Budgeting is one of the cornerstones of a solid financial plan because its essentially the planning, tracking, and managing of your short-term finances. When it comes to budgeting, there are many ways to do it but the purpose is the same - knowing how much you are spending on what.

While I contend that all the deadly sins are equally deadly, I think that failing to budget is primus inter pares, or first among equals. If you were to commit all others but avoid one, this would be the one to avoid.

And with that, our third deadly sin of personal finance is…

Failing To Budget

Failing to budget can be one of the most damaging things you can do to your personal finances. Without a clear picture of how much you’re spending and on what, you’re basically wandering the forest at night without a flashlight. You might know that you want to buy a house in five years, but without an accurate figure of how much you’re spending or saving, you really have no idea whether that goal is even feasible. If it is feasible, you have no idea how much you should saving towards that goal. A budget gives you that accurate snapshot and it’s one of the reasons why an income statement, which lists expenses, is a crucial financial statement for a company.

You can’t improve what you aren’t tracking. You should always be trying to lower your expenses while maintaining the same standard of living. If you frequently shop at a particular store, it’s smart to try to find coupons so you get the same for less. If you like a particular food or drink, it pays to test out cheaper alternatives to see if you can tell the difference. Where you save in one area, you can then splurge in another. With a budget, you can tell where you stand the greatest chance of improvement. You may discover patterns you didn’t know beforehand.

You will automatically improve just by tracking. When I started working full-time, I had a budget where I tracked every expense to the penny. By virtue of doing that, my actions were affected by even recording the expense. I knew of times when I packed a lunch because my dining out expenses were nearing artificial milestones like $50 that month or $100. There was one time I thought about buying a new pair of jeans but stopped myself because I hadn’t spent money on clothes that month. Since I was nearing the end of the month, I figured I’d buy it next month (I never did until much later).

Budgets help you make informed decisions. With a budget and an accurate picture of your spending, you can make an informed decision. If you know you have slack in the budget, you can enjoy yourself more knowing that you’re safe. Friends planning a vacation next month? You can happily agree to go without guilt or concern if you know your budget can handle it. How long will it take for you to build up your emergency fund? With a budget, you now know.

After a few months of budgeting, it’s okay to slack off and not track as diligently. Once you have an accurate picture, you simply need to adjust it to changes in your life. But every once and a while, track expenses for a week or two just to see that there haven’t been any big changes.

One of the interesting discussions that came out of the Personal Finance Blogger’s Conference in San Francisco was a discussion of how people budget and some of the budgeting styles. While we didn’t explicitly go over some of the more common budgeting systems, I felt it would be useful if I hit on a few to see where their benefits and drawbacks are.

Personally, I did the Track to the Penny system for a few months until I got a good handle on my monthly expenditures, then I essentially did the Reverse Budgeting/Nothing strategy. In between the two systems, I reviewed my expenditures to see where my spending was going and whether I could make some improvements. I saw that I was eating out far too often, a detriment to both my wallet and my health, so I took steps to start buying more groceries and preparing lunch more often.

Envelope Budgeting

The appeal of envelope budgeting is in its simplicity, though there are plenty of tools out there that will gladly make it more complicated for you if you’d like. The system relies on a series of envelopes, hence its name, to budget and each envelope contains a fixed amount of money for that expense. An example would be an envelope for groceries, where all grocery expenditures would come from that envelope. If an envelope is depleted, the funds must come from another envelope in the system.
Benefits: Simple to use, intuitive, and fixes your expenditures at a certain amount. In monthly reviews, you can see which envelopes are consistently non-zero and use that to adjust your budget.
Drawbacks: Cannot handle large emergencies, as a big emergency could break the bank. Limits the number of categories you can track, unless you have a million envelopes, and is less flexible in our credit-happy age.

Reverse Budgeting

Reverse budgeting is the idea that you save first, then spend the rest. This system is a back-ended system in which you force the savings, thus guaranteeing it, and then let the chips fall where they may on expenditures. By auto-drafting these savings out of an account, you essentially guarantee you won’t “accidentally” spend them away. An example of this would be if you set your 401(k) contributions ahead of time to draft from your paycheck and then let your spending go where it goes.
Benefits: Simplest process of them all, simply save and then you can spend from one big envelope.
Drawbacks: Lacks visibility into expense types for expenditure improvement, doesn’t force you to have the “budget discussion.”

