Mutual Fund envelope or a Stocks envelope, if you are interested.

Any other ideas? Drop me a comment!

Thrift - The success secret of the millionaire
And I definitely don't mean being miserly, stinginess, penny-pinching etc... I mean being sensible with money, smart-spending, prudence, economizing etc...

Once you begin noting down your monthly expenses, you will be more aware of how much you need in each spending category. Refer to the list mentioned above and have a separate envelope for each one that you need. Put aside the required amount each month into the envelopes and spend from them. Once the amount set aside for a month is over, do not spend any further.

Avoid impulse buying
If you see something online that you desperately need, save it for later. Or bookmark it. Or add it to the cart, but don't complete the purchase. Wait for at least one month. And then go back to decide whether to complete the purchase. Half the time, believe me, you won't want it as badly. 

While shopping, it is imperative to have a shopping list with you. Not just to remind you of all that you need, but also to prevent you from loitering around the aisles piling up stuff in your shopping cart.

Look up this video for an interesting insight on Needs v/s Wants: https://www.youtube.com/watch?v=RjbjaPLa0-g

Go shopping once a week only
Okay, twice a week. Don't go shopping everyday. The less you visit the store, the more stuff you'll have to buy each time. This will automatically prevent unnecessary purchases.

Pay in cash
It is much more difficult to hand over solid money than to swipe a card on a machine.

NEVER EVER USE CREDIT
I quote Dave Ramsey again "Spending money that you don't have to buy stuff that you don't need to impress people you don't like" is a sure-shot way to financial ruin.

A debit card works just as well and will never let you use money-you-don't-have. Cut up those credit cards. They are not doing anything good for you at all. Look up this video on Credit and Debt: https://www.youtube.com/watch?v=88bCYyLAx3A


Managing the envelopes every month

Let us go back to our hypothetical example. It is March 10th and you have received the salary for this month. Remember you are allocating for May now. On the Commute envelope, mark May 2015 and put the amount reserved for Commute category inside. Behind the envelope write down the date, the amount put in and the balance (Use this template).

March moves on and so does April. It is now May and you need to fill up on petrol tomorrow. So take out say 1/4 the amount allotted for each month and cross out 1/4 of the writing ( like this: May 2015). Behind the envelope write dow  n the date, the amount taken out and the balance.Crossing the month off helps to ensure you don't overspend during the month and take over the amount kept away for the next month.

Next time you need to use more from this envelope during May, take out another 1/4 ( i.e. now half of the amount for the month of May is used up) and cross out half of the month (like this: May 2015). And remember to write down the date, amount and balance behind the envelope.

This is how your envelope should look like at the before mentioned date - with half of May money used up and the Aug money still in reserve:
Jan 2015
Feb 2015
Mar 2015
April 2015
May 2015
Aug 2015

Note that during the month of Feb 2015, you were able to save half the amount allotted.

Let me also direct you to the following link in which Dave Ramsey talks about how you should save, spend and invest during different stages of your life.
http://www.daveramsey.com/blog/your-age-your-money-how-to-spend-save-invest-now

Cheat Sheet:

1. Every single rupee of your income must be accounted for and allotted for a specific purpose
2. Build up an emergency fund first 
3. Every month, first set aside money in the Share Envelope 
4. Next fill up the Settlement Envelopes - Eliminate this category as soon as you can
5. Then fill up the Save Envelopes - For long-term investments, look towards Mutual Funds or Stocks or Fixed Deposits
6. Lastly fill up the Spend Envelopes
7. Always save for the month after next - Do yourself that favor!
8. Be prudent while spending. Mull over big-time purchases for at least one whole month
9. Always use cash
10. NO CREDIT CARDS - Use debit cards, if you must

Thank you for visiting Random Writez ...  

Varsha