Recovery from Financial Disaster

Ever wonder how you’d handle a complete reversal of your finances? I have a friend who had a lifestyle most people would envy and lost everything, including her marriage. I didn’t meet her until after her recovery from her financial disaster. She is one of the most resilient, generous people I know and was kind enough to let me interview her about the changes in her life, the financial lessons she learned and her advice to you on how to avoid finding yourself in a similar situation.

The High Life

“My life was very plentiful with many material objects.

  • 6,000+ square foot custom designed home – 6 bedrooms, 5 bathrooms and two full kitchens
  • Photography and recording studios
  • In ground swimming pool
  • Custom designed furniture
  • Six cars
  • Trips
  • Private education for both kids
  • Entertainment

I never priced groceries, just grab and dash.  We belonged to a private country club as well.  We also had an investment property that we rented to a family member.”

Tell Me about Your Finances

“I did not think of my financial future.  I was in my mid to late 40s and I thought the gravy train would never stop.  We had many investments, 401(k) and IRA retirement accounts for us as well as the children.  My husband was a very successful stock broker, financial planner and money management specialist. We had a dual income, and mine paid for the cream on the top.”

What Happened?

“The stock market along with the real estate market became very soft in 2007.  When I began to notice that these change were imminent, I suggested that we liquidate assets into a strong cash position.  My husband dismissed my thoughts on this topic because I had never been persistent in being a co-manager of our funds.  The economy was showing its ugly powerful head and so was our 40-year marriage.

Things went from bad to worse.  We lost our home. Instead of getting money from the buyer when we sold our house, we had to come to closing with a six-figure check to pay off the mortgage balance (because we owed more than we got for the house). Otherwise, we would have had to negotiate a short sale with the holders of the loan on the house to try to get them to accept only the amount for which we sold it, but chose to close in a traditional manner due to a prideful attitude that made no sense at all.

We divorced.  The money, the investments and the lifestyle were gone.  I was 59 years old. Our children were grown and gone.  Thank God they had their educations!”

What Did You Do?

“I moved into a house with five other people to secure a reasonable rent of $600 a month.  I rolled up my sleeves and decided to re-invent myself as a strong salesperson with a steady stream of income.  As part of creating a fiscally responsible lifestyle, I consolidated my debt and made a conscious effort to understand my taxes and my expenses.  These changes allowed me to pay off the tax liability for which I was half responsible after the divorce.”

What is Your Life like Now?

“My lifestyle now is very simple.

  • I use one credit card.
  • If I can’t afford something, I don’t buy it.
  • I shop at thrift stores, make curtains, paint, have learned some electrical skills and can do just about anything.

Having made the financial changes, I now have the opportunity to travel. I have investments and simple monthly debt. My credit score is very high and I am able to contribute to my savings account and an IRA on a regular basis.”

What Advice Do You Have?

“I learned these financial lessons that might help your readers:

  • Always know your cash position whether or not you are wealthy.
  • Have a good grasp on your finances.  Knowledge is power.
  • Cash is king.
  • Know your financial position at all times.
  • Stay away from credit cards and their incredible interest rates.
  • Save and keep adding to your retirement.”

Closing Thoughts from Susie Q

You’ll notice that my friend’s financial lessons learned are similar to themes you’ve seen in posts I’ve written, especially in the post on advice we gave our kids.

Her story, though, provides real-life insights into why these actions are so important.

You’d never know if you met my friend now that she had to make such a long recovery from financial disaster. She is always upbeat, willing to lend a hand and a great motivator. In fact, she contributed to the initial costs of this blog because she was so thrilled that I am willing to share my knowledge with others to help them be financially literate. I hope I am as resilient as she is if I ever face an equally daunting challenge.

Retirement Savings: How Much Do You Need

Retirement Savings

Retiring is one of the riskiest financial decisions you will make. On the day you retire, you can calculate your net worth. You won’t know, however, how much retirement savings you need because you don’t know:

  • how much you will actually spend on day-to-day expenses
  • how much those expenses will be impacted by inflation
  • whether you’ll have significant medical or other expenses
  • how long you will live or
  • what returns you will earn on your investments.

I retired a little over a year ago and realized that, even though I have a lot of money saved, it wasn’t enough to give me confidence we wouldn’t run out.  I took on a large consulting project to help cover our expenses for the next year or two. Researching this post, though, added even more confidence as we have more than enough to meet some of the simple rules of thumb.   We will see what happens.

In this post, I’ll provide some insights about how to think about a target you might want to set for your retirement savings.  As a follow up, I’ll talk about how much you need to save to meet your retirement savings goal in this post.

4% Rule and Multiply by 25 Rule

As I checked to see what others were saying on this topic, I found a very common theme for determining how much you need to save for retirement.  In some places, it was called the 4% Rule and, in others, the Multiply by 25 Rule.  Being the math geek that I am, my first thought was that 4% = 1/25 so they are the same thing!  It turns out that, in the nitty gritty details, the Multiply by 25 Rule is intended to tell you how much you need to have available on the day you retire while the 4% Rule guides you in how much you can spend in your first year of retirement.  Nonetheless, as explained below, they both result in the same amount needed in savings on your retirement date.

4% Rule for Retirement Spending

The 4% rule is intended to tell you how much you can spend from your retirement savings each year.  Let’s say you have $1,000,000 in invested assets when you retire.  It says you can spend 4% of that amount or $40,000 (including all of your expenses and taxes) in your first year of retirement.  In each subsequent year of your retirement, you can spend $40,000 increased for the cumulative impact of inflation since you retired.   The 4% Rule assumes that you are invested 50% in stocks and 50% in bonds.

4% Rule Illustration

The graph below shows the amount you can spend each year (blue bars which use the left axis scale) and the amount you’ll have remaining at each age (red line which uses the right axis scale) if you retire at 65, inflation is 3% per year, bonds earn 2.5% and stocks earn 7% annually. These assumptions are similar to long-term average assumptions that are common these days.

As you can see, in this scenario, the amount you can spend increases from $40,000 when you are 65 to almost $100,000 a year when you are 95 solely due to inflation. In the first few years, your spending is less than your investment returns, so your savings increases.  After you turn 72, your savings exceeds your investment returns so your savings starts to decrease.

4% Rule Background

The 4% rule was developed by William Bengen and is presented in detail in a 1994 study published in the Journal of Financial Planning.  (If you like numbers and graphs, check out this paper. It is a surprisingly easy read.)

Using historical data from 1926 to 1991, Bengen found that there were no 50-year periods in which a retiree would run out of money if his or her initial withdrawal rate was 3.5% or lower.  With a 4% initial withdrawal rate, the shortest time period in which the savings ran out was 33 years.  In only 10% of the scenarios did the money last for less than 40 years.

If you turn this rule around and know how much you want to spend in your first year of retirement, say $60,000, you can calculate the amount you need to have saved by dividing that amount by 4% (=0.04).  In this example, you need $1,500,000 (=$60,000/0.04) in savings on the day you retire using this rule.

Multiply by 25 Rule for Retirement Savings

The Multiply by 25 Rule says that the amount you need in retirement savings is 25 times the amount you want to spend in the first year of retirement.  Using the example above in which you want to spend $60,000 in your first year of retirement, you would calculate that you need $1,500,000 (=25 x $60,000) in savings.  As I said, the math is the same for determining how much you need to save because multiplying by 25 is the same as dividing by 0.04.  It is just that the rules are stated from different perspectives (how much you can spend given the amount saved as opposed to how much you need to save giving how much you want to spend).

When do you need more or less?

As indicated, those rules make assumptions that might not be right for you. There are a number of personal factors that impact how much you need in retirement savings.

