Overview:

Now that we’ve discussed what needs and wants are, how can you work to control them to drive yourself to achieve net worth growth. The first step to net worth growth is to put together a short-term and a long-term balanced budget.

Purpose:

As a follow up to the Finance First Controlled Spending article, the purpose of this article is how to build a budget, specifically a 5 year budget.

Analysis # 1:

If you’ve never done a budget before, it’s a rough endeavor. It can be very scary, but to me it’s the major step to drive you to real net worth growth. If this is your first budget or even looking to restart your net worth growth, first I would recommend setting up 3 different budgets. These 3 budgets will be over 3 different time frames.  I believe by breaking down the budgets into 3 different time frames, it will drive you to finish a budget, rather than be scared away. Just like any project, you can start with the end goal (net worth growth), but if you don’t break it into manageable sections, you’ll never achieve the end goal. I would recommend you break your budget into 3 different budgets:

–          Monthly (or paycheck)

–          Yearly

–          5 year

As you set up each of these 3 budgets, I have some principles that are applicable to all 3 budgets:

–          First, we need to make any budget manageable. We’ve already started to solve part of that problem by splitting our budget into 3 time frames.

–          By having too many inputs, tabs, assumptions, etc. on a budget can lead to errors and thus make your budget not affective for net worth growth. 

–          In our personal budget, I don’t budget to include any bonus money. Thus, if we do receive our bonuses, we have more options and freedom to use that cash to grow our investments (such as our rental home), to pay down additional debt, or to use it as our vacation fund for planning future trips.

–          In our personal budget, I don’t budget to expect a tax refund. Finance First has plenty of articles on the dangers of tax refunds, thus I exclude tax refunds in my personal budget.

–          When including your income, make sure you use the gross amount of your paychecks. This way you can understand all your income and spend for insurance, 401k contributions, health insurance, taxes, etc. as well. 

–          When including your income, to the best of your ability, add in any employer benefits, such as employer paid health insurance, 401k match, etc. These employer benefits can be used as well when you are doing an analysis of a possible job change.

–          In our personal budget, I like to have a small cash fund available for those short times where you might be “over budget” in your monthly budget (a timing difference). Note that this small cash fund is not the same as your emergency fund. Thus, I only have about half a paycheck as my small cash fund.

–           I also like to a have a home equity line available for any timing differences.

–          Here’s an example of how I use both of those items to deal with timing differences. First, think of times like the holidays or prepaying for a vacation flight where you might spend just a little more cash than you bring in during your normal monthly budget. You can pay back that timing difference the next time you have additional cash inflow. By borrowing from your small cash fund, the amount of lost interest on your small cash fund would be a lot less expensive than credit card debt. By borrowing from your home equity line, that amount of interest incurred would be a lot less expensive than credit card debt. See the appendix for a detailed example.

Analysis # 2: 5 Year Budget:

Now that we have some basic principals around building a budget, why do we need a 5 year budget? A 5 year budget gives you a long-term view of how your net worth growth will take place. While you can decide to do a longer term budget (10, 20, 40 years), a 5 year budget is short enough that most likely a significant job, income or expense change won’t occur, but long enough that you can factor in items (like schooling) that might drive future revenue growth (like schooling) and expenses (like a new car).

To start your 5 year budget process, you need to make some overall assumptions to apply to all figures as you go year by year:

–          I would recommend building in a yearly 3% growth in income (We’ll consider this a reasonable rate as it was the median of the average inflation rate from 1914 – 2018 of 3.25% & the average inflation rate from 1983 – 2018 rate of 2.70%.[1]). I realize all jobs don’t have the same raise schedule, but at least its gives you a good baseline to judge that your job is keeping up with inflation. As you review your 5 year budget, if you aren’t getting those yearly 3% raises, it would give you the opportunity to see why your jobs isn’t keeping up with inflation. This might also be a great opportunity to review if a job or role change is necessary.

–          I would recommend building in a yearly 3% increase for all expenses related to inflation. However, you can exclude your mortgage payments (though not real estate and insurance payments) from this increase. One advantage of most 30 year mortgages is that the payments terms do not increase with time via inflation.

As you build out your budget, you will also need to look at some personal facts and build those into your budget:

–          Look at your personal life. The budget should look at possibilities of marriage, pets and kids. Even if you are single, could you imagine you could meet someone and thus be married before 5 years (I did)? If you are thinking of having a kid, even if not married yet, will you maybe look to other possibilities like adoption?

–          Look at your personal health, are there medicines, doctors’ appointments, possible surgeries, etc. you might need.

–          Look at your dental health, could you need a crown, wisdom teeth pulled or children’s braces?

–          Make a list of all your assets, year purchased, estimated use life and estimated yearly maintenance expenses.

As you build your budget, you will also need to look at your assets and build those into your budget:

–          If you own a home, review your inspection report to see any short-term or long-term items that might need a repair.

–          With the above two items, you can now build out a budget for your capital funds for cars, home and appliances. I recommend you build in an estimated percentage for the likelihood of each occurring to help the budget not be too pessimistic or too optimistic.

–          Schooling – training. I’m a big believer in continuing education. Your learning should NOT just stop because you are 21 or you get some fancy letters at the end of your name. How do you plan to grow yourself to help drive future income? The need for education should be included in your budget with seminars, industry publications, continuous education, etc.

Conclusion:

A 5 year budget is a difficult, but useful step to see where you want to be in your net worth growth. It will give you the tools to see where your shortfalls are and how best you can tackle those.

Here are some tools to use to help you in the journey that I might recommend. {Full disclosure I don’t use all of them, just going off testimony from other finance, one’s I personally use are in italics

–          Mint.Com

–          Betterment – Ability to set up recurring savings

–          Capital One – Useful for small cash funds in that you earn a good interest rate on savings (formally ING in the United States)

–          The Finance First Budgeting Tool – 5 Year Application

Action Steps:

Now that we have a 5-year budget, here are some other steps for your net worth growth:

–          Review the Finance First articles on 1 year and monthly (paycheck) budgets;

–          Review the Finance First articles on continuous education and training; 

–          Write down your goal of your net worth 5 years from now, set an alert for 5 years from now;  

–          Write down your net worth today, as you review your 5 year plan, track how your net worth has grown;

–          Set reminders to review your budget and track your progress and any possible downfalls. If you experience a downfall use it as a learning opportunity; and

–          Keep a positive attitude towards spending, budgeting and income growth and in time you’ll hit that goal.