Saving and Budgeting

Saving and budgeting can often be overwhelming and scary topics. But if you don’t know where you are spending your money and find you don’t have any money left over to save, you won’t be able to achieve your goals. Keeping it simple and easy to follow will help you stick with it.

In a previous post, I discussed reasons why you should save. Here, I talk about a framework for saving and budgeting. Budgeting, while it may be a pain for some, is a very important aspect of financial health. It doesn’t have to be detailed or tedious, but you need to know where your money is going for it to be able to work for you.

Many financial advisors try to work backwards from a specific goal you want to achieve (eg. retirement at a certain date with a specific income, or a house down payment of X amount). Many young professionals know they should be saving, but may not know how much. Retirement is a long way off, and you may not know when you want to buy a house or how much it will cost. If you don’t know how much you should save, I personally like LearnVest’s framework:

Essential Expenses: Spend no more than 50% of your net income (i.e. after taxes) on essentials like housing, food, utilities, transportation etc.,
Financial Priorities: Use 20% or more of your net income for financial priorities: pay off your existing debts (this doesn’t include regular mortgage payments, which would be included under the essentials bucket) and/or save, and
Lifestyle Choices: The remaining 30% goes to other expenses like entertainment, travel, dining out, clothing, etc.

This framework is simple, flexible, and easy to follow. For example, say you really want to purchase a house within the next year or two. If your essential expenses don’t add up to 50%, you can put the rest into savings, or cut down on your “fun money” and put that money towards paying off debt, and savings. It also provides you with a framework when you are finally looking for a house. Make sure that the mortgage on the house you buy doesn’t put you over that 50% limit on essentials. Once you’ve saved up for that down payment, the regular savings can be converted into extra mortgage payments or investments.

Essential Expenses

I like the flexibility of the first bucket, essentials, rather than having a relatively defined limit for each essential expense. For example, I have an apartment close to work, so I walk every day. My housing expenses might be a bit higher than average, but transportation costs are much lower since I don’t have to pay for parking at work, buy gas on a regular basis, have lower maintenance expenses, etc.

Financial Priorities

Within the financial priorities bucket, it is always best to pay off high interest debts like credit cards as quickly as possible. From an investment perspective, paying off your debts is equivalent to investing in a GIC or other risk free bond at the same rate. So if you were paying 3.5% percent on a line of credit, and you wanted to save money in a savings account paying 1% interest, you’d be better of paying off that debt since that’s equivalent to earning 3.5% in your savings account. If you’re choosing between paying off debt and investing in volatile investments, Graham Westmacott provides a framework for that analysis here. Having an emergency fund of at least 3-6 months worth of expenses is also a good idea.

One great way to boost your savings is through employer pension plans. You can find more detail about different types of pension plans on The Investor Education Fund site. Most young professionals with employer pension plans will likely have a Defined Contribution pension. A Defined Contribution pension plan is one where you contribute to the plan which is held by a large financial institution and your employer often will match your contribution, up to a certain percentage of your salary/income. This is a great way to get “free money” from your employer. According to an article in the Financial Post, Canadians are losing out on 40-50% of available matching funds. My colleague, Graham Westmacott discusses why this might be, including the confusing aspects of these types of plans. It would be a shame if young professionals miss out on these opportunities not out of lack of funds, but as a result of lack of knowledge. Investing in a Defined Contribution plan also provides a tax benefit, since you are contributing from pre-tax dollars. However, whether you should save within a pension plan, RRSP, TFSA or regular savings account depends on your situation and goals. This is something I will discuss in an upcoming blog.

Lifestyle Choices

Finally, there is not much to advise on the Lifestyle Choices aspect of someone’s budget. It’s important to include this bucket though, because if your budget only includes essentials and financial priorities, it won’t be realistic and you won’t stick to it. Interestingly, there has been a great deal of research on whether or not money can cause happiness (which is outlined in the book “Happy Money: The Science of Happier Spending” by Elizabeth Dunn and Michael Norton). Articles in the Wall Street Journal and Michael Kitces’ blog (no subscription required), outline the research which show that it’s not about the amount of money you have, but how you spend that money, that makes the difference. In a nutshell, if you spend your money on experiences, rather than material items, you are likely to be more satisfied with the purchase. This is counterintuitive because we often think “if I buy this item, it will last me months or years, whereas a vacation or a concert is fleeting”. Spending money on others (i.e. giving it away) also makes people happier, whether you are poor or rich. Professor Dunn, who has done the research, says “A lot of us think we’ll give to charity one day, when we’re richer, but actually we see the benefits of giving even among people who are struggling to meet their own basic needs”. Finally, consider how what you are buying affects how you spend your time: if you buy the big house in the suburbs but are spending 2 hours commuting to work every day, you may very well be less satisfied. The caveat to all of this however, is that spending more than you can afford is a route to misery.

Some people love to map out each expense and source of income in detail, where others prefer to determine how much they can reasonably save, and leave the rest to spend however they choose. Neither option is right or wrong; whatever will result in you sticking to your goals is the best option.