Your Risk Tolerance

The 4% Rule assumes that you invest half in bonds and half in stocks. Some people are willing to take more risk by investing more heavily in stocks. Other people can’t tolerate the ups and downs of the stock market, so invest more heavily in bonds. As shown in this chart below, taken from my post on diversification and investing, the higher percentage of stocks in your portfolio, the higher your average return (the blue lines) but the more likely you are to lose some of your principal (the portion of the whiskers that fall below 0).


If you plan to put more than 50% of your retirement assets in stocks, you can withdraw a bit more than 4% each year. Turning that around, it means you need a bit less than 25 times your estimated expenses in your first year of retirement. The table below was copied with permission from a March 19, 2019 article from Schwab found at this link.  It shows how your time horizon (see below) and investment risk impact the 4% Rule.

Life Expectancy and Retirement Age

The analysis underlying the 4% Rule focuses on a retirement period of 30 years.  If you retire in your mid-60s, it would imply that you would most likely have enough money to last through your mid-90s.  If you are in poor health or have a family history of dying early, you could consider spending a bit more than 4% (that is, multiply by less than 25 to determine how much you need to save).

On the other hand, if you plan to retire at 45 and want to have enough money to last until you are 95, you’ll need to save more.  The Schwab table above shows planning horizons up to 30 years.  Based on the numbers in the table, it looks like you could subtract about 0.1 percentage points from the numbers in the 30-year row for each year your planning horizon extends beyond 30 years to estimate how much you need to save.

For example, if you want to be highly confident (90% sure in this case) you will have enough money to last for 50 years, you would be looking at 20 years beyond the 30-year horizon.  Multiplying 20 years by 0.1 percentage point is 2.0%.  According to the table, you can spend 4.2% of your savings in the first year with a Moderately Conservative portfolio and 90% (highly) confident that you won’t run out of money in 30 years.  My approximation would subtract 2.0% from 4.2% to estimate that you could spend about 2.2% of your savings in the first year if you wanted to be 90% confident you won’t run out of money in 50 years.  You could then divide your estimated first year expenses by 2.2% or multiply by 45 to estimate how much you need to save.

Other Sources of Income

Some people’s employers provide defined benefit retirement plans.  These plans generally pay a flat amount every month starting at normal retirement age (as defined by the employer) until death.  In the US, people who have worked or whose spouses have worked are eligible for Social Security benefits, as discussed in this post.  Many other countries have similar programs.

When you are estimating how much you need to save for retirement, you can consider these sources of income.  If all of your other sources of income increase with inflation, it is a fairly straightforward adjustment.  You just need to subtract the income from these other sources from your first-year-of-retirement expenses before applying the 4% Rule (as adjusted for other considerations).

For example, if you plan to spend $100,000 a year in retirement and have $40,000 of Social Security and defined benefit plan benefits,  you would subtract $40,000 from $100,000 to get $60,000.  Using the Multiply by 25 Rule, you would multiply $60,000 by 25 to get $$1.5 million instead of multiplying the full $100,000 by 25 which would indicate you need $2.5 million in savings.  In this example, you need $1 million less in savings because you have other sources of income.

Unfortunately, most defined benefit plan benefits do not increase with inflation.  The math for adjusting the Multiply by 25 Rule is fairly complicated.  I’ve developed a simple approximation that you can use that will get you close to the correct percentage.  To approximate the adjustment to the amount you Multiply by 25, divide your defined benefit plan income by 2 before subtracting it from your first-year expenses.

You Want to Leave Your Assets to your Beneficiaries

I remember being a teenager and having my father explain to me how much I needed to save for retirement.  The approach he proposed was that you could spend 2% of your assets which is equivalent to a Multiply by 50 Rule.  (No wonder I was nervous about my finances when I retired!)  His logic was as follows:

  • Invest in the stock market and get a 10% return.  (He did this analysis a long time ago, when stock market average returns, inflation and taxes were all considered to be a bit higher than they are today, but not by so much as to make the logic faulty.)
  • You will pay taxes of 40% of your returns, which makes your after-tax return 6%.
  • Inflation will be 4% per year.  Because he wanted his investment income in every year to cover his expenses without dipping into the principal, he had to re-invest 4 percentage points of his investment return so he would have 4% more investment income in each subsequent year.
  • Subtracting the 4% reinvestment from the 6% after-tax return leaves an amount equal to 2% of his investments that he could spend each year (excluding taxes because he separately considered them).

So, if you are like my father, you will want to save closer to 50 times your first-year retirement expenses, rather than 25 times.  It is important to remember that my father’s Multiply by 50 rule applies to your expenses excluding income taxes and the Multiply by 25 Rule applies to your expenses including income taxes, so they aren’t quite directly comparable.

Liquidity of your Assets

As indicated above, the 4% Rule assumes your assets are invested 50% in stocks and 50% in bonds. You may have other assets that contribute to your net worth, such as equity in your home, your personal property, a family farm and rental property, among others. These other assets are all consider illiquid – that is, you can’t convert them to cash easily. Further, some of them are assets that you never want to have to convert to cash to cover expenses, such as your home and personal property.

As you project how much you will have in retirement savings, you’ll want to exclude any equity in your house as it isn’t available to invest.  A portion of it may be available at some point if you plan to downsize, but you’ll want to be cautious about including it in your savings plan.  Other of these assets, such as rental property, could be liquidated to cover retirement expenses.  In your planning, though, you’ll need to make sure you consider the selling costs (e.g., real estate agent’s commission) and taxes you need to pay on capital gains and that they may not generate a return as high as underlies the 4% Rule.

Irregular Large Expenses

The analysis that supports the 4% Rule assumes that you have the same expenses every year and that they change due only to inflation. That’s not how life works! You may want to be like me and want to take an expensive vacation every three or four years in retirement, you’ll likely have to replace your car at least once in retirement or you could have major home repairs if you own your home.  In addition, end-of-life medical bills can be very expensive.

As you are determining your first-year retirement expenses, you’ll want to include amounts for any such expenses in your budget at their average annual cost.  For example, let’s say I want to take a vacation (in addition to my already budgeted travel expenses) every five years that has a total cost of $10,000.  I need to add $2,000 (= $10,000 per vacation divided by one vacation every 5 years) to my regular annual expenses for these big vacations.  Similarly, if I plan to buy a $25,000 car every 15 years, I need to add $1,667 (= $25,000/15) to my annual expenses.  In both cases, you would add these amounts to your budgeted expenses before you divided by 4%.

How to Set Your Personal Target

So, what can you do to estimate your personal retirement savings target? Follow the following steps.

Make a Budget for Today if You Don’t Already Have One

It is hard to estimate your expenses in retirement, but it is very helpful to understand what you are spending today.  If you don’t have a budget or haven’t tracked your expenses to see where your money is going, I suggest starting there.  Here is a link to a post I wrote with a spreadsheet to help you monitor your expenses.

Estimate Your Expenses in Your First Year of Retirement

Next, look at your current budget and/or spending and estimate how it would change if you were retired today.  On what types of things might you want to spend money in the future that you don’t spend now?  Might you want to buy special gifts for your grandchildren that are more extravagant than what you spend for your children’s gifts now?  Also think about expenses you have now that you won’t have in the future, such as commute expenses and possibly a separate wardrobe for work.

Be sure to think about Social Security (or equivalent) and income taxes. In addition to Federal income taxes, you may pay state or provincial and possibly local income taxes.  If you plan to live somewhere else in retirement, it might have a higher or lower tax rate.  In the US, Social Security taxes are 6.2% (12.4% I you are self-employed) of your wages up to the limit ($128,400 in 2019).  As you adjust your budget, you can eliminate Social Security taxes and will want to think about whether your state or provincial and local tax rate will be substantially different from their current rates.

