"When you use the term "budget" when speaking to most people, they automatically assume that you don't have much money. The people who feel this way lack a basic understanding of both economics and personal finance."
In this chapter I will explain to you why a budget is one the most powerful financial weapons you can have in your arsenal. In this chapter I will also show you how a budget can be used to help you gain financial independence. Before I can do this, it is first important for me to go over the definition of a budget. In finance, a budget is defined as "a list of purchases, expenses, and revenues which are planned." The concept of a budget is extremely important in fields such as microeconomics, and by using it; you will be capable of balancing the trade offs between various goods and services. Like inflation, while many people have heard of the term budget, they don't truly understand what it means or how to use it. One popular expression that you might hear people use frequently is "being on a budget," or "I'm on a budget." When many people hear these expressions, they tend to assume that you don't have a lot of money, since you apparently only have so much to spend on a given item. In reality, this is a fallacy. Both billion dollar corporations and governments have budgets, and they are far from being "poor." When you have a budget, you simply have a plan for how you will purchase various goods and services.
Budgeting is extremely important, because planning is the key to financial independence. Many people are broke or in debt precisely because they don't have a well defined budget. When they go to the store to buy food, they don't know "exactly" how much they will pay. When they go out to buy clothes, electronics, or other goods, they don't have a detailed plan for how much they will spend. If you conduct your finances without a well defined budget, the chances of you gaining financial independence are quite low.
The reason for this is because no matter how much money you have, or how much money you make, your resources are limited. There is not a person or organization on planet Earth who has unlimited financial resources. The wealthiest billionaires and millionaires could become broke quickly if they purchased goods and services at a rate which was beyond the amount they earned or saved within a given period of time. As an example, while Donald Trump is one of the wealthiest men in the world, he would push himself into bankruptcy if he attempted to purchase the Palace of Versailles (which has an
estimated value of between $13 and $300 billion dollars, while Donald "only" is worth a mere $2.0 billion in comparison).
Whether or not Donald Trump wants to purchase the Palace of Versailles is irrelevant. What matters is that he couldn't because he simply doesn't have enough resources to do so. If you wish to become financially independent, you must realize what your resources can and cannot buy. If you wish to purchase something, but the item or service you want to purchase is beyond your budget, you must accept the fact that you can't have it, no matter how much you want it.
If you wish to become financially independent, the only way you can get something that is beyond your budget is to save for it or increase your income. While borrowing money is the strategy most people use, it is a strategy that leads to debt and economic slavery. The banks and lending companies prey on people's desire to "have something now," even if their budget can't afford it. The banks and credit card companies make it easy for people to borrow money for every little thing, and this is what leads to a life of economic slavery. While there are many different types of budgets, in this chapter I will focus on
the personal budget.
Creating Your Personal Budget
To create your personal budget, you must first sit down and analyze your income, expenses, current savings, and savings rate. Your income is the money you make each month, and your expenses are the different bills and purchases you pay for out of your income. Your current savings are the amount of money you "have" in your possession, which is different from your income, which is the money you make. Your savings rate is the amount of money you save each month. If you spend more than you save, you have a negative savings rate. If you save more than you spend, you will have a positive savings rate, and if your savings balances your spending, you are said to be a in a state of
"equilibrium.”
As I have showed in this book, most Americans have a negative savings rate, and statistics from the U.S. government show the same thing. Therefore, your goal should be to gain a positive savings rate, because this allows you to become financially independent. After you've sat down and analyzed your income, expenses, savings, and savings rate, you will be able to determine your own financial situation. If you are like most people, and your savings rate is negative, or you're not saving 30 to 50% of your
income, you need to make adjustments’.
The good thing about a personal budget is that it is both flexible and simple. If you see that you have too many expenses, and these expenses are causing you to have a negative savings rate, you need to get rid of some of them. This is where trade offs will need to be made. You may need to get rid of some expenses, even those that you like, in order to give you a positive savings rate. Since I have talked about how to do this throughout most of this book, I won't dwell on it here, and you will want to go reread previous chapters on this.
Each person is different, and what works for one person may not work for another. However, a budget is a tool that everyone should use. Despite this, a budget can be challenging for people who have irregular incomes. A good example of this is an entrepreneur, or anyone who makes money based on commission. If you're in this field, your income will vary from one period to another. While you may sometimes have good months, other months may not be as good. If you're in this situation, you will need to adjust your budget on a monthly basis, at least until your income becomes more stable. However, if you have an irregular income, it is very important for you to keep your expenses as low as comfortably possible. This will keep you from overspending. If you have an irregular income, it is extremely important for you to follow the rules in this book. If your income is irregular, it doesn't make much sense to have a bunch of expenses which keep you from saving money, especially if you aren't guaranteed a paycheck next week. Also, no budget will ever be 100% accurate. The reason for this is because spending and the cost of goods tend to fluctuate, so to be on the safe side, you want to keep your expenses 10% less than any amount you list for them in your budget. A budget is powerful because it allows you to keep iron clad control over your finances. Most people have a negative view of budgets, and this is precisely why many of them are broke and in debt. They would rather spend money whenever they feel like it, instead of looking over their income, savings, and expenses to determine if they can afford it. When you create a budget, it is important for you to keep it simple. Avoid making it complex at all costs. Studies have shown that when people create complex budgets, they are less likely to follow them. Even if you have a steady income, your needs will change from month to month, so you must be able to adapt your budget to meet these needs. One important rule
of thumb that you should follow is that only 25% of your monthly budget should go towards housing.
