Building a Budget

Figuring out your net worth is a critical step in managing debt. But if you really want to get serious about managing debt, you must have a household budget.

In an era where consumer spending is high and there are plenty of new goods and services to buy that weren’t available even 20 years ago, knowing how to budget properly is a big key to your financial success. According to a recent American Express consumer survey on everyday spending, today's list of typical, day-to-day expenses is still dominated by traditional items such as groceries, fast-food lunches, tolls and gasoline. But they've been joined by such new millennium wallet-sappers as cellular phone service, paging fees and Internet service costs.

The survey also tracked increases in expenditures on several traditional household expenses. Insurance premiums were up 35 percent (from $2,016 to $2,722, annually); utilities, up 15 percent ($1,536 to $1,764); fast food, up 43 percent (from $504 to $720), and subscription expenditures climbed 42 percent (from $228 to $324). All climbed within a five-year period from 2000-2005.

In its review of a total of 11 spending categories, American Express found that overall expenses increased by 5 percent.

Consequently, as everyday expenses increase, managing a household budget becomes more complicated. The best solution? Get those costs into your budget as soon as possible. That’s because people tend to spend whatever money is left over after the fixed expenditures and stop only when either the ATM won't give them more cash or the bank calls.

One way to keep money from flying out of your pocket is to write down what you're spending, as you spend it. You may not realize it, but that glass of merlot after work, the dry cleaning you picked up on the way home, and that four-cheese pizza you had delivered to your door for dinner all add up. A record of your daily, weekly or monthly expenditures makes for some interesting reading in most American households, testing the patience of millions of spouses in the process.

Some consumers like to use a credit card to buy everything (the credit card companies LOVE to push that strategy). That way, at the end of the month, they have a ready-made laundry list of expenditures sent to them by their credit card firm. Bad idea. Sure, you get a nice, clean list of what you spent each month. But getting into the habit of using a credit card is never a good ploy. It’s easy to treat that Visa card like cash – but it ain’t. Sooner or later you’ve got to pay for it, with high interest payments to boot if you’re not on time every month. Besides, in the age of the laptop, it’s easy to sit down at the end of the day and compile your own list. You’ll have your record and you won’t get sticker shock opening your credit card bill every month.

Primarily, all budgets are divided into income and expenses, but most good ones now include a third component, savings. Items in the "income" section can include after-tax salary, pensions, investments and tax refunds.

Items in "expenditure" can include rent, mortgage payments, food, gas, utility bills, childcare, entertainment, gifts and holidays. The "savings" section logs how much you put away each month, after satisfying spending requirements. As much as 10 percent of total expenses should be put into this category to allow for unforeseeable events such as dental emergencies

One way to attack your budget is to use what some debt counselors refer to as “the snowball method”. Using this strategy, simply list your debts in ascending order with the smallest remaining balance first, the largest last. Do this regardless of interest rate or payment. You will pay these off in this new order. This works because you get to see some success quickly and are not trying to pay off the largest balance just because it has a high rate of interest.

Once you pay off the lowest balance, take that payment and combine it with the next payment on the list, so that each month you're making a larger payment on that debt. Repeat the process, again and again, so that your payments are getting larger, your debts are being paid off faster, and the process starts to snowball until all your debts are paid.

If you’re one of those people who can’t sleep at night worrying about bigger bills, go ahead and address those bills first. Just rank your debts in order of highest interest rate to lowest. Then whittle away at them in that order. Make sure you are not comparing apples and oranges. The effective interest rate is often different from the nominal rate quoted by the lender. For example, mortgage rates are compounded semi-annually, while rates on credit-card debt are usually compounded monthly.

Tomorrow I'll list a budget "checklist" that has everything you need to get your budget started.