Some people say that your expenses will decrease by 20% when you retire.  In my very short retirement, I find I’m spending more than I expected as I have more time to do things and many of them cost money.  This post from Financial Samurai provide some insights as to how retirement might impact your expenses.

Increase Your Retirement Expenses for Special Purchases

Do you want to travel? How often do you think you’ll need to buy replacement cars and how much do you think you’d spend if you bought one today? What other expenses might you have that aren’t in your budget? For each of these expenses, divide the amount by the time between them to estimate an average annual cost, as I illustrated earlier in this post.

Adjust Your Budget for Inflation

All of the amounts you’ve estimated so far are in today’s dollars.  That is, they reflect the current prices of every item.  You’ll want to increase these amounts for inflation between now and the time you retire.  Over long periods of time, annual inflation has averaged 3% to 3.5% though it has been a bit lower recently.  To adjust your budget for inflation, you’ll want to multiply it by 1.03n, where n is the number of years until you retire.  Don’t like exponents?  The table below provides approximate multipliers by number of years until you plan to retire.

Years 5 10 15 20 25 30 35 40 45
Factor 1.15 1.35 1.55 1.80 2.10 2.45 2.80 3.25 3.80

Subtract Other Sources of Income

If you think you’ll have a defined pension plan benefit or will receive social insurance (Social Security) benefit, you can subtract those amounts from your inflation-adjusted budget.  My post on Social Security provides insights on how to estimate your benefits for my US readers.

Figure Out your Risk Tolerance and Length of Retirement

If you want to be almost 100% confident you will have enough money to last for your full retirement, regardless of how long it is, and leave most or all of your principal to your heirs, multiply the difference between your inflated budget (excluding income taxes) and other sources of income by 50 to derive your retirement savings target.

If you plan to be retired for only 10 years, you can multiply by a number as low as 10, according to the chart from Schwab. Where between those two numbers you choose is up to you. The longer you expect to be retired, the more conservative your investments and the more confident you want to be that you won’t run out of money, the higher your multiplier.

 

 

The Best Ways to Pay Off Your Debt

The Best Ways to Pay Off Your Debt

The best way to pay off your short-term and revolving debt depends on your priorities and what motivates you.  Two of the common approaches for determining the order in which to re-pay your loans discussed in financial literacy circles are the Debt Snowball and Debt Avalanche approaches.

Both of these methods apply when you have more than one debt that needs to be re-paid.  If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, making the minimum payments as often as you can to avoid finance charges which will be added to your principal in addition to the interest charges on any portion of your balance you don’t pay.

In this post, I’ll describe how the two debt-repayment methods work using some illustrations.  I will then help you understand which approach might be better for you.  For more information about the fundamentals of debt, check out my posts on loans and credit cards.

What’s Included and What’s Not

The debts covered by this post include credit cards (one kind of revolving debt), personal loans, car loans and other bills that are overdue. While longer-term loans, such as mortgages, are referenced in the budgeting process, I haven’t included them in the debt re-payment examples. If you have unpaid short-term debt, you’ll want to keep up with the payments on these longer-term loans first, but don’t need to pre-pay them. For this discussion, I will assume that you intend to re-pay all of your debts to your current debtholders. That is, you haven’t dug a hole so deep you need to declare bankruptcy and you don’t feel you’ll benefit from transferring some or all of your high-interest rate loan balances to one with a lower interest (i.e., debt consolidation).

Debt Snowball

Dave Ramsay, a well-known author on financial literacy topics, proposed the Debt Snowball method for paying off your debts.  Under this method, you do the following:

  1. Identify all of your debts, including the amounts of the minimum payments.
  2. Make a budget. (See this post for more on budgeting generally or this one for the first of a step-by-step series on budgeting including a helpful spreadsheet.) Your budget should include all of your expenses excluding your short-term and revolving debts but including the payments you plan to make on your longer-term debts (e.g., car loans and mortgages).
  3. Determine the total amount left in your budget available to re-pay your debts, remembering that you need to be able to pay for the total cost of all of your current purchases before you start paying off the balances on your existing debt. If the amount available to re-pay debts is less than the total of your minimum payments, you may need to look into your options to consolidate or re-structure your debts, get them forgiven or declare bankruptcy.
  4. Otherwise, make the minimum payment on all of your debts except the smallest one.
  5. Take everything left over in your budget from step (3) and reduce it by the sum of the minimum payments in step (4). Use that balance to pay off your smallest debt. After you fully re-pay the smallest debt, you’ll apply the remainder to the next smallest debt and so on.

Debt Avalanche

The Debt Avalanche method is very similar to the Debt Snowball method, except you re-pay your debts in a different order.

The first three steps under the Debt Avalanche method are the same as the first three steps under the Debt Snowball method.  It differs from the Debt Snowball method in that you pay the minimum payment on all of your debts except the one with the highest interest rate at any given time instead of the one with the smallest balance.

Examples

I’ve created the two examples to compare the two methods.  In both examples, I have assumed that you use a different credit card or pay cash for all new purchases until your current credit card balances are re-paid.  That is, to make progress on getting out of debt, you need to not only make extra payments on your existing debts, but also not create additional debt by borrowing to pay for new purchases.  It’s tough!

Example 1

In this example, you have two debts with the balances due, interest rates and minimum payments shown in the table below.

Example 1 Balance Due Interest Rate Minimum Payment
Debt 1 $1,500 20% $30
Debt 2 500 10% 10

You have determined you have  $100 available to pay off these two debts.  The minimum payments total $40 in this example, so you have $60 available to pay off more of the principal on your debts.

Example 1: Debt Snowball

Under the Debt Snowball method, you will use the additional $60 a month you have to pay off Debt 2 first, as it has the smaller balance.  That is, you will pay the minimum payment of $30 a month on Debt 1 and $70 a month on Debt 2 for 8 months, at which point Debt 2 will be fully re-paid.  You will then apply the full $100 a month to Debt 1 for the next 17 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 25 months and will pay $428 in interest charges.

Example 1:  Debt Avalanche

In Example 1, you will use the additional $60 a month you have to pay off Debt 1 first under the Debt Avalanche method, as it has the higher interest rate, whereas you used the additional amount to pay off Debt 2 first under the Debt Snowball method.  That is, you will pay the minimum balance of $10 a month on Debt 2 and $90 a month on Debt 1 for 20 months, at which point Debt 1 will be fully re-paid.  You will then apply the full $100 a month to Debt 2 for the next 4 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 24 months and will pay $352 in interest charges.

Example 2

In this example, you have five debts with the balances due, interest rates and minimum payments shown in the table below.

Example 2 Balance Due Interest Rate Minimum Payment
Debt 1 $1,000 10% $40
Debt 2 500 0% 25
Debt 3 10,000 20% 100
Debt 4 3,000 15% 75
Debt 5 750 5% 30

You have $500 available to pay off these debts.  In this example, the minimum payments total $270, so you have $230 available to pay off the principal on your debts in addition to the principal included in the minimum payments.

Example 2: Debt Snowball

Example 2 is a bit more complicated because there are more debts.  As a reminder, under this approach, you apply all of your extra payments ($230 in this example) to the smallest debt at each point in time.  In this example, you will make the additional payments on your debts in the following order:

Debt 2

Debt 5

Debt 1

Debt 4

Debt 3

It takes only two months to pay off Debt 2 and another four months to pay off Debt 4.  As such, you will have fully re-paid two of your debts in six months.  In total, it will take 43 months to re-pay all of your loans and you will pay $5,800 in interest.

