Pimp Your Finances

How many times has this happened to you?

Depressed by your bank account, you decide that a change is in order.

So you sit down to work out a budget. You pull out a piece of paper (or open up a spreadsheet), and write your paycheck on the top line. After that, you diligently list and subtract all of your monthly expenses. Cell phone, electric, gas, internet, rent, etc…. Next, you set aside chunks for your emergency savings and retirement fund.

Looks great, right? You can’t wait to get started. It seems all too easy to follow your freshly-minted map to prosperity. But along the way – normally after the first month or so – you hit road blocks. Why is that?

There are three reasons why budgets fail:

• The budget was unreasonable to begin with
• There was no emergency fund to back it up
• The budget used cash based accounting, instead of accrual

I’m going to talk about the latter, because it’s the least obvious of the budget killers.

What is accrual based accounting?

There are two different methods of accounting:

1. Cash-based: in this approach, expenses and income are recognized only when they are paid/received. As an example, let’s say that you pay car insurance once a year. For that month, you’d have a car insurance expense. For the rest of the year, you’d show nothing.
2. Accrual based: in this system, expenses and income are recognized as they occur. You spread the amount equally over the relevant time period. Using the example above, each month would have a car insurance expense of 1/12th of the total cost.

What does this have to do with personal finance? Simple. Using a cash based system in your budget will give you an excess in good times, but leave you gasping for air when times are hard. It will break your budget.

What’s the big deal?

To show the effects of a cash-based mindset, let’s take a look at a real world example: Social Security.

Social Security has had a budget surplus every year in it’s existence, and will continue to do so through the year 2016. The surplus is always loaned to the federal government in exchange for Treasury securities. The federal government then spends the money in its annual budget.

While Social Security currently holds $2.3 trillion in Treasury securities, it won’t help the government as a whole pay for anything. The reason? The government essentially gave a loan to itself in exchange for an I.O.U., then spent all the money. When Social Security goes to cash the I.O.U, the government still has to pay for it.

Rather than investing the surplus in non-Treasury assets, the government spent it.  As a result, they won’t be able to pay for the program. They’ll have to cut benefits, print more money, or borrow to pay for it. None of the options are especially appealing.

Had they used a true accrual approach, the government would have non-government investment assets (not I.O.U.s), and would be able to pay for Social Security for a much longer period of time.

What does it mean to my budget?

Using cash based accounting is an inaccurate way to estimate your expenses. Budgets are more successful when they are consistent. It’s a lot easier for us to spread the cost of insurance out over six months than it is to scrape together the cash to pay for it all at once.

Also, this mindset can lead to dangerous spending patterns. Ignoring expenses until they’re actually due enables us to spend recklessly the rest of the time. When you fall into this trap, you’re living off of more than paycheck at a time, and hoping that you can make up for it later.

You may be able to pull it off a few times, but in the end, it’ll catch up with you. And when it does, most people just use credit cards to make up the difference, which throws off the budget even more.

What can I do about it?

Switch to an accrual based view of personal finance.

To start, make a list of all the one-time expenses you’ll face over the course of a year:

• Car insurance
• Gym memberships
• Health insurance
• Holiday shopping
• Subscriptions
• Vacations

Then, take it a step further. List your monthly expenses that vary significantly:

• Electric bills
• Gas (for your car)
• Heating bills (including natural gas)
• Water

Next step – estimate the annual cost

For all the items you’ve listed, estimate the total cost throughout the year. This is easy for fixed expenses like car insurance or membership fees, but it can be tricky for other things.

For gifts, use this opportunity to set a limit for how much you want to spend for holidays and birthdays. It will be hard to use discretion on the fly, but if you make a budget in advance, it’ll force you to be more reasonable later.

For utilities, you have a few options. If you have access to the previous year of bills, just add up the total. If you don’t have access to previous bills, try to remember how much your cheapest and most expensive bills were. Add them together, then multiply it by six. That will give you a very rough estimate of the yearly cost.

I included gas in my list, because it can more than double if prices go up at the pump. It’s easier for me to set aside more than I need to, rather than be caught off guard the next time prices go to $4 a gallon.

What I like to do is estimate how much it would cost me to fill up for the year if gas is $3 a gallon. For example, my car has a 17 gallon tank. If I fill up every other week, it’ll cost $1326 for the year.

Figure out the monthly cost

After you have the yearly total for all your expenses, figuring out the monthly amount to set aside is a snap. Just divide it by 12. Once you have the monthly amount, make sure that you include it in your monthly budget, and treat it like you would an actual expense that has to be paid out.

The hard part – setting it aside

Budgeting on an accrual basis is just half the battle. The hard part is making sure that you actually save the money until it’s needed.

For fixed expenses, set aside the amount you planned on. For variable costs, you set aside any extra you have left over after paying the actual expense.

As an example, if you budget $50 for gas every month, but it only costs you $40, make sure to set aside the extra $10 so you have it available in case gas prices go up later.

If you budget $150 for electric, and it only costs $100, make sure to set aside the extra $50 for the more expensive months.

Our natural instinct is just to spend any money we don’t need immediately, but you have to fight it. The best way to do it? Transfer it away from your regular account, so that it’s out of sight and out of mind. You won’t be tempted to spend money that you can’t see.

What I did to keep my money separate is open an account with ING Direct. They make it quick and easy to open a new account, and the site is easy to use. There are no minimum balances, and no transfer fees. I use ING, but there are other similar options available, like HSBC.

Once you have a main account, you’re free to add as many additional accounts as you’d like. I created sub-accounts for car-insurance, vacations, mortgage payments, etc…. One nice feature is that you can add nicknames for your accounts, making it easy to tell exactly what each is for.

Transferring money in

After you set up the accounts, putting money aside is easy. When you get paid, just transfer money from your regular checking to the ING account. Or if it’s a variable expense, transfer the money you have leftover after paying the current month’s cost.

Incoming funds take 2-3 days to show up in the account, and they are not available for use for 10 days. I like that I can’t use the money right away. It’s like a built in waiting period. Also, by the time 10 days has passed, I’ve forgotten about it anyway.

Paying money out

When the time comes to pay for one of your accrual expenses, you have a few options.

Some bills can be paid directly from your savings account. It all depends on the merchant you are paying. If they don’t accept payments from savings, they probably accept electronic payments from a checking account (which is also free to setup at ING).

If you’d rather use your regular checking account, just transfer the money from ING back to your bank. There are no fees, but it takes about 3-4 days for the money to show up, so make sure you plan accordingly.

Conclusion

Sticking to a budget is a lot like holding a drink while riding a bike. It’s easier to do if our path – and our expenses – are level and flat, rather than a series of peaks and valleys.

Taking an accrual based approach to planning ensures that our expenses are consistent from month to month. This makes it easier to plan ahead of time, and eliminates shortcomings (which are too often filled by credit cards).

If we consider expenses only when we have to pay them, it’s guaranteed that we’ll hit bumps and spill our drink along the way.