Budgeting To Build Your Net Worth In 2021
Budgeting and reviewing your income and expenses is important in building wealth. There is no one right answer on the best way to do this, however, I will provide some pragmatic tips to effectively budget.
Where do I start?
There are many experts out there that say it is important to automate your budgeting process. There are apps like Mint that help you budget. Most of the banks even have budgeting services like RBC's MyFinanceTracker.
Everyone is going to approach this differently in my opinion. Personally, I do not completely automate the process because it forces me to review and classify my transactions. I review every single purchase and determine if it is groceries, eating out, utilities, etc. Its important to understand where your money is going. It is also a great review to see if you were charged for something you shouldn't have been.
Personally, I like you use Excel or Google Sheets for budgeting. This budgeting template is one that I have been using for the past 4 years. It has really helped me understand where my money is going. I have added fictitious amounts for demonstration purposes.
This is my bi-weekly process:
Login to online banking. Download my transactions in excel.
Add up the expenses per category on my budget. This is the part that takes the longest. I have a tool that I use that adds up all amounts per category once I am done classifying them.
Enter the actual amounts in the actual column of the spreadsheet.
Go back to online banking, make any debt or investment payments according to my budget. For example, if you are paying down debt, make those payments right away. If you are investing, pay yourself first!
Next, I pay off my credit card. I use my credit card for every single purchase I make and pay it off every two weeks. Paying it off every two weeks helps with my budgeting process. It also helps with my credit score. My credit score currently sits at 870 out of 900. Most people don't know this, but you don't want to carry too big of a balance on your credit card or it could impact your credit, even if you are making the payments on time.
Enter the balances of loans, investments, and bank accounts on the spreadsheet.
Review your budget versus actual amounts. Think of ways to improve for the next two weeks. Looks for problems in your budgeted amounts and fix for future periods.
Review the year to date (YTD) columns to see how I am tracking for the year.
Review my net worth amount at the bottom of the spreadsheet. I have a graph showing my net worth growth over the years that I review every two weeks to see where am headed. At any given time, I know where my net worth will be in 1, 5 and 10 years from now.
What expense categories should I include?
Pick categories that make sense for you. Don't include too many categories as you don't want your budgeting process to be complicated. Make sure it is clear in your head which types of expenses go to which category. I have a miscellaneous category on my budget as a "catch-all" but I try not to use it as much as possible.
How often should I review and update my budget?
This depends on personal preference. However, I would suggest doing it at least every month. I personally complete my budget every two weeks and have found this is the right cadence. I also update my budget as I go for small errors or issues. Every 6 months I do a big update and budget for the next 6 months.
How do you budget for one-off large expenses?
This is a tricky one. What I have found to work the best for me is to try to plan as much as possible when you think large expense will be incurred. For example, if you know you are going on a vacation next year, but aren't sure the exact date, make your best guess and put it in your budget. They key here is to always update your budget as you go. As you get closer to the date and you know exactly when the expenses will be incurred, adjust your budget accordingly.
Some people suggest spreading the cost over each budgeting period. For example, let's say you plan to go on a vacation that will cost $3,000 next year. You then take $3,000 and divide it by 12 months and budget $250 per month. I don't suggest doing this because it won't help you understand your cashflow. You won't know when you need to save up a bit more more cash.
Calculate your net worth
I suggest that along with your budget, you also include a net worth statement. This is the enjoyable part of budgeting for me. Its also arguably just as important as budgeting. It helps you plan where you are headed financially and can be a great tool in planning for retirement.
A true net worth statement will include cash, investments, equity in your home, vehicles and any other assets minus any debt. Personally, I only include investments, cash, and debt. I don't include vehicles or equity in my home. The reason I don't include my vehicle is that it depreciates quickly, so it can be difficult to know the true value of it. Plus, I know I will always need a vehicle to get around, so I don't include it for this reason. I also don't include the equity in my home for the same reason - I will always need a place to live. If you do decide to include the equity in your home, that is fine as well!
If you own a business, you should include the value in your net worth. It can be difficult to place a value on a business. An extremely rudimentary method would be to include the owner's equity in your net worth. A more accurate method would be to use a EBITDA multiplier to determine the value. Ask your accountant if you are unsure.
Paying down debt vs. investing
This is not a concept that is new to personal finance. However, it still amazes me how people think differently when it comes to this. Or even worse yet, when people don't think about this whatsoever.
Should you pay off debt before investing? It comes down to the interest rate you are paying on your debt versus the interest you earn on investments. For example, is it better to pay off extra on your mortgage with an interest rate of 2.5% or invest at 8%? I believe it is better to put your money into investments in this situation and not make an extra mortgage payment. Generally, its best to put your money towards to investment or loan with the highest interest rate first.
However, there is a caveat to the rule mentioned above. Investment returns are far from certain, however, the interest saved by paying down debt is guaranteed. For example, if I am deciding to pay down debt with an interest rate of 6% versus investing at 8%, I will likely pay down the debt at 6% even though it is a lower number. The reason is that I am certain I will save 6% worth of interest on the debt. Some discretion is needed in this situation. Personal preference plays into this as well. Some people like the peace of mind knowing they don't have any debt, and that is perfectly fine as well.
One final comment I wanted to mention is around the psychology of budgeting and managing your finances. Don't beat yourself up if you went over your budget in a period as it won't help. Figure out what went wrong, how to fix it for the next period and move on!
If you are feeling overwhelmed with the amount of debt you have, be patient and diligent. It will be paid off quicker than you think. Think of ways to make extra money or spend less. You should always be working to improve your finances.
To end on a positive note, watching your wealth grow can be a very rewarding process. By watching your net worth on a regular basis, you think more critically about buying that thing you don't necessarily need. This will sound nerdy, but I look forward to every other Friday when I spent the 45 minutes going through my budget and net worth statements as it has become a very rewarding process for me.