Example 2:  Debt Avalanche

In this example, you will make the additional payments on your debts in the following order:

Debt 3

Debt 4

Debt 1

Debt 5

Debt 2

It turns out that Debt 2 is fully re-paid in 20 months even just making the minimum payments.  Debt 5 is paid off 7 months later again with only minimum payments, followed by Debt 1 2 months later.  As each of these debts is re-paid, the amounts of their minimum payments are added to the payment on Debt 3 until it is fully re-paid after 39 months.  At that point, the full $500 a month is applied towards Debt 4 which then takes only 2 additional months to fully re-pay.  In total, it will take 41 months to re-pay all of your loans and you will pay $5,094 in interest.

Comparison

Dollars and Sense – Two Examples

Looking at the two examples, we can get a sense for how much more interest you will pay if you use the Debt Snowball method instead of the Debt Avalanche method.  The table below compares the two methods under both examples.

Example 1 Example 2
Interest Paid Months of Payments Interest Paid Months of Payments
Snowball $428 25 $5,800 43
Avalanche 352 24 5,094 41
Difference 74 1 706 2

In these two examples, you pay more than 10% more interest if you use the Debt Snowball method than the Debt Avalanche method, leading to one or two additional months before your debts are fully re-paid.

Dollars and Sense – In General

The difference in the amount of additional interest depends on whether your debts are similar in size and the differences in the interest rates.  I’ll take that statement apart to help you understand it.

  • If the debt with the lower interest rate is very small, you will pay it off quickly.  As a result, there is only a very short period of time during which you are paying the higher interest on the larger loan under the Debt Snowball method.  As such, there will be very little difference in the total amount of interest paid between the two methods in that case.
  • If the debts all have about the same interest rate, it doesn’t really matter which one you re-pay first, as the interest charges on that first loan will be very similar to the interest charges on your other loans.

Dollars and Sense – Illustration

The graph below illustrates the impact of the differences in interest rates and sizes of two loans on the difference in the total interest paid.  To create this graph, I took different variations of Example 1.  That is, you have two loans with outstanding balances totaling $2,000 and the interest rate on the larger debt is 20%.

 

How to Read the Axes

The interest rate on the smaller loan was calculated as 20% minus the increment shown on the axis labeled on the right.  That is, the interest rate on the smaller loan for scenarios near the “front” of the graph was 18% or 2 percentage points lower than the 20% interest rate on the larger loan.  Near the “back” of the graph, the interest rate on the smaller loan is 0% or 20 percentage points lower than the interest rate on the larger loan.

The loan balance on the smaller loan divided by the total debt amount of $2,000 is shown on the axis that goes from left to right.  The small loan is $40 (2% of $2,000) at the far left of the graph and increases as you move to the right to $960 (48% of $2,000) on the far right.  Note that, if the small loan exceeded $1,000, it would have become the bigger loan!

The Green Curve

The green curve corresponds to the total interest paid using the Debt Snowball method minus the total interest paid using the Debt Avalanche method.  For example, at the front left, corresponding to the small loan being $40 with an 18% (=20% – 2%) interest rate, there is a $2 difference in the amount of interest paid.  At the other extreme, in the back right of the graph (0% interest rate on a small loan with a balance of $960), you will pay $167 more in interest ($308 versus $140 or more than twice as much) if you use the Debt Snowball method rather than the Debt Avalanche method.

What It Means

Interestingly, moving along only one axis – that is, only decreasing the interest rate on the small loan or only increasing the size of the smaller loan – doesn’t make very much difference.  In the back left and front right, the interest rate differences are only $15 and $22, respectively.  The savings from the Debt Avalanche method becomes most important when there is a large difference in the interest rates on the loans and the outstanding balances on the loans are similar in size.

Sense of Accomplishment

For many people, debt is an emotional or “mental-state” issue rather than a financial problem.  In those situations, it is more important to gain a sense of accomplishment than it is to save money on interest.  If you are one of those people  and have one or more small debts that you can fully re-pay fairly quickly (such as Debts 2 and 5 in Example 2 both of which were paid off in six months under the Debt Snowball method), using the Debt Snowball method is likely to be much more successful.

Key Points

Here are the key points from this post:

  • A budget will help you figure out how much you can afford to apply to your debts each month.
  • If you can’t cover your minimum payments, you’ll need to consider some form of consolidation, re-financing or even bankruptcy, none of which are covered in this post.
  • If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, but making the minimum payments as often as you can to avoid finance charges.
  • You will always pay at least as much, and often more, interest when you use the Debt Snowball method as compared to the Debt Avalanche method.
  • Unless you have two or more debts that are all about the same size and have widely varying interest rates, the total interest you will pay is essentially the same regardless of the order in which you re-pay them.  As such, if the sense of accomplishment you get from paying off a few debts will help keep you motivated, using the Debt Snowball method may be the right choice for you.
  • If you have two or more debts that are all about the same size and have disparate interest rates, you will want to use the Debt Avalanche Approach.  Because the balances are all about the same, it will take about the same amount of time to re-pay the first loan regardless of which loan you choose to re-pay first!  As such, it is better to focus on the interest you will save by using the Debt Avalanche approach.

 

6 Ways to Slay Your Student Debt This Year

Slay-Student-Debt

From Susie Q: I’m not as familiar with student debt as I am with the other topics on which I write, so was pleased to accept this guest post from Kate Underwood.  Kate is a freelance writer and staff writer for Club Thrifty, a website dedicated to helping people dream big, spend less, and travel more.  With Kate’s permission and approval, I’ve interspersed some comments and numerical examples in italics to expand on a few of her points.

Unless you’ve been living under a rock, you’re probably aware that we’ve got a bit of a student loan crisis on our hands. The amount currently owed by borrowers isn’t in the billions…nope, it’s actually past the $1 trillion mark!

Chances are, you don’t want to be saddled with your own student debt forever. Debt can hold you back from buying a home, starting a family, traveling the world, and other exciting parts of life. Don’t let student loans ruin your dreams – it’s time to start slaying your student debt this year.

Think it’s impossible? Check out the following ways to attack your student loans with a vengeance.

Follow A Budget

A budget is an essential financial tool that gives a job to every dollar you earn. Get yourself on track by making and following a smart budget. Be sure to account for all necessary expenses, including your student loan payments.

Balance out how much you’re earning with how much you’re spending (and don’t spend money you don’t have). When you’re stuck with student loan debt, it’s key to eliminate luxury spending. Put every spare dollar, after necessities, into paying off your loans.

While it’s tempting to overspend when you get your first “real” job, it’s a bad move. Don’t make the mistake of financing new cars or spending too much on stuff you don’t need. Living within – or below – your means could make a big dent in your student debt. Just live like a college kid for a little longer.

Susie Q adds: For a more detailed discussion of how budgets can be helpful, check out this post or start here for my week-by-week guidance on creating a budget using a spreadsheet template I’ve provided.

Trust me, it’ll be worth it! The faster you pay off your loans, the sooner you can get started building wealth and planning for your next big goal!

Start Repayment Right Away

That little grace period from your lender is appealing, but don’t hang out there too long. The sooner you can begin repayment, the better.

Even during the grace period, interest accrues for many types of loans. So, while you’re allowed to postpone repayment for a time (usually 6 months), it’s prudent to begin repayment as soon as possible.

