Last week we discussed how to understand your monthly budget, your cash flow, and how to automate your savings. We started out with what is usually considered to be the most boring part of managing your finances. It’s everyone’s least favorite thing to do.
At the end of the day, budgeting is a short term exercise. In this week’s video, we explore the next logical step to budgeting – which is forgetting it.
Now, we’re not going to throw out everything to do with budgeting, but we’re going to go beyond the restrictive boxes usually associated with it. We’re not going to pay attention to X number of dollars going into stringent categories like food, entertainment, shopping, etc…
Rather, we’re going to again look at total monthly spend versus total monthly income – your surplus. This introduces the idea of reverse budgeting.
This is the practice of starting with your goals in mind, estimating their costs, and then automating the necessary savings/spending to fund them. Finally, you’re totally free to spend whatever is left over.
Let’s take for example a person that has $10,000 of monthly income and $6,000 in monthly expenses ($4,000 in surplus).
This person knows they want to do the following:
- Travel (yearly) – $6,000
- Roth IRA contribution (yearly) – $6,000
- Save for home (monthly) – $1,000
- Invest in a taxable account (monthly) – $1,000
To afford this, they’re going to need to allocate $3,000 per month to fund these goals.
Reverse budgeting says, income comes in, let’s automate those amounts first.
- $500 to the Roth IRA
- $500 to the travel savings fund
- $1,000 to the house savings account
- $1,000 to the taxable investment account
This person now has $7,000 per month left to spend on whatever they want or need. To be clear, this isn’t saying you MUST spend all of the extra money. It’s simply saying that your goals are already met, and you now have the freedom to allocate the remaining funds where you see it best spent or saved.
The advantage here is that you no longer have to view your monthly budget and analyze your food expenditure and say, “Oh no, I’ve spent $200 more dollars than I should have on food.”
The goal of reverse budgeting is to prioritize your own goals. In effect, it allows you to be free of self imposed arbitrary restrictions that you set on your financial picture. You’ve met your goals already through automated savings.
Your goals can always change and update. Perhaps, this year you can’t save as much as you’d otherwise want to because there is a great opportunity to travel with family and friends. With reverse budgeting, you can update month to month as long as you keep your surplus in mind.
It’s your life, not your budget’s. Simplify your journey by using this technique – it’s worked for plenty of people I’ve worked with. Keep in mind that you should start with a few months of tracking expenditure rigidly so that you have a good understanding of where your money is currently going. You can then move onto reverse budgeting, once you have that understanding of monthly expenditure.
Finally, after 6, 9, or 12 months, go back and use some type of budgeting software to analyze the prior period’s expenses. Determine if your lifestyle is overinflated. Do you need to adjust your goals or adjust your spending? Lifestyle creep affects most people, so make sure you’re doing checkups on yourself.