Financial Freedom: Budgeting to Wealth
Total Income – Total Expenses = Total Investable Funds
Like every business, everyone should create a budget. Not knowing exactly how much money is being spent relative to how much money is being earned makes it difficult to assess where a person is financially which, in turn, makes it virtually impossible to create the necessary changes to get them to where they ultimately want to be. Playing it by ear has never been a good strategy when it comes to money. Not only does a budget provide for an individual an accurate picture of where they stand financially, it also gives them the opportunity to take the next necessary steps towards financial freedom with the proper foothold.
The primary goal of budgeting is to maximize Total Investable Funds. Ideally, Total Income far outstrips Total Expenses enabling a person to invest the difference and take sizable steps towards financial freedom on a consistent basis. Unfortunately, that may not now be the case for some. Total Income may, at present, be equivalent to Total Expenses. Or some may even be in a position where Total Expenses are larger than Total Income on a monthly basis forcing them to rely upon other sources of income (debt, government subsidy, charity) to make ends meet. Regardless of where a person is now, a sound budget faithfully adhered to can take anyone to an entirely different place. The important thing is to start and to be consistent.
The Beginnings of a Budget
When I first embarked on creating a budget, I focused primarily on the Total Expenses portion of the equation noted above. This was the most practical way for me to maximize my Total Investable Funds because curbing my monthly expenditures was the lowest hanging fruit. I suspect this is true for most people. I was not profligate by any means, but if given the choice between spending less money or finding a second job, the far easier option is painfully obvious. It takes no time at all to keep my credit card in my wallet. It takes several hours a week to earn a second income. Additionally, it makes little sense to earn a second income just to see most, if not all, of it drained by out-of-control spending. Best to put a tourniquet on a gaping wound before seeking blood donations.
I, therefore, started out by monitoring every single penny spent on a daily basis for three months straight. I literally carried a notepad with me everywhere I went and notated every single outlay of capital – from the purchase of a cup of coffee to my monthly mortgage. This approach had three benefits (1) it helped create a more accurate picture of my daily expenditures, (2) it startled me to discover that I made a variety of frivolous purchases on a daily basis without any hesitation and very little forethought and (3) as a result of that startling realization, I was more reluctant to make certain purchases. It is impossible to deal with a problem until a person acknowledges there is one. This documentation of daily expenditures went a long way in providing the necessary awareness of a spending issue that I had only ever acknowledged in passing.
At the end of those three months, I tallied my purchases and categorized them. I plugged in the numbers and I was able to come up with a more structured and more focused panorama of my financial condition. Once the picture was set, I endeavored to squeeze every ounce of blood out of an over bloated turnip. In order to do that, I eliminated certain expenses entirely while drastically lowering others.
Total Expenses
I categorize my monthly expenditures into two buckets – (i) Fixed Expenses and (ii) Variable Expenses. Although this is by no means accurate in terms of accounting nomenclature, I found that categorizing my monthly expenditures this way is very helpful.
Fixed Expenses
Fixed expenses are those that I cannot entirely eliminate or drastically diminish. These are expenses that are relatively static (i.e. mortgage/rent, taxes, insurance, car note, student loan, utilities etc.). I focused on my fixed expenses first and I was able to reduce a few expenses, but, by and large, I was not really able to make a great deal of headway in this category. I have labeled these expenses fixed for a reason. I was able to nip and tuck at certain expenses, but the drastic improvements in my financial panorama had to be made in the area of variable expenses. Unless I was willing (I was not) to make drastic changes to my lifestyle (i.e. live with my parents, ride the bus, live without the internet etc.), trying to eliminate or drastically diminish my fixed expenses was like pushing on a string.
Again, I was not living extravagantly by any means. I did not own a large home or a luxury vehicle. Consequently, my property taxes, insurance rates and maintenance and fuel expenses were fairly modest. Of course, this is not the case for everyone. For those who have outsized fixed expenses because they are living well beyond their means, eliminating or drastically diminishing their fixed expenses may prove a fruitful endeavor. It was not for me. I had learned my lesson from VH1’s Behind the Music.