Susie Q adds: As an example, if you have a $30,000 balance on a 5% loan with 15 years left in the term and don’t defer your payments during the grace period, your payments will be $237 a month. You’ll pay a total of $12,703 in interest over the life of the loan. If you make the same payments and defer your loan, you’ll pay an extra $1,628 in interest payments and extend your loan by 13 months (6 months of grace period and 7 months of extra payments to cover the extra interest).

Pay Extra Each Month

Once you know what your minimum payment amount is every month, don’t get too comfy with it. If you push yourself to increase that amount by even $25 or $50 more each month, you could destroy those loans much faster! At the very least, round up to the nearest $10 or $50 mark. So, a minimum payment of $62 could be rounded up to $70 or $100.

Just be sure that, if you’re making extra payments, they’re applied to the principal, not the interest. If you’re in doubt, talk directly to your lender or loan provider to find out how you can go about doing this.

Susie Q adds: Using the same example as above, if you don’t defer your loan for the grace period and round up to $250 a month, you’ll save over $1,000 as you’ll pay only $11,676 in interest and will pay off your loan a full year earlier.   You can include your student debt in your debt repayment strategy to figure out how much you can pre-pay each month, as discussed in this post.

Another tip: make biweekly payments rather than monthly. After one year, this simple step will add up to having slashed an extra month’s payment off your total. However you choose to set it up, paying more than the minimum will lead to student loan freedom sooner!

Refinance Your Loans

One strategy for paying off your loans faster is to refinance your student loans. The general idea is that if you refinance to a lower interest rate, you’ll end up paying less over the life of the loan. Plus, you can pay them off faster, since you won’t owe as much in interest! Win-win!

A couple of factors to beware of: you usually don’t want to refinance if your credit score has taken a recent hit. That will likely only get you a higher interest rate – you definitely don’t want that! Also, if you plan on utilizing student loan forgiveness programs, you typically need to stay away from refinancing. Most of the forgiveness programs will disqualify you if you’ve refinanced.

If you’re unsure about how to go forward with refinancing, Credible is an online loan marketplace that can make that decision easier. Compare interest rates for which you may qualify with different lenders in order to make the best choice.

Susie Q adds: Using the same example as above, if you are able to re-finance your loan at 3.5% and continue to make the same $237-a-month payment, you’ll save over $5,000 as you’ll pay only $7,485 in interest and will pay off your loan almost two years earlier. This savings will be offset by any fees you need to pay when you re-finance your loan.

Now, if you’re such a rock star that you plan to pay off the full balance within a really short time, like 2 or 3 years, refinancing might not be worth the trouble. Just pay those babies off and be done with them!

Start A Side Hustle

One of the best ways to pay off any debt fast is to increase your income. I’m a big proponent of side hustles. You can make extra cash to pay down debt and side hustles are often super flexible with your other responsibilities.

If you’re looking to begin your own side hustle, you can check out these work-from-home jobs and see which might be a good fit. The possibilities are nearly limitless, so be creative and think about your skills and things you enjoy doing anyway.

You could start doing freelance writing or blogging from home (our favorites!). Or start selling your to-die-for cakes for special occasions. Try your hand at bookkeeping, photography, or proofreading or any number of other ways people are raising their income.

Susie Q adds: For more ideas about ways to increase income or reduce expenses to help free up money to reduce your student loan debt, check out this post. Also, if you decide to pursue a side hustle, you’ll want to make sure you don’t spend more money than you earn!

Just imagine how much extra money you could throw at your student debt by starting a side hustle!

Use Employer Benefits

Some companies are looking to build positive relationships with employees by offering student loan repayment assistance. So, before you decide to take a job, it might be beneficial to ask if it offers this option. If you’ve already signed on to work somewhere, talk to your HR department to see if it’s available.

You should also explore various government student loan forgiveness programs. Though it’s extremely important to follow all of their rules to be eligible, if you’re working in a career field that allows you loan forgiveness, you might as well go for it!

A piece of advice: save enough during your repayment period that you could pay the entire loan balance off just in case the forgiveness doesn’t come through! Most applications for forgiveness so far have been rejected, so those borrowers are still on the hook for the full balance.

Say Goodbye to Student Loans Fast

Debt sucks. You know you don’t want to keep your student loans around forever, so use any and all of these tips to slay your student debt as fast as you can!

 

 

 

How to Budget Step 9 – Monitoring your Budget

You may have thought you were done when you created and balanced your budget.  However, there is one very important step left in the budgeting process – making sure you are living within the guidelines set by your budget, i.e., monitoring your budget.  That is, are you earning as much income as you planned? Are you limiting your expenses to the amounts in your budget?  Did you put aside the savings you included in your budget, whether for expenses you pay infrequently, for retirement or something in between?

In this post, I’ll tell you how to use a new, budget-monitoring worksheet to compare your budget with your actual income and expenses.

Entering Your Budget

Since the purpose of the spreadsheet is to compare your actual expenses with your budget, the first thing to do is to enter your budget.  Most people find it easiest to monitor their budget on a monthly basis, even if they created an annual budget.  If you created an annual budget, you’ll want to divide all of the values in your budget by 12.

Once you have your monthly budget, you’ll enter it on the Budget Monitoring tab of the budget-monitoring spreadsheet at the link below.  Note that this spreadsheet is different from the one you used to track your expenses and create your budget, though many aspects of it will work the same as the budget creation spreadsheet (named Budget Template).

Enter Your Category Names

To enter your budget, enter the names of the categories from your budget in Column A starting in Row 8. Here are three different ways you can input your category names:

  1. Type the names directly into Column A.
  2. Use Excel’s copy and paste features to copy them from your Budget Template spreadsheet.
    1. On the Budget tab in your Budget Template spreadsheet, highlight all of your category names by putting your cursor on cell A11, holding down the shift key and moving the down arrow until all of them are highlighted. Let go of the shift key.
    2. Hold down the Ctrl key while you hit C or hit the copy button if you have one.
    3. Go to the Budget Comparison tab of the monitoring spreadsheet.
    4. Put your cursor in A8.
    5. Hold down the Alt key while you hit E, S and V or hit the paste-values button if you have one. If you just use a regular paste button, you will get errors because the cells from which you are copying have formulas in them.
  3. Link your monitoring spreadsheet to your Budget Template spreadsheet.
    1. Put your cursor in A8 of the Budget Comparison tab of your Budget Monitoring spreadsheet.
    2. Hit the equal sign on your keyboard.
    3. Go to the Budget Template spreadsheet.
    4. Go to the Budget tab.
    5. Put your cursor in A11.
    6. Hit Enter.
    7. Excel should return you to cell A8 of your Budget Monitoring spreadsheet.
    8. Hit the F2 (edit) key.
    9. Hit the F4 key 3 times. Hit Enter. There should now be no $ in the cell reference.
    10. Copy the formula in A8 and paste it in as many cells in Column A as needed until all of your category names appear.

When you enter the category names, make sure that the row with the total amount of income is called “Total Income,” the row with the expense total is called “Total Expenses,” and the difference between those two values is called “Grand Total.”

Enter Your Budget Amounts

Next, enter the monthly budget amounts in Column B next to each of the category names in Column A. You can use any of the three approaches described above for the category names. If you have an annual budget, you’ll need to divided the values by 12 before copying them if you use the second approach or add “/12” (without the quotes) in step (i) before you hit enter if you use the third approach.

Entering Your Actual Income and Expenses

You can enter your actual income and expenses using the same instructions as were used for entering them in the Budget Template spreadsheet.  See my posts on tracking expenses and paychecks and income for more details or review the instructions at the top of each tab.  Be sure to use the same category names as you used in your budget so all of your income and expenses will be included in the Actual column on the Budget Comparison tab.

