Zero Based Budgeting System Using Envelopes
Budgeting is the start of all financial planning. Till a person is not able to take full control of their most powerful wealth-building tool i.e. their income, they will not be able to obtain personal wealth. There are many different budgeting systems which are available in the market. There are also some mobile applications that can be used for this purpose.
However, most of these tools have two drawbacks. Firstly, they are complicated, and secondly, they are either forward-looking or retrospective in nature. This is because people generally reconcile their budgets at the month-end and by the time the damage may have already taken place. They plan for the future and create a budget accordingly. However, often people discover that they are unable to meet their budgets. This is largely because of the fact that the element of control is missing in the budget.
Dave Ramsey has provided a unique solution to this problem with a zero-based budgeting system. He uses simple everyday items such as envelopes in order to control the expenses. In this article, we will have a look at what the zero-based budgeting system is and how it can be used to build wealth.
Zero Based Budgeting System
The meaning of the term zero-based budgeting is that the outflow of a person over a given period of time will be the exact same as his/her income. It is important to understand the term used is an outflow and not expenses. The term outflow is a larger term that is comprised of expenses as well as investments for the future.
Dave Ramsey recommends that each month a written budget be developed. This budget should have the savings targets written down. This budget should also have the income and expenses of that particular month listed down. Dave Ramsey recommends that savings targets also be considered as expenses with high priority. For instance, if a certain amount needs to be added to the retirement account, it should be considered a bill just like an electricity bill.
The end result of the entire exercise should be that the income minus outflow should equal zero. Dave Ramsey often emphasizes this by saying that every dollar should be given a specific task to do. In the absence of a specific task, the dollars tend to get wasted.
Using the Envelopes
Dave Ramseys envelope system is the next step in the budgeting process. During the budgeting process, it is important to categorize the expenses from the point of view of control. Some expenses like rent, insurance payments, and utilities, etc. remain the same on a month-on-month basis. There is not much of an element of control here. The only thing that needs to be done is one needs to ensure that these expenses are not paid for using a credit card. Instead, they are paid for using cash so that the budget remains in place.
On the other hand, there are some expenses such as grocery, gas, recreation, etc which are variable in nature. These are the expenses that typically end up breaking the monthly budget. Dave Ramsey recommends identifying these categories, deciding on a monthly budget, and then using an envelope to fill this budget. For instance, if a person has decided to use $1000 for groceries in a month, they should only use money from that envelope to pay for groceries.
This may seem like a simple thing to do. However, the reality is that this is very powerful for a couple of reasons. Firstly, the envelope based system reduces the possibility of overspending, and secondly, it provides real-time feedback.
For instance, if you have a $1000 grocery budget and you have already spent $500 within the first week, a look inside the envelope tells you that you need to cut back on those expenses. This is exceptionally powerful for discretionary expenses like eating out and going to the movies. If there is no money in the budget, then the activity can be postponed to a later date. The budget system does enforce discipline. However, some hygiene factors are important. For instance, money from one envelope should not be taken out and put in another envelope unless it is absolutely urgent to do so. Otherwise, it defeats the entire purpose of using the envelope based system.
Budgeting for Irregular Expenses
It is important to budget for expenses that have an irregular schedule. In this context, the term irregular means, not paid monthly. This means expenses such as mobile phones, laptops, furniture, clothes, and vacation. These expenses do not happen uniformly each month. Some of these expenses may happen annually whereas some of them may happen semi-annually or even bi-annually. This can throw a budget completely off track if these expenses have not been budgeted for.
It is important to convert all these expenses into a monthly figure and keep them in an account. For instance, if you use a cell phone worth $500 and you replace it every 2 years, then you should set aside $20 for it each month so that at the end of the two years, the money is ready for the cell phone to be replaced. Once again, this money needs to be set aside in a special account earmarked for annual expenses. Only this account should be used to pay for these expenses.
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- Process of Financial Planning
- The Financial Life Cycle
- Three Types of Income
- Misconceptions about Personal Finance
- Macro-Economic Factors and their Effect on Personal Finance
- Going From Financial Goals to a Financial Plan
- Components of a Financial Plan
- Personal Financial Statements
- Advantages and Limitations of a Budget
- Ratio Analysis in Personal Finance
- Dollar-Cost Averaging
- Pitfalls of Dollar-Cost Averaging
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- The Rent vs. Buy Decision
- Financing Your Home
- Fixed-Rate Mortgage vs. Adjustable Rate Mortgage
- The Phenomenon of House Poverty
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- Retirement Basics: 401K Plan
- Retirement Basics: Roth IRA
- Auto Loans and Personal Finance
- Earnings Power in Personal Finance
- Personal Financial Planning For Small Businesses
- Common Pitfalls of Tax Planning
- Zero Based Budgeting System Using Envelopes
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- The Financial Independence Retire Early (FIRE) Movement
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- Rich Dad Poor Dad Philosophy
- The Pay Yourself First Principle
- Personal Finance Lessons from Rich Dad Poor Dad
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