Many of us fail to see the relationship between budgeting
and saving. Budgeting is a process that starts by setting spending targets that help you to stay within your means. A personal budget
is useful in controlling personal expenses.
Reasons for having a personal budget usually change over time. In our 20s, we focus on repaying debts or saving for a down payment on a home. We may want to budget in order to set aside several thousand dollars for a trip around the world. In our 30s and 40s, budgeting is important to help pay for our children's living and college expenses. By the time we enter our 50s, saving for retirement becomes a major financial goal
Budgeting is the cornerstone of saving. No personal budget often means an inability or unwillingness to identify a potential source of regular savings. A personal budget imposes some discipline on adhering to a savings plan
Some important steps in setting up a personal budget include:
Select a period to measure. A monthly budget often works best. Most of us pay our rent, mortgage, and utility bills monthly. It is also the period that many of us get paid. If you are paid every two weeks, you can add the amounts to determine a monthly figure.
Calculate net cash flow for the period.
Your personal net cash flow
subtracts your cash expenses (cash outflows
) from you cash income (cash inflows
). If you charge with your credit card, add those charges to your cash expenses. Using your credit card is only a means of postponing cash outflows. While you're at it, be sure to add the little items, like those $4 lattes and video store trips. These items easily add up to $100 or more in a month.
Accurate records will help you to keep a history of several budgeting periods. You can string together 12 months of budgets to create an annual budget. You can use your budget records to compare actual and budgeted spending. The differences in actual and budgeted spending are called variances
. Be as precise in your record keeping as you can afford to be.
Monitor and review. Your records help you to compare how well you budget. The key is to identify positive budget varianceswhere your budgeted cash outflows are less than your actual cash outflows. These variances are a source of funds to save and invest. For example, if you budget $1,500 in monthly cash outflows but routinely only have cash outflows of $1,400, you have identified a source of savings worth $100 a month.
Save for an emergency fund.
As you gradually find you can save each month, you may want to first set aside enough for an emergency fund
. An emergency fund consists of three to six months of savings. An emergency fund is also called a rainy-day fund and should be used only to pay for unanticipated financial setbacks. These setbacks may include losing a job, becoming ill, or suffering the death of a family member.
A personal budget may have led you to identify a way to save $100 a month. Investing this extra $100 every month lets you take advantage of dollar-cost averaging
. Dollar-cost averaging is a basic principle of investing. Studies consistently show that, over time, dollar-cost averaging buys shares at a cheaper price than if you attempted to time your purchases. In addition, your regular contributions fuel the compounded
growth of your investments.
The six tables, below, show how even amounts of as little as $25 or $50 can grow if invested every month. Investment horizons range from one to 30 years. Interest rates range from 5% to 8%. For example, $50 invested at 5% every month for the next five years will grow to $3,400.
The tables also illustrate the benefit of compounding
. For example, $25 invested for five years at 8% grows to $1,837. However, $25 invested for 10 years at 8% grows to $4,574. This is an extra $900 of compounded interest that you earn during those five years.
Since your emergency fund serves a vital purpose, you want to have access to the funds. At the same time, you want to earn interest on these funds. As a result, you should plan to invest it in only the most liquid
and safest of investments. These investments include CDs
, savings deposits, and
money market accounts
. All of these instruments are insured by the FDIC
for up to $100,000 per depositor per institution. Money market mutual funds
are not guaranteed by the FDIC. However, money market funds seldom drop in value because of the high quality of their investments.
An effective investing technique for your emergency fund is laddering
. First, you divide your investments into roughly equal amounts. Next, you deposit these amounts in short-term CDs of different maturities
. The length of maturity terms should be spaced at intervals that don't jeopardize your access to at least some of your emergency fund at any given time.
For example, you may wish to divide $4,000 of a $5,000 fund into four equal parts, keeping $1,000 in an account you can access immediately. Next, you may consider investing $1,000 each in a 3-, 6-, 9-, and 12-month CD. As each CD matures, you extend, or roll over
, the CD for one year. This allows you to establish a stream of CD investments that mature every three months. If you ever need more than $1,000 of your fund, the longest you would have to wait (unless you paid a fee for early redemption
) would be three months.