For monitoring your actual income and expenses, you don’t need to enter the number of times per year you receive each type of income or pay each bill since your goal is compare what you actually received and paid with your budget.

Options for Expenses You Don’t Pay Monthly

Here are three different ways to monitor expenses that you don’t pay monthly:

  1. Enter them in the Monitoring Spreadsheet as you pay them and keep them in mind as known variances from your budget each month. This approach is the easiest to implement but also the least helpful for comparing your actual expenses to your budget.
  2. Adjust the budget amounts to reflect the amount of those expenses you expect to pay in each month. For example, if you pay your car insurance bill four times a year in March, June, September and December, you would
    • take your budget amount
    • adjust it to a full year if you budgeted on a monthly basis by multiplying by 12
    • divide the annual amount by 4
    • include the result in your budget for March, June, September and December
    • put 0 in your budget column in all other months

This approach is a little more complicated to implement, but will make comparing actual expenses with your budget much easier.

  1. Add an expense transaction every month equal to 1/12thof your annual expense on the Bank Transactions, Cash Transactions or Credit Card Transactions tab. In the months in which you actually make the payment, you’ll enter 1/12th of your actual annual expense.  If the total of the amounts you set aside in previous months differs from the amount you actually pay, you’ll need to include this difference in the actual payment amount in the month you make the payment. This approach is equivalent to moving money from your checking account to your savings account in every month you don’t have this expense and moving it back to your checking account in the month in which you pay the expense.

You can also use any one of the above approaches for income you don’t receive monthly.  If you use the third approach, you’ll put 1/12th of your actual annual income on the Income tab.

Monitoring Your Budget – What Happens When Your Actual Isn’t as Good as Your Budget

There are many reasons why your actual income and expenses might look worse than your budget.  You may have been planning to work overtime or get a second job to increase your income.  Those lifestyle changes can be challenging, so you might not have done them.

More likely, you spent more than you budgeted, either due to an emergency, an impulse purchase or difficulty in breaking long-standing habits.  Emergencies happen to everyone.  If possible, you’ll want to include building or re-building your emergency savings (see this post for more on that topic) in your budget. While overspending your budget can be problematic, especially if you do it continuously, don’t be too hard on yourself. Changing your spending habits is really hard.

A Few More Words about Budget

Congratulations!  You made it through the entire budgeting process. As I said in my first post on budgeting, staying on a budget is like being on a diet.  Just as every calorie counts, so does every dollar spent.  Sticking to your budget will increase the likelihood you will meet your financial goals, so do your best!

Download Budgeting Monitoring Spreadsheet Here

How to Budget Step 8 – Refining your Budget

Very few people have a balanced budget on the first try.  This week, I’ll talk about how to refine your preliminary budget if it isn’t in balance.  I have been very fortunate in that it has been a long time since I found it challenging to meet my financial goals.  Also, I don’t know the specifics of any of your budgets, life-styles or financial goals. So, in this post, I will identify the changes you can make to refine your budget at a high level and provide links to articles by other financial literacy bloggers that provide a whole host of ideas on the specifics.  I hope that one or more of those articles will provide you with the ideas you need to successfully balance your budget.

The Bottom Line

The number on which you’ll want to focus is the Grand Total on the Budget tab.  If it is close to zero (i.e., within a percent or two of your total income) and you have incorporated all of your financial goals, you are done.  Otherwise, you’ll want to look at the section below that reflects your situation, i.e., whether the Grand Total is positive or negative, to learn how to refine your budget.

Your Budget Shows a Large Positive Balance

Congratulations!  If the value in the Grand Total line of the Budget tab shows a large positive number, you have more income than you are spending and saving.  You are among the fortunate few.

Before spending your excess income, you might want to review your financial goals.   Questions you could ask yourself include:

  • Do I have emergency savings of three to six months of expenses?
  • Are there other large purchases I’d like to make in the future?
  • Do I have enough savings to take maternity/paternity leave?
  • If you have children, am I saving for their education?
  • Have I studied the full costs of retirement and am I saving enough?
  • Have I contributed the maximum amounts to all of my tax-advantaged retirement savings accounts (IRAs and 401(k)s in the US, RRSPs and TFSAs in Canada)?
  • Do I want to retire sooner (which would require more savings now)?

If you still have a positive balance after your review, you can consider increasing your discretionary expenses (possibly a newer car or a nice vacation or the addition of a regular treat).  Of course, there is never any harm in increasing your savings.

Your Budget Shows a Large Negative Balance

A large negative balance is much more common than a large positive balance.  I wish I could give you a magic answer to resolve this situation, but there are really only three options.

  • Increase your income.
  • Decrease your expenses.
  • Borrow money either from a third party or by drawing down your savings.

Unless absolutely necessary, I suggest avoiding the third option.  If your expenses exceed your income and you make up the difference by borrowing either from your savings or a third party, you are likely to have a worse problem next year.  Unless either your income or expenses change, it can lead to a downward spiral.

Increase Your Income

Increasing your income can be a more effective way to balance your budget.  However, it has its own challenges and often requires a significant investment of your time and/or money.   Examples of ways to increase your income include:

  • Get a part time job, but make sure it won’t jeopardize your primary job.
  • Work overtime if you are eligible.
  • Make sure you are earning a competitive wage by looking at relevant salary surveys. If you aren’t, ask your boss for a raise, such as described in this post, or look for another job in your field that pays more or offers more benefits.
  • Consider getting more education that will provide you with the opportunity to make more money in the future. Some employers will pay for some or all of your tuition if the additional education is related to your job.  This choice is likely to cause more pain in the short term, but can produce large benefits.  As an example, check out this post.
  • Sell things that you don’t need. Here is a  post on this topic.
  • Start your own business. This option is one that I suggest you pursue only very cautiously if you already have a tight budget.  Starting a business can be very expensive, which of course will put further pressure on your budget.  Also, a large percentage of new businesses fail which means the owners lose money. According to Investopedia, 30% of business fail within two years of opening and 50% fail within five years.  Of those that survive, one source indicates that many business don’t make money until the third year.  If you want to start a side business, turning a hobby into a business is one of the most fun ways to do so.  Here is an article with some suggestions on how to do so.
  • There are hundreds of articles about “side hustles.” I’ve provided a few examples. There are lots of pitfalls with side hustles, including many that might end up costing you money rather than making it. So, as with starting your own business, I suggest exercising caution if you decide to proceed with one or more of them.

Decrease Your Expenses

To be blunt, it is hard to decrease your expenses.  Here are some tips on things to consider:

  • Separate your discretionary expenses from your required expenses. Required expenses include the cost of basic housing, a basic car, gas, groceries, medical care, insurance and the like.  Discretionary expenses are things you could live without, even if you don’t want to.  Here are several posts I’ve seen that provide ideas on how to cut back on discretionary expenses.
  • Review the amount you pay for your necessities to see if you can reduce any of these costs. Here are several posts that provide some ideas.
    • 40 Smart Ways to Reduce Your Monthly Bills
    • 5 Ways To Save $532.30 On A Tight Budget
    • This post focuses specifically on your cell phone bill.
    • This post discusses your energy costs.
    • I really like this post as it covers one of my biggest areas of savings – cooking at home instead of in restaurants. Here is another variation on the same theme.
    • Figure out how much you are spending to pay off your debts, particularly if you have a lot of credit card debt. Research ways to re-finance your debt to reduce interest rate or, if necessary, lengthen time to payment.  For example, if you have something you can use as collateral, a collateralized loan will have a much lower interest rate than your credit cards. See my post on loans to understand the factors that affect the interest rate on a loan and the sensitivity of your monthly payments to changes in interest rates and term.  This post has a lot of great information on re-paying student loans. I also like this post which talks about refinancing student loans – are you ready for it and some options.
    • There are dozens (hunderds?) of blogs on FIRE (Financial Independence, Retire Early). These bloggers tend to post their personal stories about how they are living very frugally so they can retire very early.  Although many of their approaches seem almost draconian, reading one of more of their posts might give you some ideas how you can cut back on your expenses.

