A household budget is the heart of an effective financial plan, says Alex Lucas, Vice-President, Product and Marketing, Manulife Bank & Trust. It is the tool for understanding what you can afford today and where you are going in the long term. A good budget provides a framework for making choices. Here are some tips that can help you with your household budget.
1. Figure out what you’re spending your money on.
The first step is pretty straightforward. How much money are you spending and where is it all going? Determine how much you have coming in and going out in the average month. Group your expenses into high-level categories like mortgage/housing, groceries, entertainment, etc.
2. Separate discretionary and fixed spending.
Some expenses are necessary and difficult to reduce beyond a certain point, such as public transit, water, electricity, Internet, rent or mortgage and groceries. Other expenses are discretionary, and based on choices you make - including vacations, dining out and other forms of entertainment. It is in discretionary spending that people make their key choices. This is where the practical decisions can be made.
3. Know how much you are saving.
One of the key reasons for having a budget is to identify how much you’re saving now and to determine if that level of saving will allow you to achieve your longer-term financial goals. Without an understanding of how much you’re saving and what your needs are in the long term, it’s hard to know if you’re saving enough. Savings are at the core of a household budget. The percentage to save depends on individual preferences, income and age. The concept of saving should also include paying down debt, since people typically pay a higher interest rate on their debt than they earn in a savings account. Ensuring you aren’t carrying expensive debt like credit card balances, is another way to save money.
4. Know when you are making tradeoffs between short-term and long-term goals.
A common mistake is that people look at only the short term or only long term - and so don’t know when they are making trade-offs. You should have a sense of both and be realistic about the impact of immediate wishes on your aspirations down the road - such as the age of retirement and lifestyle in retirement. For example, vacations can range widely in their financial cost and, depending on how elaborate and expensive you want those vacations to be, can affect how much money you’re able to save for retirement. Other common short-term decisions that can impact long-term goals are buying a car or more everyday preferences like how much you spend eating out. There’s no right or wrong, but it’s important that people identify all their goals and understand how they’re making their budgeting decisions.
5. Talk to a financial advisor.
Financial advisors have the qualifications, experience and tools to help people determine whether they are on track to meet their long-term goals. Some people find it hard to be realistic about the progress they are making - so when you talk to an advisor look for one who is able to help with budgeting and tracks net worth as part of your plan. That will ensure you are monitoring both your savings and level of debt. The discipline of reviewing your overall finances annually will help you identify if your budget is working for you. When circumstances change, a financial advisor can help you determine how to adjust your budget and understand the impact to short-term and long-term goals.
6. Make building net worth your long-term goal.
The difference between your assets and your debts is your net worth – and your net worth supports your retirement. You need to be monitoring both sides of the household balance sheet. If you focus only on savings and investments but ignore your debt, you may have a false sense of your progress. You need to regularly check that your household debt is where you expected it to be.
7. Review your budget annually.
When sitting down with a financial advisor, the usual process is to go over what happened with your savings, investments and debt over the past year, look at the goals you’ve set, and discuss whether things are progressing the way you expected them to. The more you allocate to savings or paying down debt, the faster your net worth will grow. Your review should clearly identify whether your net worth has grown as expected and what adjustments to your budget may be required.
8. Reduce debt over time.
Debt in itself is not bad. It can be a cost-efficient way for people to purchase houses or cars, improve their standard of living and build wealth over time. Think about it as being similar to investments: Just as people have an expectation of how much their investments will go up over time, they should have a similar expectation of how their debt will go down over time.
9. Track spending closely if you’re not progressing toward your goals.
Should you mark down everything you spend? Not necessarily. The important thing is to have an overall sense of how you’re allocating your money to discretionary and long-term financial goals. However, detailed tracking is valuable if you want to get a clearer understanding of how to maximize the money you have available for other goals. A detailed analysis is typically only needed when somebody wants to dig more deeply into their spending habits and find opportunities for additional money to put toward their goals.
10. Plan for unexpected expenses or risks to the household budget.
Everyone gets hit by expenses they didn’t plan for. A house or car repair, sometimes an unexpected life event or illness. The place of insurance in a household budget is an individual matter. Talk with a financial advisor to understand risks to your household and define the policies that fit your household’s circumstances. One of the goals in your financial plan should relate to mitigating some of these risks to your household budget. A good financial plan takes into account your short- and long-term goals, growth of investments, your net-worth growth and the risks to your plan.