Friday, May 16, 2008

Envelope Budgeting

I've been wanting to do a post on Envelope Budgeting for some time now. Envelope Budgeting is truly what enables me to stay home to care for my family. Without that second, supplemental income, it is more crucial than ever to budget for every conceivable expense. Otherwise our ship would have sunk a long time ago.

The reason why budgeting fails for most people, is that they only budget for their recurring, monthly expenses. They fail to budget for those things that are bound to occur sooner or later, or occur predictably every year. Like Christmas! Some people act like Christmas sneaks up on them, and they had no idea it was coming. I used to be one of those people!! For the past 32 years of my life, Christmas has fallen on the same day, every single year. :) It's time I started anticipating it and planning for it! Birthdays will, without a doubt, occur from time to time. Clothing gets worn out and outgrown, and will need to be replaced. Appliances will break down eventually. And Murphy's Law states that your car will break down at approximately the same time.

In the past, we would have just pretended that none of those things were really going to happen to us, which, ultimately, is why we have debt. Debt is merely the result of not saving up for things, and thus spending money you don't have when the inevitable occurs.

My first "aha!" moment occured when I began reading about Mary Hunt's "Freedom Accounts". Mary Hunt basically advocates for saving up for large, annual, seasonal, or occasional expenses in a separate bank acccount that she calls a Freedom Account. (Freedom meaning it frees you from debt, and puts you in charge of your own financial destiny). So we started off by doing this for larger expenses, like Christmas, clothing, and car repairs. I still diligently used cash to pay for everything else. When a "Freedom Account" expense would come up, since it was in a savings account, we would use our MasterCard (with air miles!) to pay for the expense, and then transfer the money out of our savings account to pay the MasterCard. This was working so well, that we decided to use the same process for ALL of our expenses. Our money would sit in savings, earning interest for the month, and we would pay for things with our Air Miles MasterCard, earning air miles on things we would buy anyway. I deduct each and every purchase from its appropriate "envelope", and always treat it like cash - to us, our credit card is like a debit card, we deduct the purchase immediately from our available funds. At the end of the month, we just pay the bill with the money sitting in the account. We are saving up our Air Miles until we have enough to take the whole family to Disney World. :)

This hybrid credit card/envelope system works really well for us, because we are disciplined enough NOT to treat it as a credit card - we are fully aware that we are spending REAL money. For anyone who struggles with credit card debt, I would never advocate this approach, I would stick with cash or a debit card. The same principle applies, however.

I began by making a list of every conceivable expense. Our current list of "envelopes" is as follows:

(Our allowance we actually do take in cash - each of us gets some of our own spending money that does not have to be accounted for in the budget. This is what keeps us sane, and allows us each a little bit of spending freedom)
Auto:Other (Parking, etc.)
Auto:Purchase (saving up for our next vehicle - a van!)
Bank Fees
Gifts & Occasions
Home:Property Tax
Personal Care (hair cuts, etc.)
Student Loans

Since my husband is on salary, it is pretty easy to maintain this system. I created an excel spreadsheet and started with my husband's income at the top, and then started plugging in all of the numbers for the various expenses. Your goal is to have a Zero-Based budget. Every single penny should be given a job. All the more reason to make sure you have every possible expense covered, because there's no money floating around without purpose. If it doesn't balance, you are forced to find areas to cut back until it does balance. Once all the numbers balance out (Income-Expenses=0), you can then go ahead and create your envelopes. They can be real envelopes (with cash!), or they can be pretend envelopes, where you leave the money in the bank, but write the amounts on the back of the envelopes. It can be a notebook, where each page represents an "envelope", and you put the starting balance at the top, and then subtract each expense as it occurs. It can be a spreadsheet, with a different column for each envelope. There is some software by Snowmint Creative Solutions called "Budget" that uses the envelope method, with pictures of real envelopes representing each category. Personally, I use Quicken to track our envelopes. I have Pocket Quicken on my Palm Pilot, which goes everywhere I do, and I can quickly see at a glance how much is remaining in each "envelope" before I make a purchase. I can also enter transactions on the go, so my balances are always up to date. There may be thousands of dollars sitting in the bank account (there's not, but it's possible!), but I can tell at a glance that I only have $53.00 left for groceries, and will budget accordingly. Our bank account balance becomes irrelevant, because it's really the "envelope" balances that matter.

What I LOVE about this system is the following:

1). It reduces stress. We never have to panic about how we are going to pay for something. The money is set aside in advance, and when a bill comes, we simply pay it. Even our heating costs are spread out evenly 12 months of the year, so during heating season we aren't worried about an increased expense - it's covered in our monthly budget.