There are a few other expenses you can adjust to balance your budget, but I suggest you do them only after you have fine-tuned your budget and looked into re-financing your debt.

  • Reduce the amount you set aside for savings. Clearly, covering the basics, such as food and shelter, take priority over meeting your longer-term financial goals.   Once you have covered those expenses, you’ll need to balance your short-term wants with your long-term goals.  For example, you’ll need to decide whether you want to spend more today on entertainment or put more into your savings so you can have the retirement you desire. The idea of foregoing things today to the benefit of something you will get in the future is called delay of gratification.  It is a difficult concept to implement in practice but is often a key to long-term financial success.
  • Avoid taking on too much more risk. For example, one way to save money on insurance (cars, homeowners/renters or health) is to increase your deductible, lower your limit of liability or, in the case of car insurance, not purchase physical damage coverage.  As I discussed in my post on making financial decisions, these choices reduce your upfront cost, but can have serious consequences in an adverse situation.  If your budget is tight, you may not be able to afford to pay your full share of costs in the case of a serious accident, damage to your home or serious illness.

Closing Thoughts

Working to refine your budget to bring it in balance can be a real challenge. If you can’t do it on the second or third try, be patient with yourself. Learning to be financially responsible is often a long, challenging process.

How to Budget Step 7 – Create your Budget

You made it!  This week your only task will be to create a first draft of your budget.  

Budgeting can be challenging as you try to balance your long-term goals with your short-term needs and wants.  As such, I suggest creating it in two steps. This week I’ll provide guidance on creating the first draft of your budget.  Next week’s post will talk about how to refine it.

Practical Steps

To create your budget, you will enter values in Column D of the Budget tab of your spreadsheet.  As long as you don’t enter values in Column D of any of the “Total” rows, the formulas will automatically calculate those values.

While the spreadsheet was built to be fairly flexible, one of its weaknesses is that it is not easy to add or delete income or expense categories once you have started entering your budget amounts.  So, before you get started, I suggest making a final review of the line items on the Budget tab. If you need to make changes, you can look back at last week’s post for the instructions.

If you find you need to add or delete a line after you have entered budget amounts, here’s what you’ll need to do:

  1. Make a note of the budgeted amounts of all of the line items you’ve entered.  
  2. Add or delete the line item name according the instructions in the last week’s post.
  3. Copy the formula from cell D110 to all of the cells into which you previously typed values.  You can copy a formula by:
    1. Going to cell D110.
    2. Holding down the Ctrl key and hitting C.
    3. Moving your cursor to cell D11.
    4. Holding down the shift key and then hitting the down arrow until all of the cells into which you entered values are highlighted.
    5. Holding down the Ctrl key and hitting V.
  4. Re-enter the budget amounts that you noted.

If you don’t take this approach, some or all of your category names in Column A will change rows, but your budgeted amounts in Column D will stay in the same rows.  You’ll end up with a mismatch between category names and budget amounts.

Budget Amounts

For each line item in your budget, you’ll need to select a budget amount.  These selections will require your informed judgment. Things to consider in making your selection include:

  • How much you’ve recorded in each category over the past several weeks, as shown in Column B.
  • Any changes in your income or expenses you anticipate in the next several months.  
    • Some of these changes might result from life changes – a new job, moving, getting a roommate, getting married, having children or the like.
    • Other changes might result from intentional changes in your habits – fewer meals in restaurants, hiring a cleaning service, newly carpooling, among others.
    • You’ll also have changes from prior expenses if you change your spending or income to better align with your financial goals.
  • If you’ve used the tax approximation, the amounts in Column C for Federal and State/Provincial income taxes.
  • The goals you set as described in my post on setting financial goals.  You might want to increase one or more of your emergency savings, savings for a designated purchase (vacation, house, new car) or long-term or retirement savings.

Final Steps for This Week

Once you have completed your first draft, take a look at the value in Column D of the Grand Total row.  If that value is positive, it means you have more income than expenses and additions to savings. If it is negative, your expenses and savings goals are higher than your income.  In this href=”https://financialiqbysusieq.com/how-to-budget-step-8/”>post, I’ll talk about things you can do so the value is close to zero.

 

Review the Expenses for your Budget

You’re almost there!  Only one more week until I describe how to create your budget.  Before you can do that, you’ll want to make sure that the income and expenses you’ve entered don’t have too many mistakes.  In this post, I’ll talk hot to review the expenses and income you’ve entered in the spreadsheet to make sure you have an accurate starting point for your budget.

Before getting to that topic, here are your budgeting tasks for this week:

  1. Continue using and refining your expense tracking system.
  2. Continue to enter your income and expenses into the spreadsheet.
  3. Make sure to update the number of months you have been entering information on the Basic Inputs tab.
  4. Review the first two columns of the Budget tab, as described in the rest of this post.

Make Sure Categories are Right

Over the past several weeks, you’ve been entering the category name with each income and expense line item.  Mistakes I’ve made include using more than one variation on some of my category names, such as household expense and household supplies.  I also sometimes misspell one or more of category names.

If you’ve made similar mistakes, you’ll want to correct these mistakes so you have exactly one line in your budget for each type of income and expense.  Here are the steps to find and correct these mistakes:

  1. Go to the Budget tab.
  2. Review the category names to see if there is more than one row in Column A that corresponds to the same category.
  3. If there is, figure out which category name you want to use.
  4. Make note of all of the incorrect names.
  5. Go to each of the Bank Transactions, Cash Transactions, Credit Card Transactions, Less-Than-Monthly Expenses, and Income tabs.
  6. Hold down the Alt Key and hit E.
  7. Hold down the Alt Key and hit F.
  8. Enter one of the incorrect names in the box next to “Find What.”
  9. Hit the Find Next button.
  10. Any time Excel finds the incorrect category name, replace it with the correct name.
  11. Repeat steps 9 and 10 on each of the tabs listed in Step 5 until the incorrect label no longer appears on the Budget tab.
  12. Then repeat steps 6 through 11 for any other incorrect names.

You’ll know you are done when each category name appears exactly once on the Budget tab.

Make Sure Amounts Look Reasonable

Once all of the category names appear only once and have the names you want, you’ll want to make sure that the values in Column B look reasonable.  These values are the totals of the values you entered on the various tabs, adjusted to either an annual or monthly basis depending on the choice you made in Cell B5 on the Basic Inputs tab.  Two reasons these amounts could look wrong are (1) you entered the wrong amount for a transaction or (2) you entered an incorrect value in the “How Many Times a Year” column.

If a number looks too high or too low, you can use the following steps to help find the problematic input:

  1. Identify the category name in Column A of any value in Column B that looks too high or too low.
  2. Go to each of the Bank Transactions, Cash Transactions, Credit Card Transactions, Less-Than-Monthly Expenses, and Income tabs.
  3. Hold down the Alt Key and hit E.
  4. Hold down the Alt Key and hit F.
  5. Enter a category name that has an unexpected value in the box next to “Find What.”
  6. Hit the Find Next button.
  7. Look in the Amount column of any row in which Excel finds your category name.
  8. Does the amount look right? Common entry errors are to transpose digits (i.e., enter them in the wrong order) and put the decimal point in the wrong place.
  9. Fix any errors in the amount.
  10. Look in the “How Many Times a Year” column.
  11. This column can be blank for any row that contains an expense you pay every month.
  12. For payments made less than once a month, the entries in this column should be the numbers of times per year you make payments of the amount shown. For example, if you pay your auto insurance bill twice a year, the semi-annual amount should be in the Amount column and 2 should be in the “How Many Times a Year” column.
  13. Repeat steps 7 through 12 on each of the tabs listed in Step 2 until the amount on the Budget tab for this category looks reasonable.

