In this article we’ll be utilizing a tool that I call reverse budgeting, which is an incredibly powerful way to find out where you are overspending. To understand the power of reverse budgeting and help you get the most out of it, we first need to quickly look at traditional budgeting and why it is so ineffective. Then we’ll use that traditional budget to do a reverse budgeting exercise. Finally, we’ll look at how you can use your reverse budget continually to get you on the road to Financial Independence so you can Retire Early (FIRE).
With a traditional budget there are two paths you can take. You can either take a hypothetical path where you set up a budget based on your expectations or you can go back through your records for the past few months or years and try to build an actual, backwards-looking budget. The hypothetical budget can be a great tool, for example, if you want to teach your kids about how household budgets work or to help your older kids figure out how much they’ll need to make once they are out on their own. Backwards-looking budgets are useful for figuring out where the money went, but not for much else. An example hypothetical budget may look like the following:
This type of budget tries to take into account all of the spending categories, but you can quickly see where things can start to go wrong. First, as you get more detailed your list of categories will grow or you will start to develop a catch-all “Other” category that will include lots of spending you can’t fit into the above or that you don’t think about except for one time of year. For example, where do the flowers you bought a girlfriend go? Or what about the Christmas gifts you sent your brother, sister, and parents? Or what about the unexpected cost you had when you printer ran out of ink or the hard drive on your laptop broke?
Now, let’s look at an actual budget of per month costs:
Now see that our budget has grown quite a bit and we now have savings that are projected to be less than $300/month instead of the more than $1100 we planned on savings. When we look at this budget on its own we can have a hard time figuring out where we can make cuts. Maybe we spent too much on travel? Oh wait, we did that once in a lifetime trip to hike the Inca Trail… so can we cut that for next year? What about clothing? Well, I did buy a suit, maybe that is why it was so high.
Now it is time to combine these two and conduct a reverse budgeting exercise. In reverse budgeting, we take our hypothetical budget, we set it beside our actual budget, and then look to see where our Expectations don’t match our Actual spending. Below is the side by side comparison:
Now we can go through line by line and start to explore where there are major differences on a monthly basis and decide if we can save money there. In the Shelter category we can see that our electricity is coming up high. Here we might be able to save money by either setting a more efficient heating/cooling schedule on our thermostat or by calling a few other companies to see if we can get a lower rate.
The Internet/cable bill is nearly $8/month higher than we thought. In this case it was because of a rate change after an initial promo offer expired. In this case it is definitely worth calling and telling them you want another promo or you will change companies. You can often save yourself 25% or more by doing this.
When we explore the Movies/Concerts/Other we see that we are $15/month too high. Going back through you remember that you went to a couple of pro sports games. Maybe that is something you really enjoyed – if so, we can leave it in, but we need to adjust our expectations.
Dining out is one of the biggest single areas of overspending, and it is very common for many Americans. Going back through you realize that it has really been driven by going out for lunch with your colleagues and after-work drinks with friends. Eating out at lunch time may be required for some jobs, but for many it is just something that becomes a spending habit. Bringing a sandwich, chips, and a soft drink from home will cost you $2-3/day (at most) while eating out every day will cost you $10 or more. With 20 workdays/month at $7-8/day savings you’ve just found a way to cut your overspending by $140-160/month!
For maintenance you didn’t budget anything because your car was under warranty, but you ended up spending $50/month because you needed tire rotations and alignment, oil changes, car washes, etc. Some of this is good spending because it will make your car last longer saving you money down the road. However, maybe you could cut out paying for car washes and do it yourself (which comes with the side benefit of getting some sunshine too). With car insurance rates can creep up and it’s worth shopping around at least once per year to try and find a better deal. It’s not uncommon to save 10% by switching companies on an annual basis.
Finally, there is the dreaded “Other” category. The goal here is to split items out into re-occurring monthly items like your gym membership and one-off items like your Christmas/birthday gift spending. Once you’ve done that you can then start reverse budgeting for some of those items and see if your spending matches your expectations.
After doing this, we may realize there is scope to reduce our spending by as much as $200/month without making any real cuts or major changes in our lifestyle.
Once you’ve done this examination you can set up your re-adjusted hypothetical budget and start tracking your monthly spending against that budget, continuing the process every month. Once you start hitting your budget, then you’ll be in a better position to start looking for new places to save money.
Hypothetical budgets are good training tools, but on their own they aren’t very useful. Backwards-looking budgets can help you see where the money has gone, but they don’t tell you where you are over-spending. However, combining a hypothetical budget of your expectations with an actual budget allows you to do a reverse-budgeting exercise to discover where you are overspending and gives you a tool to address that overspending. You can keep performing this exercise every month until your actual spending comes closer to, or falls below, your expected spending levels. And that is what will put you on the road to FIRE.
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