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Budgeting & Compounding

Are you one of the many Americans who don’t have a personal budget? Do you find yourself living from paycheck to paycheck, never having anything left over to save for a rainy day?  More and more of us are faced with this dilemma than we care to admit.  It seems we all have the intention of creating a budget later, but somehow later never comes.  We’re also faced with the dilemma of whether to save for retirement, children’s college, a rainy day, a vacation, or countless other things that we can’t seem to prioritize and begin saving.  First, let me just say that no one likes to talk about a budget, it is the dreaded six-letter four-letter word!  Unfortunately it is one of the most important conversations you can ever have. 

This is the best time of year to work on a budget.  Why not January you may ask, well I’d say January is full of other resolutions that may add a line item to your budget instead of taking one away.  This time of year, you’re thinking about your tax return.  And while you still have that extra cash, let’s look at ways to keep it longer!

How do I create a budget?  I don’t know where to start.

  1. Create a record of your expenses and income.  Start by writing down everything that you’ve spent that month.  There aren’t too many people that still use a check register, but your bank still has them available.  Some of you may ask, “What is a check register?”  Well, in the not so distant past we weren’t connected and online via our smartphones with balance alerts and everything else available at our fingertips.  We had to keep a record of all of our purchases and deposits in a check register and wait for our monthly bank statement to come in the mail to reconcile, or balance, our checkbook. There is something to be said for that now nearly nonexistent ritual, it really helped you know where you were spending your money.
  2. After you’ve created that record of your expenses and income, do you have money left over or are you negative?  If you’re negative, you truly need to take a hard look at where your money is going.  Next thing is to categorize your spending: housing (rent, mortgage), utilities, restaurants, shopping, credit card or car loan payments, to name a few.  Now ask yourself, “Can I skip the coffee today?  Do I really need that dress (handbag, golf club, etc.)?”  More times than not, the answer is yes on the coffee and no on the dress.  It may be difficult to drive past the coffee shop, but let’s put it in terms of your future.  You spend $15 a day on coffee and lunch during the work week, that’s $3,900.  Wow!  And is that golf club going to help you achieve financial freedom?
  3. Now comes the hard part, actually making these things happen.  So you’ve set a goal to save $50 per week.  Easy way to do that?  Set up an automatic transfer from your checking to savings or update your direct deposit information so that the money goes straight to your savings without a stop in the checking account.  Still feel you’ll be tempted?  Start an account at another bank and do not get a debit card or checkbook.  That way you’ll actually have to go to the bank to get your cash.  This gives you more time to think about whether or not what you’re buying is a need or a want.  We hope that this money becomes something that you mostly forget about, out of sight out of mind. 
  4. Let’s look at that $50 per week over five years – that’s $13,000!  Now, that is simple math and not including the power of compounding.  When you add in the interest element, that number quickly exceeds $13,000.

What is compounding interest and how does it help me?

Compounding interest is basically earning interest on your interest.  It allows your money to work harder and grow faster.  Assume you have $1,000 and you earn 3%, you now have $1,030.  The next credit you receive of 3% will be on the full $1,030, leaving you with $1,060.90.  This continues for the entire time you are invested.  Let’s assume that you saved $1,000 per year for ten years from age 20-30 and stopped, allowing this to grow until age 65.  Your friend saved $1,000 per year for twenty years, from age 45-65.  Assuming a flat 6% annual compounded return, you end up with nearly three times more money than your friend.  This is represented in the illustration below.  Compounding is an amazing thing!

Which should I focus on first – retirement, rainy day money, debt repayment, children’s education?

While this question is best answered case by case, but as a starting point we ask you to look at your employer’s retirement plan.  Is there a matching component?  Such as if you contribute 3% of your salary they will match you 3% of you salary?  If so, great!  Let’s start there.  That 3% match is free money!  Be sure that you are contributing enough to take full advantage of the match.  3% is only $3.00 for every $100 you make.  I promise, you won’t miss it after a couple weeks.  Never has anyone said to me or anyone on my team, “I wish I hadn’t saved so much for my retirement.”

Having rainy day money, or an emergency fund, is one of the most rewarding things that you can do for yourself.  You never know when the washing machine is going to go out or you have to replace tires on your vehicle unexpectedly.  As a general rule you should have enough cash on hand to cover three to six months’ worth of household expenses.  We start this by simply putting a few dollars away at time using the methods above.  The hardest part is staying out of it!  The next part, and the harder part, is seeing the big picture and not giving in to that new trendy outfit.  It is easy to set a goal, but no one else will hold you accountable.

“How am I ever going to pay for my child’s college?”  While having the goal of paying for your child’s education is wonderful, you must be able realize that you are not doing them a disservice by planning for your retirement first.  Let’s face it; they don’t want you living in their basement because you planned for their college and not your retirement!  We all want our kids to have it easier than we had it, and that is wonderful if you can comfortably make that happen.  Just don’t sacrifice your financial wellbeing to make it happen.  There are many ways to tackle the costs of college, so be sure to seek advice when the time comes.

Debt repayment is sometimes a huge mountain to climb.  Have high interest credit cards?  Did you know that you can transfer the balance of that high interest credit card to a new credit card, often times with little to no interest and a nominal fee?  Check that out, it may save you hundreds of dollars.  There are several online resources you can use to find the right credit card for you.  In most cases, you can even apply and input your balance transfer information right there.  Starting out with student loans, remember they were worth it.  I promise you’ll thank your parents later when they still have money to retire and aren’t living in your basement.  The key word to any debt is consolidation.  You can consolidate your student loans into one payment.  This will help you chip away at the principal faster.   Have a 30 year mortgage?  Keep in mind that you’re not tied to that mortgage for 30 years, you can refinance to take advantage of lower rates.  Another great advantage to home ownership is the ability to access your home’s equity to, here it is again, consolidate debt. 

To sum all of this up, it is up to you to determine which route makes you feel better and be able to sleep at night.  Unfortunately finances are not all dollars and cents, it is mostly behavioral.  While we all want to all be debt free and have plenty of savings, we must first take the small steps that will lead to greater strides.  I encourage you to sit down and take a hard look at everything to determine what is best for you.  No one else can plan for your future but you.  Still have questions or need some guidance?  You can check out the resources available on our website www.AxiomFSG.com or contact me for more information.

This article was written by and provided courtesy of Michelle Konkle, CFP®, Financial Advisor with Axiom Financial Strategies Group in New Albany, IN.  She can be reached via email at [email protected] or by phone at 812-913-7701.  Visit our website at www.AxiomFSG.com.

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