2). It's fun! It makes it so much easier to save up for something if you can see that you are directing it to a certain category. You can create envelopes for special expenses, something fun, and then watch the balance grow as you add to it month after month.

3). It's flexible. With some costs rising, I find it necessary to tweak the amounts going to various categories so that we can pay for other expenses. I've had to increase our grocery budget lately, which meant carefully shaving amounts from various other areas.

4). It's empowering. For those of you who have been following my blog, you know that I am a fan of being proactive, rather than reactive. Envelope budgeting is as proactive as it gets. Setting money aside for future expenses puts you in the drivers seat of your financial destiny. YOU decide where your hard-earned money goes, not the other way around. YOU choose what is important to you and your family, and direct your money accordingly. Even if you can only afford to put $1.00 into a particular category each paycheque, that $1.00 will become $2.00, and then $3.00... whereas 0 multiplied by any number is still 0. If you don't put any money toward things, it will never add up to anything.

5). It provides incentive. It's much more motivating to find ways to reduce your power consumption, if it means YOU get to decide where to re-direct that money you've saved. Maybe it's to an essential category, like food. Maybe it's to a fun category, like Travel. In any case, without envelopes, that "saved" money would just get lost in the shuffle, and you might not see it again. With Envelopes, you get to see exactly where it goes, which provides that sometimes much-needed incentive to cut back in some areas.

6). Balances carry forward from month to month. I particularly love this feature. With traditional style budgeting (where you write everything out on paper and then cross your fingers and hope for the best!), I always wondered what would happen to that clothing money you didn't spend, or the extra money you had left in your grocery budget for being such a good little shopper. This way, the money just floats into the next month, and the month after that - which provides even more incentive to be frugal. You can either sweep extra money into another envelope, or you can allow it to accumulate. For us, because we budget monthly, we have to allow for the months of the year that have 5 weeks in them. This can wreak havoc in categories like food or gas, so I like to leave a little cushion that builds up, which carries us through those longer months.

7). Windfalls can go where you want them to! In addition to your regular source of income (in our case, my husband's salary), there are often extra bits of money that come into our lives. Whether it's an income tax refund, or money from selling things, or some extra income earned on the side, it's fun to decide where to direct that extra money! Sometimes it needs to go to an essential category (maybe there is too much month left at the end of our grocery budget), but sometimes we can put it toward whatever we want. It's fun to add to a particular envelope and watch as you can meet your goals faster than you expected.

In addition to our "Envelopes", we also have a separate account set up for an Emergency Fund. This is the FIRST bill we pay every single month. While we try to plan for every conceivable expense, there is still a chance that something catastrophic could happen that we truly did not forsee. This would also cushion us in the event of a job loss, and provide us with some income until we were able to get back on our feet. This is THE MOST IMPORTANT expense we have, as without a cushion for emergencies, we are truly at the mercy of the universe. If you don't have an emergency fund because you think you can't afford it, ask yourself what you would do in a worst-case scenario event such as a job loss. Even a month without an income would sink most of us. Our goal is to eventually have a minimum of 6 months income sitting in a separate account. We have a long, long ways to go, but at least we are moving in the right direction. Even $5.00 a month would add up over time, and would give you a sense of security and help you sleep at night. As you are able to reduce your other expenses, you can gradually increase the amount you can set aside. Just make it a priority and do it FIRST, before you pay any other bills, or else you will never do it.

Well that turned out to be a much longer post than I thought it was going to be! As you can see, I really, really like envelope budgeting. :) Even if we were rich, I think I would still do it, because it provides such great clarity about where you are directing your money.

Happy Budgeting!

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  1. I for one, really appreciate your post. Very informative. My husband handles all our finances which is the way I like it lol but I really should be more proactive.. and implement some of these ideas you have suggested. I am kind of excited after reading your post to start an "envelope" system with my husband. Thanks for taking the time to explain what works for you :)

  2. Hi Tara,

    Glad you found it helpful! You'll have to come back and let me know how it worked for you. :)


  3. Tara, this is a great post and very well done. I am a credit Counsellor and this is exactly what my clients need. You budget exactly like I do (cashless envelope system) and we use an excel spreadsheet with formulas to subtract for us. This spreadsheet should match exactly to our bank account and if not somebody spent something somewhere. Thanks again.

  4. Great post.

    Learning to plan for the expenses that don't happen every month is a huge change in behavior that really does help people avoid debt. Excellent personal coverage of the topic.

  5. Thank you for sharing. I also read some of your posts and I learned a lot of things.