This means that if you make $2000 per month from a job, and your monthly rent is $800, your rent is too high, because it is 40% of your monthly income rather than 25%. If you wish to begin saving money to put yourself on the path of financial independence, you should find a place where your rent is $500, or 25% of your monthly income. If you are living in a large city such as New York or Boston, this rule may be difficult to follow, and if you fall under this category, you will have the following options available to you:
1. Get roommates to reduce the cost of your housing.
2. Continue to pay for higher housing costs alone, but reduce your budget in other areas, such as eating out or entertainment.
3. Move to a place which has a better balance of income and housing costs.
While the needs of each person will vary, the categories of a budget will generally be broken down into the following categories below. As you get older and become more educated, your income is expected to increase. As your income increases, you can allocate more money to the various categories below. Such is the power of a budget when followed. It allows you to keep full control over your personal finances, while working your way towards financial independence at the same time. The budget should be broken down into:
1. Retirement: This is the money set aside for when you want to retire.
2. Savings for the Long Term: This is money placed aside for large purchases such as houses, cars, etc.
3. Irregular Expenses: This is the money for expenses that don't occur frequently, such as car repairs, vacations, etc.
4. Play Money: This is the money that you reserve for play and entertainment.
5. Regular Expenses: These are the things you need to function, such as food, shelter, clothing, etc.
If you've made the mistake of putting yourself in debt, I advise you to take a portion of the money you save for retirement and apply it towards these debts. Generally, you should allocate about 20% of the money for this purpose. In Finance Wars, I've shown you how to save from between 30% to 50% of your annual income, and if you follow this rule, you will want to divide up your savings between all the categories listed above. Another rule of thumb is to keep your regular expenses as low as possible.
Keeping your regular expenses as low as possible is important for a number of reasons. First, these tend to be the highest expenses you'll pay for on a monthly basis, which I've discussed in previous chapters. Second, these are the expenses which are most affected by inflation. During periods of high inflation, your food, energy, and housing will increase the most in value. It is for this reason that you want to keep these expenses in check, and pay as little for them as you can. Another reason why you want to reduce these expenses is because doing so will increase the money you have in the other categories of your budget.
When you have a large surplus of money available in the other categories of your budget, you have what I call "liquidity." You have the "seeds" which could set the stage for you becoming financially independent. As you read this book, I don't want you to believe that becoming financially independent is only a long term strategy. While your retirement and long term savings are very important, once you have liquidity due to decreasing your regular expenses as much as possible, you will be able to begin investing in opportunities that could potentially increase your income, and therefore your savings. The more expenses you have, the harder it is for you to start a business, or invest in your education. When it is harder for you to invest in a business or your education, it is harder for you to become wealthier, or set yourself up to become financially independent. This is precisely why I'm against having so many living expenses in this book. These things drag you down, and stop you from ever becoming wealthy. Instead of you becoming wealthy, other people become wealthy, namely those you pay your bills to. By reducing the amount of money you pay to bill collectors, you have liquidity which allows you to begin
investing in things you want.
One good example of this is James Sun, the founder of Zoodango, a social networking site. You may know him from the sixth season of the popular reality show The Apprentice (my favorite reality show by the way). Even though James did not win the grand prize of a $250,000 per year job with Donald Trump, he did something in my opinion that was even more remarkable. While studying at the University of Washington at the age of 18, he took $5,000 he had saved and placed it in an investment fund. By the age of 23 this $5,000 had turned into $2 million dollars! This is quite a return on an investment, to say the least!
Why is this so important? The reason for this is because James Sun took money that he "had" and invested it into his business, and became financially independent because of it. He is only one of the many successful people that took money they had, and instead of spending it on products and services that have little value, invested it into something that gave them a huge return on their investment. You can do the same thing, but to do this, you must be able to free up your money and get rid of expenses you don't need. To most Americans, $5,000 is a lot of money, and not an amount they would be willing to risk on an investment that could fail.
