Finance Sessions - Post 5

[Lunar Mojito]

The art and science of budget​

Budget is considered the very basics of finance, the core of most finance functions within companies, used by the largest companies, small business and governments alike.

According to Investopedia a budget is “An estimation of revenue, expenses or changes in finances over a specified future period, usually compiled and re-evaluated in a periodic basis”.

In a practical sense, budgeting is estimating how much you will earn, how much you will spend, and comparing the real execution of these streams vs expectations, and course correcting as needed. This allows you to create awareness of how you are using your money.

Why is this so important in personal finance? Budget allows you to navigate complexity in finance, also let’s you assess your spending habits. Almost everyone can benefit from it.

What do you need to use a budget:

• A goal
• Basic arithmetic
• Pen and paper
• Discipline

I need to emphasize the last bullet point while introducing some of my experience in multiple financial functions: The hardest part of any budget is sticking to it.

Sharing some perspective, in large companies, governments institutions and other organizations there is a function (with names like “Budget,” “Financial Planning and Reporting”, “Corporate Finance”, “Planning”, etc.) whose sole job is to act like an ogre who hits with a club anyone who dares to fail budget goals. You underdeliver sales? You get the club. You overspend? You get the club. You underspend? You also get the club.

While this corporate perspective is be too restricting and impractical for most people, it shows that financial discipline does not come naturally for many, so it must be practiced and mastered. This is also why a goal is needed: control for the sake of control will turn you bitter and resentful, the budget is a tool to a goal, not a goal in itself.

First set up a financial goal, if you are new to this I recommend to use the SMART method. SMART is an acronym for Specific, Measurable, Achievable, Relevant and Time-bound.


Let’s go with an example, let’s say you are in a financial tough spot. Instead of using a generic and vague goal like “Stop being poor”, you use the framework.

S – Specific: Reduce credit card debt to zero

M – Measurable: Credit card debt is zero

A – Achievable: Credit card is zero within reasonable time frame

R – Relevant: The high level goal is to improve financial situation, so eliminating credit card debt is a relevant goal.

T – Time bound: 1 year. This point also connect with how achievable it is. If time constraint is too tight the goal stops being achievable. In this case, will depend on how large the debt is.

Now, pick your pen and paper, or any other tool of your liking. Use the tool best fit for you, some people use google sheets, Microsoft excel, some sophisticated personal finance app. Use whatever works for you. Only complex, large-scale budgets need sophisticated tools.

First, sum all of your sources of income. For most, there is only a monthly fixed salary.

Income: $5,500/month

Second, we sum and categorize all expenses. Categorization is another key element, as it will allow you to decide on any course correction.

Expense categorization is more art than science in my opinion, I will lay here some general categories that are almost universally used:

• Necessary expenses: This is the items you can’t afford to not pay. This includes rent, mortgage (for your first home only), groceries, utilities (electricity, water, natural gas, internet, phone bill), your children’s tuition, healthcare costs.
• Debt service: This is the amount you pay to honor any kind of debt, be either mortgages (for any other building that is not your first home), credit card, commercial credits and so on. I encourage you to separate debt service in both productive and unproductive, as they are treated in different way. For doubts on how to separate this, refer to finance sessions post 2.
• Short term savings: A portion of your income should go to a savings/liquid account up to a cap of at least 6x your necessary expenses. Refer to finance sessions post 3.
• Long term or other savings: This item exists for savings with an specific purpose, i.e. you are saving the downpayment of your first home, or you want to go on a lavish vacation.
• Investments: This should only exist once short term savings goals have been fulfilled. Don’t think about investing unless you have enough liquidity to cover up any unexpected expense (credit cards are NOT a way to cover emergencies, by the way).

There are a lot of other categories, like taxes. But for most part, you will find the above in all personal budgets.

Now, we sum all expenses:

Rent: $2,400/month

Social Security and taxes: $1,045/month

Credit card debt: $997/month

Utilities: $700/month

Cleaning service: $100/month

Eating out: $750/month

Others: $100/month

Total expenses: $6,092/month

Here is the first red flag, expenses are higher than income. This means the person in this example will have to either reduce it’s savings or go into debt.

Now we can calculate some ratios: 75% of Example guy’s income goes to necessary expenses!!! (rent, social security, utilities) This is way too high. If we zoom in we can see some trends:

• He does not buy groceries, only eats out.
• He lives in an expensive area, with rent eating 43% of his income.

Also, credit card debt is 18% of his income. If we consider credit card debt as unproductive debt, this is too high. And the worst part, necessary expenses and debt eat 93% of Example guy’s income!!! I would not be surprised if he viscerally hated his job (most grumpy and hateful employees are the ones who do not see their paychecks at month’s end).

By looking through a budget, the bad decisions are evident. But for Example guy’s point of view, he is only eating cheap meals outside, and saving the horrible commute in his city.

Now going back to the goal, he wants to pay his full $18,000 credit card debt in a year. His debt is currently deferred at 24 months using a 29% APR (annual interest). If he wants to pay the debt in only a year he needs to increase his monthly credit card payment from $997 to $1,728, this means we are short of $730 for credit card payment. We are also short of $592 given his expenses are higher than his income.

Some things Example guy can do:

• Move to a cheaper zone, with both lower rent and utilities. In this specific example this is the best option. And should only be discarded if:
• A.Example guy is using the time form short to no commute (he has no transportation costs, which means very likely he has no commute to work) into something productive like advancing himself, starting a side gig, investing time with his significant others. The most common error of “moving to an expensive area to save commute” is that this extra time is then used to watch Netflix or play videogames.
• B. The cheaper zones are crime ridden, in this case the high expense is a matter of safety.
• Stop eating out and paying cleaning services. He starts to cook his meals and clean himself, this is another way of using the extra time advantage of living in an expensive area.
• He increases his income. It’s preferrable most of the times, but in this case Example guy has some bad financial habits, which will probably be made worse if he gets himself a higher paying job.

Let’s say Example guy decided to move, and his new rent is $1,500/month and his new utilities are $400/month. He is now in $608/month surplus.

Here are some things he can do:

• Keep cutting expenses so he can achieve the $1,728/month payment in credit card, and be free of debt in a year.
• Rebalance his goals, he could increase the credit card payment to $1,500/month and he would still have an extra $108 every month for transportation expenses, save or buy himself something. With this option, he will pay his credit card fully in 15 months.

The difference between option 1 and 2 is mostly human, strict theory says that option 1 is the way to go, but if we into this example, this example guy could become discouraged the first months he has to commute to work. Here option 2 could allow him some extra cash flow to do something that can cheer him up.

Again, I must be redundant: the hardest part of the budget is sticking to it. Example guy could pay his credit card fully and then go in a spending spree, wasting all the effort.

As a side note, there a lot of budgeting methods that can be useful. One is my favorites is using a single credit card for "micro-expenses" like eating out, buying coffee, and so; an fully paying the balance at month's end. This helps you break the illusion of "low paying pain" for small expenses, raises your credit score and saves you the hassle of taking note of each expense. (Do NOT do this if you have credit card debt, you will be tempted to overspend).

Hope you can find this useful, may you succeed in all your financial goals.