Practical budgeting and savings techniques that revolutionise your finances
In our experience, a huge impediment to individuals getting their finances in order is a feeling of being powerless to save. Being stuck in the payday to payday cycle has people feeling constantly held hostage to the figure that lands in the bank each week.
As accountants we often sit with people that are purely frustrated with not being able to save and being continually under financial pressure. Some have stopped opening the mail, others are stuck living of credit for basic living expenses, weighed down with 20%+ interest rates. If this is you, or somebody you know. Then take this as article as an intervention into your finances, the principles contained within are timeless and work regarding of circumstances and impediments.
So let’s start with taking a look at the pure mathematics of savings. The mathematics tells us that on a moderate level of income, lets say an income of $50,000. If this individual was to consistently save 10% of the wage, by retirement age they will be a millionaire (even with an average return on investment).
That’s pretty mind boggling mathematics. The concept I find most astounding is that the determining factor in creating this millionaire is not the amount saved over their lifetime (only $250,000 over 50 years) but it is the combination of interest and time on what has been saved. These elements of time and interest creates what is called compound interest (Interest earned on interest you have received in the past, accounting for $750,000 in the above example).
While, this shows us the incredible power of consistently saving. Yet, if it that easy, why is having money in the bank so illusive. In fact, research shows that in Australia one out of every two individuals are living paycheck to paycheck. (source NAB)
If the benefits of savings are really so great, what is it that is wrong that causes us to miss out on all of these benefits?
We believe that this primarily comes down to a few factors:
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Our ability to adapt our lifestyle.
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Our ability to put a structure in place; and
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Our level of belief that we can positively influence our future financial situation
Our ability to adapt our lifestyle, is a bit of a two edged sword. In that it is the secret to changing our finances, yet is the most common trap.
The reality is that for the majority of us, what we spend is always fairly closely aligned to our income level. This often means that along with a pay-rise, we see an increase in the cost of our lifestyle. This is what economists call lifestyle inflation. This is the number one reason why we can’t unlock the potential of savings and get our money working for us.
The good news is that through a very simple change to our approach we can unlock an incredibly different future. The approach is to decide to save first and cause our lifestyle to adapt to our income after we have saved.
Saving first is a very simple concept, that has a hidden depth and power to transform how we live. To discover the hidden depth in this concept, lets take a look at the mathematical formula that the payday to payday cycle has us living according to.
The payday to payday cycle has conditioned us to earn income and we save what is left over after our expenses. In most instances this leaves nothing left to save. So the common approach of taking the income we receive and expenses is actually hurting us. Whether it’s the stockpile of bills, fuel in the car, restocking the fridge, enjoying the social scene. All of these natural priorities or necessities of life are number one on our list and often leaves no room for anything else.
What we don’t often realize is that necessities are actually situational and can grow and shrink in our own mind depending on our financial circumstances. This is because by nature we adapt. When we get a pay rise we adapt our lifestyle, when we lose our job we adapt. It’s more painful to adapt down than up, yet we still adapt.
Representing this pattern as a formula it appears as
Income – Expenses = Savings
In most circumstances, managing your finances via this pattern results in your savings equaling zero, regardless of your income! Again this is due to ‘lifestyle inflation’ and spending more as your income increases. It is very difficult and requires a tremendous amount of self control to moderate our spending using this pattern.
The simplest and most powerful change you can make to your finances, (regardless of your income level) is to simply change the equation and put savings before expenses.
Income – Savings = Expenses
In practice, this means that you decide on the amount to save first, before any expenditure. This way your lifestyle is forced to adjust to within your available resources.
Changing this hidden formula, will dramatically change your financial future. It is the beginning of breaking the cycle of never having enough and the start of having your money work positively for you. It allows you to be protected when accidents occur and eventually will allow you to create wealth without having to work for it, as your money is now working for you, creating income through investment return.
So how do we change the formula and save first? The first step is to identify savings goals. This allows you to allocate resources to the things that are truly the most important to you.
A powerful way to embed the importance of saving into your thinking and have it impact regularly on your spending habits, is to put aside some time and work through what are the big picture priorities that you want to direct your finances towards.
Identifying these big picture objectives help to clarify the overall importance of individual purchases. So when you make your next purchase whether it be your second coffee for the day or your next phone plan the importance of this decision is seen in the context of your personal financial goals.
Weighing and measuring individual purchases against these overall objectives removes the isolation of the event and ultimately allows you to consistently make purchasing decisions that help you achieve your financial goals.
What should your Goals look like?
Our advice is to use a simply goal setting strategy of creating SMART goals. SMART is an acronym for Specific, Measurable, Agreed, Realistic and Time Based. You can find more details about SMART goals and our template for SMART goals via the embedded links.
Once you have decided on this goals, convert them into the cycle at which you get paid, weekly, fortnightly or monthly, and setup direct debits that go into your account straight after you get paid.
Allocate your income to: Savings, Fixed (Bills) and General Expenses
Often an impediment to financial decision making is a lack of transparency on your financial position at a given point in time. It’s very common for bills to intermixed into our purchasing decisions. With outstanding bills, reoccurring payments, pay-cycles all needing to be considered to determine if you can afford an item or not.
It’s all very stressful and it’s easy to see why many people resort to just worrying about it later.
Our recommendation to create transparency so you know exactly where you are at all times, is to separate your expenses, between bills and other expenses. Having ongoing bills direct debited from one bank account and having the remainder of your expenses accessible via a debit card on another bank account.
This means you will now have three bank accounts.
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One for savings (or debt repayment)
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One for bills and ongoing commitments
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One for general expenses (discretionary spending)
Again each pay cycle the amount needed for bills is transferred or paid into the bills account. Meaning that you will always have enough to pay your bills. And everything that is left goes is available to be spent on other living expenses and enjoyments. Having one reference point for discretionary spending decisions means its easy to determine if you can really afford that purchase. It’s a singular bank account balance with no other bills mixed in.
This very simply structure of three bank accounts and spending priority of savings, bill and then discretionary spending, allows you to have clarity on your financial position and the peace of mind that you are not only meeting your commitments but are moving forward financially.
It really is life changing. And surprisingly requires limited ongoing discipline as the majority of your finances (savings and bills) operate on a set and forget mentality, with the only ongoing decisions based on the remaining available funds.
