2. Budgeting

2. Budgeting

A budget is one of the best tools we can use to get control of our finances. It’s not about going without things, it’s about deciding what things we want and making sure we have the money when we want to buy them. Setting a budget helps you:

• control your spending and focus it on the things you care about
• check you have enough money to pay your current and future bills without having to borrow unexpectedly
• decide what your goals and spending priorities are – what you want – and plan for how to achieve them

While it may seem easy to borrow money by spending on a credit card or using an overdraft without thinking much about it, this often comes with a high price later, forcing us to cut back harder and go without when we need to pay it back. Budgeting can avoid this by deciding beforehand what we want to spend and helping us stick to it. It can give us the confidence to spend money knowing we’ve planned for it and can afford it, helping us through the financial ups and downs we all face over our lives with the minimum of stress.

Budgeting is surprisingly easy to do. Over the next four pages we’ll take you through our simple budget planner and help you create your own budget. Save this to your computer as we’ll be filling it in as we go along. Do you want to own your own house, have a debt-free Christmas, take your family on holiday, or simply stop worrying about money? Whatever your financial circumstances and goals there are three steps to follow, and along the way we’ll give you some practical tips on how to make them a reality:

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Assess: work out your income and current spending Decide: choose you goals and spending priorities Act: make small changes towards your goals

To illustrate the process we’ll be following the example of 28 year old insurance clerk Jenny, who’s starting to budget with the help of Martin Upton, senior lecturer in finance at the Open University and director of the True Potential Centre for the Public Understanding of Finance.

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JENNY

Hi Martin! I'm Jenny, I'm 28 years old, single, I live in a rented flat share in London.

I'm an insurance clerk, it's interesting... but it's an entry level job, so I guess you can say my income is lower than average. I have lots of friends, so I do admit, I do spend a lot of money on going out.

I tend to think of myself as well organised. I always try to pay my bills on time, but it's hard to make ends meet. It's like my expenses are always increasing but I don't have the income to go with them. And I never manage to put money aside for a rainy day. I'm a bit stressed about that.

I'd love to own my own home. I also want to be able to afford to go and see my brother who lives in Australia. At 28, I'm desperate for my aspirations to become realities. I want to take tighter control of my finances and plan for the future.

Any advice, Martin?

MARTIN

Hi Jenny, well it sounds like you need to get to grips with your budget.

First assess your situation. Draw up a detailed break down of your income and spending each month. And remember to adjust monthly cash flows to take into account how some spending occurs just once or a few months each year. For example holiday spending or car insurance. Budget cautiously. Allow ample sums for unanticipated expenditure like car repairs, avoid optimistic estimates of what pay rises you may get. If you do this, it's more likely that the eventual financial outcome for you will be a pleasant surprise. With unanticipated expenditure lower than forecast, and pay rises higher than budgeted for. Better this than a nasty surprise if it's the other way round.

When you've got these details in front of you, you're in a position to decide on what to do with your spending, where to cut it and where perhaps to increase it. More importantly you can start to plan for the future and your medium to long term goals in life, when you have the present day under control.

Good luck!

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Stage 1. Assess: work out your income

We start by working out our current income in a typical month. Have the budget planner included in this course to hand as we’ll be filling it in as we go along. It can help to look at recent bank statements or payslips when doing this. Let’s start with the income part of the first column – “Assess”:

Step 1: Work out your monthly pay. This should be the amount you receive after tax, and can be found by looking on a recent pay slip from your employer or a recent bank statement. If you are paid weekly you can convert this to a monthly amount by multiplying by 52 and dividing by 12.

Step 2: Add any additional income, such as benefits you receive, income from investments, or child maintenance payments. If these are irregular estimate how many times a year each happens and convert these into monthly figures – multiply each by the number of times a year and divide by 12.

Step 3: Add these together to give your total income. If you’re in a one-person household this is how much cash you have available each month. If you have shared finances it is usually best to create a household budget by repeating these steps for each household member and combining the results.

Here’s the income part of Jenny’s budget to give you an example:

Figure 1 Jenny's budget

Extension: are you claiming all the benefits  you’re entitled to?

Stage 1. Assess: calculate your spending

We continue filling in the “Assess” column in the budget planner by calculating your spending in a typical month. If you completed the income side as a household continue to do so here as well.