Why do so many rappers and pop stars making millions file for bankruptcy protection? How does that even happen one wonders? It is bewildering that it happens at all frankly, downright befuddling that it happens with such frequency. It turns out, it’s because many spend their capital on bigger homes, chrome rims, jewelry, multiple vehicles, and their entourage in the belief that the income stream will never dry up. But, when their 15 minutes are up, the trappings of success become just that. They have property taxes, mortgage payments, insurance deductibles on homes and vehicles they can no longer afford. The income stream dries up and when the bill comes due they quickly realize that their recent purchases were not assets they were liabilities. Nobody wants to buy spinning necklaces and a lime green El Camino with gold rims and DVD players in the headrests. And very few people want to live in a home outfitted and personally customized by rappers and pop stars. These individuals become cautionary tales. It is edifying for me to remember the examples of MC Hammer and virtually every single winner of a large jackpot lottery every time I feel the need to upgrade my home or vehicle in times of financial prosperity.
Variable Expenses
Variable expenses are those that I will not entirely eliminate or drastically diminish. This is typically where the work needs to be done and it requires sacrifice and fiscal discipline. Because, in the end, budgeting one’s finances does not require a business degree or financial acumen. Creating a budget and committing to it is entirely a matter of will. The expenses that can be cut, must be cut. Now, I would venture to say that most people spend entirely too much money on things they do not absolutely need. Here are just a few examples from my own life.
I used to buy myself a latte and a pastry at my local Starbucks every single morning without fail. This cost me about $10 per day and this went on for years. I also ate lunch with coworkers on a daily basis which came to approximately $15 per day with tax and tip. I also routinely attended happy hours at a local bar after work (important note: this was before Jesus saved me) which amounted to approximately $50 per week for drinks and appetizers with tax and tip. I also ate dinner at various restaurants as a form of therapy during the week which cost me approximately $50 per meal. Routine entertainment expenses (i.e. movies, parties, local excursions etc.) also cost me approximately $50 per week on average. Vacations once or twice a year also cost me approximately $3,000-4,000 on a consistent annual run rate. This may not appear that extreme. In fact, relatively speaking I lived a fairly typical life. But, the expenses added up when calculated in the aggregate over an extended period of time.
This had to stop. And so I started making my coffee at home. I packed my lunch most days. I also limited the number of times I went out every week, and I eliminated fast food entirely. This was healthier for more than just my wallet. I went to Costco and bulked up on the essentials and I started eating in most of the time. During vacation periods, I spent more of my free time at home with family engaged in activities that did not require a great deal of expense.
This is just an example of what some of my variable expenses looked like and the frivolous manner in which I was spending most of my money. Your picture will likely look very different, but you get the idea. When I finally made the decision to create a budget and stick to it, I looked for every single frivolous and unnecessary expense and I ruthlessly cut it out. Then I immediately diverted that capital into investments that forced my money to work for me, rather than the other way around.
Now, it is important to note at this point that I did not immediately become a monk or live a life of ascetic displeasure. I splurged on occasion and I enjoyed life when called for. But, I decided to corral my expenses out of deference to a change in priority. This may be so obvious that it need not be said, but what a person spends their money on is the most accurate barometer of what they value whether or not those purchases are made with conscious value judgments attached. I wanted financial freedom more than a temporary vacation and my checkbook reflected that.
Total Investable Funds
After about six months, I was able to free up enough daylight between my income and my expenses to where the next question was what to do with the excess capital? In other words, when my Total Income outstripped my Total Expenses and I was able to free up Total Investable Funds, the question became where to invest that money?
Do I invest that money for a return on capital or should I first rid myself of debt? The answer to this question turned, for me, on my expected return on invested capital. The interest rate on my mortgage at the time was 5.45%. I had no student loans to speak of. The only outstanding debt I had was credit card debt. And so I opted to target credit card debt first before I invested for return.
Why? It did not make sense for me to incur 12-15% interest on credit card debt while at the same time diverting funds to investments that were not guaranteed to make such a high return on investment. Diverting funds away from paying off credit card debt for the sake of investing that money did not make a whole lot of sense to me nor would I suspect it makes a whole lot of sense for the average individual. It would be like sitting in a boat in the middle of the ocean with a hole at the bottom of the hull. Water is coming into the boat and instead of diverting energy and effort to plug the hole I expend that energy to expel the incoming water. And when the water is coming into the boat faster than I can expel it, neglecting to plug the hole in order to bail the water is a losing proposition.
I quickly came to the realization that this was a race I was not going to win and so I decided first to plug the hole. I diverted all of my excess capital to pay off my credit card debt. Once I was done with credit card debt I started focusing on how to invest the money. Other forms of debt (home mortgages, car notes, student loans) have relatively low rates of interest such that my investments would likely outpace the interest incurred on that debt.
I took the excess capital resulting from the elimination of various expenses and I invested that capital. Where I decided to invest will be the focus of the posts that follow.