Tracking to the Penny

With “Track to the Penny” budgeting, you track every single expenditure you make into a giant spreadsheet as you make it or in batches at the end of the day. You can then use this information to make future decisions about spending and this helps you identify “budget leaks,” or those small expenditures you don’t think about but end up costing you a lot each month.
Benefits: Total visibility into your spending, tremendous amount of information, a statistician’s wet dream.
Drawbacks: Most labor intensive, may give too much visibility, easiest to discard because of time requirements, relies on your ability to correctly categorize spending. This also doesn’t force a “budget discussion” but does provide good information for the budget discussion later on.

Tracking to the Dollar

Similar to Track to the Penny, Track to the Dollar just means you can round up or down each expenditure to the nearest dollar with the belief that it will all average out.
Benefits: A little less visibility compared to “Tracking to the Penny” but still a statistician’s wet dream.
Drawbacks: Still requires a lot of labor to keep track of incremental expenses, but less so than Tracking to the Penny.

Nothing

Not budgeting is a budgeting system but it requires that you have an income that comfortably exceeds your expenses and probably not a good place to start. In our discussions, SVB mentioned a “black box,” referring to the budget, where she said that once you get a good handle on your budget you really don’t need to track it anymore. JD then said that budgeting is most valuable when your income and expense lines are very close… it’s less valuable once your income exceeds your expenses.
Benefits: It’s the easiest “system” because you do nothing!
Drawbacks: You get no visibility into your expenditures because you’re not tracking anything!

How do you budget? Do you have a good system in place that you want to share?

(Photo by Keen)

Budgets are great, they keep you in line and they help you reach the goals that you’ve set for yourself and your family. The thing is, there’s a point when the budget stops being a means to an end and they start dominating your life… and that’s when you start tracking things to the penny. Listen, if you’re going to budget, experts advise that you track everything but I’m going to give you a few reasons why you should track to the dollar and not down to every last cent.

This particular DA is a little weak in the sense that the “conventional wisdom” aspect, budgeting to the penny, isn’t something that everyone thinks you should do but merely the default approach towards budgeting. Personally I do not budget (anymore), but when I did I budgeted to the penny and felt that technique was a little restrictive. I eventually stopped in part because of reason one. So, in this respect, I am truly the Devil’s Advocate and not merely playing the role for grins and giggles.

If It’s Hard, You’re Less Likely To Keep It Up
Let’s be honest, no one likes to budget in the first place because no one wants to feel like they have to track every single thing that they do because it takes the actual fun out of doing it. Going to the movies becomes “watch a movie, oh yeah I have to put $9.50 in my budget,” and you get a little bit away from the enjoyment of the movie. Also, if you have to track every last penny every single time, you’re probably going to put it off… and put it off… and then maybe not even track it at all! You want to put as few roadblocks in the way of you and your goal, of saving money to do X or pay for Y, and tracking to the penny is a headache that is a potential roadblock.

That Level of Visibility Not Necessary or Useful
$1.05 or $1? $50.87 or $51? Let’s be honest, when it comes to your budget, tracking to the penny really doesn’t get you all that much. Depending on how you opt to do the rounding, at the absolute maximum your budget will be off by the number of transactions you have; on average, you’ll be pretty close to your actual budget. If you always round up, you’ll be off but never short, which isn’t that bad when it comes to budgeting because you’ll “find” money at the end of the month. Unless you enjoy tracking down to the penny (and there are certainly folks who do and there’s absolutely nothing wrong with that), you can see how it doesn’t get you all that much more given the added effort.

That’s Not The Point
The purpose of budgeting is to track your expenses so you know how much you’re spending and what you’re spending it on. If you’re the type of person who blows their whole paycheck and has no idea where it went, budgeting is for you. If you’re trying to find places in your spending to trim the fat in order to pay off debt or save for something, then budgeting is for you. If you just want to keep an accurate picture of where you are, then budgeting is for you. In all three scenarios, tracking down to the penny is absolutely irrelevant and likely to derail your attempts to budget. Getting “close enough,” that is within fifty cents for each transaction or any of the other rounding tricks, is good enough and likely to keep you at budgeting a while longer.

I know there are a lot of readers who budget, so please share your strategies (down to the penny? round up? round down? keep a notebook? anything you want to share!) so we can all learn!