Step 1: Find a recent statement for all bank accounts and credit cards you regularly use.

Step 2: Note down your rent or mortgage and any other regular monthly bills you pay – e.g. council tax, utilities, phone, TV, direct debits and standing – and enter these into your budget planner. If you have any weekly bills convert these to a monthly amount by multiplying by 52 and dividing by 12.

Step 3: Divide the rest of your day-to-day spending into the categories within the budget planner. Don’t include annual or one-off payments here like holidays or furniture, we’ll come to these later, but try to estimate which category any cash you’ve spent best fits into.

Step 4: We’re trying to create an accurate picture of your spending in a typical month, however many items of spending can vary greatly from month to month. Have a look at the figures you’ve entered and adjust any that seem higher or lower than usual. Most of us underestimate our spending and it’s vital we avoid nasty surprises, so try to estimate spending on the higher end of what you think is typical. If you have bank statements from a few recent months it can be useful to compare these to help you decide.

Step 5: Make a list of your annual or irregular spending, such as Christmas presents, durable goods, holidays or car repairs. Again, it’s important not to underestimate how much you spend on these, as irregular spending can easily add up and break a budget. Convert these to monthly figures by estimating how many times a year each tends to happens, multiplying each by this and dividing by 12.

Step 6: Add these up to give you a total spending figure.

Once you have a total income and spending figure, subtract your spending from your income, as shown in the budget planner. What is the result? This should represent how much you’re saving or borrowing in a typical month. If it is positive, you should see your bank balance rise each month, and if negative it is likely to be falling. Is this the case? If not, revisit your income and spending as it’s easy to miss something.

Have a look at Jenny’s budget to get the idea:

Figure 2 Jenny's budget

Stage 2. Decide: what do you want?

Now you’ve assessed your current income and spending, you can start deciding what you want. Go to the “Decide” column in your budget planner and fill it in as you do the steps below – we’ll come back to your budget table later on but need to focus on your goals first. What are your goals, and what do you need financially to achieve them? What are your spending priorities – what kind of spending makes you happy? How can you do both while guarding yourself and your family against financial shocks that may lie ahead?

Step 1: Make a list of your goals – things you want or would like to achieve. They might be a particular holiday you want to have, an item you want to own, an experience, a new skill you want to learn, or a change in your circumstances such as being debt free or being more confident and less worried about your finances. They could just be being able to spend more money on a certain area, such as your children, clothes or going out more. I’d suggest thinking of around 2-10 goals.

Step 2: Imagine yourself in the near future with each goal achieved or not achieved, and concentrate on the difference each makes. For example how happy would you be if you’d just come back from a particular holiday, if you owned your own home, or if you were free of money worries, compared to how you are now? This may sound like a silly exercise but research shows matching your personality to what you spend money on can have a bigger impact on your happiness than how much money you have, and one of the most positive effects of budgeting is to refocus your spending towards things that really make you happy.

Step 3: Narrow your list to the 1-2 goals you think would make you happiest. Write them in the goals table on your budget planner.

Step 4: Think about the implications of each goal – what needs to happen to achieve each? What actions do you need to take? You may find there are trade-offs between different goals. If so, try to identify which are most important for you to achieve.

You’ll notice that goal 3 is already filled in: regularly save a small amount into a savings account. There is a huge amount of evidence that having even a small amount saved in case of an emergency significantly reduces the impact financial shocks have on us, and that we all underestimate how likely a shock is to occur. Things like your car or boiler breaking down, losing your job, falling ill, or any of the host of other reasons you might need to find some money quickly. Debt charities estimate that half of all households who find themselves in serious debt problems – around 500,000 people – wouldn’t do so if they have £1000 saved. Saving a small amount regularly, even if you can only afford a few pounds a month, may be the single most important thing you can do for your and your family’s financial wellbeing. Later on we’ll show how virtually everybody can do this.

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JENNY

Hi Martin! So, I've assessed my situation, and I've come up with some goals that I really want to achieve. Here they are!

First, in the short term, I want to balance my budget. I want to reduce and get rid of the gap between my income and my spending. Next, I want to build up my savings, so I have an emergency fund if ever I need it. And I want to pay off my personal loan, that's a given. So that's all in the short term. In the medium term I want to buy property, maybe even a new car.