While I don't believe you should put all your eggs in one basket, imagine if you followed all the rules and guidelines in this book. Imagine if you make $33,000 per year (about what the average American makes), and make it your goal to save 30%. In two short years, you would have $19800. Now, imagine if you took only $5,000 of this money, and invested in a business that brought you back $2 million. Even if the idea was to completely flop, and you lost the $5,000, you would still have $14,800 left over, more than most people in your income bracket. You would not be broke or in debt and most importantly, because you’re now saving 30% of your income, it wouldn't take you long to put that $5,000 back in the bank. Since your living expenses are low, and it wouldn't take you long to recover the money you lost, you could afford to invest in yet another venture. This is yet another chance in which you could become successful, and eventually, if you don't give up, one of your ideas will be a success.
To put yourself in a position where you can invest in your education or business, you must gain liquidity. To gain liquidity, you must create a powerful personal budget. There are two types of people in this world:
1. Those who want to work for others, and
2. Those who want to work for themselves and have others work for them.
If you're going to work for someone else, you should work at a job that gives you a great salary and benefits and not some dead end job that you could lose tomorrow. But to get these jobs, you generally have to be educated or have technical skills, and getting this education costs money. No matter how you look at it, if you want to succeed in life, whether with a business or a high paying job, saving money and maintaining a sound budget is something that can allow you to achieve this goal. I would next like to talk about a phenomenon that I will refer to as a Budget Bust.
A Budget Bust is when you are suddenly hit with an expense that goes beyond your budget. No matter how skilled you are with your personal finances, a Budget Bust will happen every so often. Depending on the severity of it, you may be required to dig into your savings. If you don't have any savings, a Budget Bust could also put you in debt. Some examples of expenses which could cause a Budget Bust include car repair bills, medical bills, or similar expenses. While a Budget Bust could occur in a number of different forms, it tends to have a few similarities. Some of these similarities are:
1. It comes as a surprise. It is an expense that you didn't expect.
2. Though it is an irregular expense, it is abnormally expensive.
3. The cost of such an expense tends of take up a sizeable percentage of your monthly income.
While it is impossible for you to avoid Budget Busts completely, there are a number of things you can do to greatly decrease the likelihood of them happening, or make them less of a shock when they do occur. Some of these things are:
1. Saving a large percentage of your income so you won't be pushed into debt if a Budget Bust occurs.
2. Simplify your life by getting rid of expenses you don't need.
3. Reducing your spending in other areas if a Budget Bust does occur.
By following these three guidelines, you will be well protected in the event that a Budget Bust occurs. Another variation of the Budget Bust which exists is one I will call "The Self Directed Budget Bust." This is a scenario in which you choose to spend beyond your budget, and there are no surprises. While a Self Directed Budget Bust is better than a Budget Bust since you control it, I generally advise you to avoid these most of the time, since they can impact your ability to save money.
There are times when a Self Directed Budget Bust can be a good thing, such as when you go on vacation. Generally, if you take a vacation, especially to an international destination, the cost of your vacation may often exceed that of your monthly income. However, since most people only take one vacation per year, this should not impact your ability to save money. Even then, you should be cautious when planning your vacation, and not go overboard. Perhaps the hardest part of using a budget successfully is following it. This is where many people fail. They simply lack the discipline or determination to follow it, and even after taking the time to create the budget, they fail when it comes to actually using it. Following your budget is a very important part of becoming financially independent. Too often, many people overlook the power of a solid budget. Many books on personal
finance fail to mention it. As I said earlier in this chapter, one reason for this could be the negative connotations that are associated with a budget. Because so many people are ignorant of finance and economics, they've been led to believe that "being on a budget" means "being poor."
However, when you consider the fact that billion dollar corporations have budgets, it becomes easy to see why such a viewpoint is ridiculous. If you follow your budget carefully, you will stay out of debt and build wealth at the same time. When you know how much you make, what your expenses are, and how much you can spend on any goods or services, you become less likely to put yourself in debt to pay for something that is beyond your budget. Like saving money itself, maintaining and following a sound budget is one of the poisons which kills or alleviates debt, and it allows you to become a master of your financial future. If you have a negative view of a budget, I urge you to get rid of this view, for I feel that society plays a role in why people feel this way. In a society based on credit and debt, where big spending is encouraged, it becomes easy to see why so many people roll their eyes when you talk about a budget. However, "those in the know" realize that a budget is an irresistible weapon that should be an important part of your financial arsenal. In fact, I would go as far as to say that a budget "is the sibling of saving money" since both are so closely related. These two financial tools compliment each other very well. However, there is a phenomenon at play in our society that can stop you from following a budget, and thus saving money. It is a phenomenon that is heavily advertised in the media, and if you can't see past it, the chances of you becoming financially independent are very low. Can you guess what this phenomenon is? The answer is Conspicuous Consumption, and I will talk more about it in the next chapter. This phenomenon is one of the key reasons why many people will never obtain financial independence, and will always live "behind the 8 ball," in debt to lenders and banks.