Next Steps

Next week, I will talk about how you can create your budget using the income and expense information you have tabulated so far and corrected.

Download Budgeting Spreadsheet Here

How to Budget Step 5 – Paychecks and Income

Your budget includes your income in addition to money you spend.  In my previous posts on the budgeting process, I talked about setting your goals and tracking and recording your expenses.  This week, I’ll focus on your paycheck and other sources of income.

Before getting to that topic, here are your budgeting tasks for this week:

  1. Continue using and refining your expense tracking system.
  2. Continue to enter your expenses into the spreadsheet.
  3. Record the details from your pay stubs and any other sources of income.

Pay Checks

Your pay stubs include both your wages and some expenses and taxes that are deducted by your employer.  This information can be entered on the Income tab.  You’ll need your pay stub as it lists all of the items that flow into and out of your paycheck to get the net amount of your check or automatic deposit. Put information from each line on your pay stub in a different row on the Income tab of the spreadsheet.

The date of each paycheck goes in Column A.

Record the amount of each line item in Column B.  Your income, such as your wages, should be entered with positive numbers. Deductions, such as taxes, your share of employee benefit charges and retirement savings, should be entered using negative numbers.  Use one row in the spreadsheet for your wages and another for each of your deductions.

You can record the category for each line in Column C.  If you want to use the tax approximation included in the spreadsheet, you’ll need use the labels “Wages”, “Retirement Savings” “Federal Income Taxes” and “State Income Taxes” for each of those categories.  Otherwise, you can use whatever labels you want.

If you get paid less often than once a month, enter the number of paychecks you get each year in Column D of each row.  Otherwise, leave this column blank.

Other Sources of Income

If you have other sources of income you receive on a regular basis, such as returns on investments, disability income or support from your parents, you’ll want to include those in your budget.  Unless you are on a leave from work or retired, you might leave any investment returns in your savings and not use them for spending. It is important to be aware of all sources of income in your budget including increases in your savings, so I suggest including them in your budget explicitly.

Interest, dividends and appreciation are the three most common types of returns from investments. If you have any such returns, enter their amounts in Column A, their category in Column B and how often you receive the amount from Column A in Column C.  The three types of returns are taxed differently in the US.  If you live outside the US or don’t want to use the very rough tax approximation in the spreadsheet, you can enter a single line item for total investment returns and call it whatever you would like.  Otherwise, enter “Interest” in Column B for interest payments, “Dividends” for dividends received and “Appreciation” for changes in the market value of your investments.  Appreciation can be either positive (market value has gone up) or negative (market value has gone down).

For any other sources of income, enter the amount, category (with a name of your choosing) and how often you receive that amount in Columns A through C, respectively.  Sources of income other than investment returns and wages will be ignored in the income tax approximation.

Download Budgeting Spreadsheet Here

How to Budget – Expenses Not Paid Monthly

Your budget won’t be complete unless you include all your expenses, including those that you don’t pay every month.  In the past three weeks, I talked about creating systems for tracking and recording your expenses and setting your goals.  This week, I’ll focus on expenses you pay less often than monthly.

Before getting to that topic, here are your budgeting tasks for this week:

  1. Continue using and refining your expense tracking system.
  2. Continue to enter your expenses into the spreadsheet.
  3. Identify and record expenses that you pay less frequently than monthly into the spreadsheet using the instructions below.

Less-Than-Monthly Expenses

Many people have expenses they pay every year, but don’t necessarily pay every month.  Examples of these expenses include car and home/renters insurance, property taxes (if you own your home), car maintenance and registration, contributions to your retirement savings other than those that are withheld by your employer, and holiday and birthday presents.

Even though you don’t pay these expenses every month, you’ll need to include them in your budget so you have the money when you need it.  In practice, I suggest transferring the total budgeted amount for all of these expenses to a separate account, possibly a savings account at the same bank as your checking account, every month or every time you get paid.  You can then transfer the money back to your checking account to pay the expenses when they are due.  You’ll need to remember that the money in that account is designated for specific purposes and shouldn’t be used for emergencies and particularly not for discretionary purposes.

Identifying Your Less-Than-Monthly Expenses

The first step in recording these expenses is to identify them by:

  • Looking at the examples I’ve listed above.
  • Thinking about these types of expenses.
  • Looking through at least one year of bank and credit card statements.

Determining the Amount of Less-Than-Monthly Expenses

The next step is to estimate how much these expenses cost you each time you pay them and how many times a year they are paid.  It is likely that you have not paid one or more of these types of expenses during the time period you are tracking and recording your expenses.  For others, you may not have paid an amount corresponding to roughly one-twelfth of your annual costs.   For example, if you pay your property tax bill twice a year and have recorded two months of expenses, you’ve probably paid either no property taxes or a half year’s worth.  Neither of these amounts corresponds to the average amount you would pay in the two-month time period you’ve been recording your expenses in my example.

You’ll know the annual amount of some expenses fairly closely.  Examples of these are insurance and property taxes. For these expenses, this process will be fairly straightforward.  For other expenses, such as presents and car maintenance, you’ll have to use a lot of judgment to estimate how much you tend to spend.  Again, a review of your bank and credit card statements for the past year will be informative.

Adjust for Expenses Already Recorded

Once you have created your list of these expenses, review the transactions you have entered so far on the other tabs to eliminate any that you have already included.  If you have already recorded a small amount for this type of expense but it is not as much as you would expect on average, you can adjust the payments on the list you just made downward for the transactions you’ve already recorded.  This adjustment is a bit complicated.

  • Total the amount of expenses you have recorded in this category.
  • Divide the total by the number of months of transactions you have entered.
  • Multiply the amount by the ratio of 12 divided by the number of times per year you expect to pay this expense.
  • Calculate the total annual amount you expect to pay from the list you have made.
  • Subtract that result from the amount on your list of expenses to get the amount you will record.
  • Divide that difference by the number of times per year you make that payment.

Recording Less-Than-Monthly Expenses

You can now enter the information from your list, after adjustment for transactions you’ve already recorded, on the Less-Than-Monthly Expenses tab.

Rows 1 through 6 briefly summarize these instructions.

You’ll enter the information about your cash transactions starting in Row 11.  I’ve highlighted the cells for inputs in light green.  Enter the amount of each payment in Column A and the corresponding category in Column B.

If you make contributions to a retirement savings plan other than through a payroll deduction (i.e., Roth or Traditional IRA or individual RRSP or TFSA) and want to use the built-in tax approximation, enter “Retirement Savings” in Column B.

If you make estimated tax payments to the Federal or state/provincial government and plan to use the built-in tax approximation, enter “Federal Income Taxes” or “State Income Taxes”, as appropriate, in Column B.

In Column C, you’ll record how many times a year you make a payment of this amount.  For example, if you pay your car insurance twice a year, enter the semi-annual payment in Column A and 2 in Column C.

New Categories

As you start preparing your budget, you might find that there are new categories of income, expenses or savings that you want to include going forward.   You can add these categories on this tab with $0 in the amount column.  These categories will then appear as line items in your budget which I’ll discuss in a couple of weeks.

Download Budgeting Spreadsheet Here