I want to be able to afford going to visit my brother in Australia. And eventually plan for a family. But overall, from this point forward, I want to avoid wasting money. I want my spending habits to reflect a more balanced lifestyle and better financial health. What do you think?

MARTIN

Hi Jenny! Those are great goals. Well done in assessing your income and spending. We're in agreement that now you've got to take action. You're spending more than you're earning. If you go on like this, you'll end up borrowing more. In the long-term, you'll never be able to buy property if you haven't got a financial plan to build up savings for a deposit.

First, sort out what is essential spending and what is non-essential. Shop around - using the internet to trim the cost of utility bills, phone bills and insurance. Comparison sites help but do look carefully at all the details of the competing products - often you're not comparing like-for-like. Stop smoking - that'll save you money and improve your long-term health. Consider going out a few times less each month - maybe entertain at home instead? And for some items you actually may have to set aside more money than you are budgeting now. Have you allowed for the cost of possible repairs to your car or the amount you would need to find if you wanted to replace your current car?

Once you've settled on a financial plan, it's time to put it into practice. Remember, as you act on your financial plan, it's important to review your plan and amend it, to reflect any spending needs you need to take into account or habits that have altered. Good luck!

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Stage 3. Act: make small changes towards your goals

After having realised what you want, you know your goals and you want to get there. To achieve your goals you’ll likely need to reduce your spending in some areas. This isn’t easy and will require effort, but by working out what’s important to you and focusing on small changes to your habits you can often have a much bigger impact with less pain than you’d expect.

Always keep in mind the positive – the goals you’re working towards, why they matter to you, and how your life will be different when you reach them. You’re not cutting spending, you’re moving it from things you currently spend it on to what you’ve decided you really want.

Go to the “Assess & Act” table of your budget planner. With each step look at the current spending figures in your budget planner, consider how you want to change it, and write the new figure in the budget column.

Step 1: Explore ways you can save money without noticing it. For example are you paying for a gym or subscription you no longer use? Have you got extended warrantees or specific insurance to cover goods already covered by your home insurance? Could you get a better deal on your mobile phone, TV, mortgage, credit card, insurance, or energy bills? We’ve collated some tips on saving money for personal finance experts below, though these are far from exhaustive. Money Saving Expert has many more tips on saving money, and an active forum where you can ask questions.

Step 2: Rule out spending you cannot change. Look at the current spending table of your budget planner. Which items do you consider essential spending that you could not reduce at all? We all have lines we are not willing to cross but be strict with yourself when ruling out changes.

Step 3: Think about changes in your life you’d like to make that could also save you money. For example you may want to stop smoking, drink less alcohol, have a meat-free day, or cycle to work rather than driving. These are all difficult changes to make but the financial benefit could provide the additional motivation you need to make that change.

Step 4: Work out the one or two areas where spending money makes you happy and try to find cheaper alternatives for everything else. Most of us have one or two things we really care about and many others where we’d barely notice the difference. Personally I don’t mind buying cheaper clothes, taking tea bags to work rather than going to the coffee shop, having friends over instead of going to a bar, swapping the gym for a run, or driving a cheap-but-reliable car, but I love food and would struggle to cut my grocery bill. Focusing your spending in this way minimises the pain of cutting back, and you may even find you can afford to spend more on the area you particularly care about. Budgeting is not about going without but about deciding what you want and where you can afford to treat yourself.

Step 5: If you still need to reduce your spending further, consider what you could bear to go without and compare it to your goals. Often the small changes above are enough to meet your goals without feeling like you’re giving too much up, but sometimes you’re faced with difficult choices. Ask yourself if each goal is worth what you’d have to go without to reach it. Imagine your future with each trade-off and compare which future you prefer.

Does your new budget enable you to reach your goals? If not then repeat steps 1-5 above, or revisit your goals and decide if they’re realistic and whether you’re willing to make the changes necessary to achieve them.

Here’s Jenny’s new budget as an example:

Figure 3 Jenny's revised budget

Once you have your budget, try to stick to it. This is easier said than done, but by simply writing down how much you want to spend on different areas it can help you follow it. Always keep in mind why you’re doing this – your goals – to help with motivation.

Revisit your budget if your goals or circumstances change or unexpected expenses arise. It can be useful to put it in a prominent place to remind you – I pin mine to the fridge.