• Nicholas Pihl

What Most People Get Wrong About Budgeting

Updated: Aug 30, 2021

Budgeting is a powerful mental and psychological tool that can greatly improve your quality of life. Unfortunately, done improperly, it frequently does more harm than good. Rather than enjoy the freedom of a more uniquely fulfilling life, most people instead get trapped in feelings of guilt and anxiety. The difference between budgeting well, and budgeting poorly is how you approach it.

For most people budgeting means cutting back. It means a routine process of beating yourself up about overspending, recommitting to unrealistic goals, trying again the next month, and failing again. You try to divide the world arbitrarily into "wants" and "needs," implying that "wants" are indulgent and should ideally be avoided, while "needs" are relatively immutable. By extension, saving money this way looks like reviewing your spending and looking for places to cut back. "Oh we really should be saving more. Let's see...we spent $200 on takeout last month, so let's try to save $50 by only spending $150 next month." There is not a harder way to save 5% of your income, nor is there one that is more likely to fail over long term. Not coincidently, this is also the least enjoyable way to interact with your money.

Budgeting done properly, however, is all about making sure your spending is aligned with what is important to you. It asks not, "what do we need to stop spending money on?" but rather, "what are the goals and priorities we want to put our money behind?"

To see how each of these two methods play out, consider a hypothetical couple, Martin and Andi. They are 40 years of age, have $100,000 of combined annual income ($6300/month take-home pay), and have two kids, Oliver and Theodore. The two parents each work part-time so that they can enjoy more time with their children. They have a $3500/month mortgage payment, and utility bills of $300/month. This means they can spend a combined $2500/month on all other expenses, including their kids, car insurance, car payments, groceries, restaurants, travel, and home maintenance. They are currently spending the full $2500/month and are living paycheck to paycheck. They are not yet saving for retirement, but feel like they should. They are stressed.

With the first method of budgeting, the mortgage payment and utilities get treated as a "need." After all, having a place to live, as well as the electricity and water to make it livable, is definitely a need. Meanwhile, they also spend $200 a month on date nights for the two of them. But since these date nights fall in the "dining out" category, they are misclassified as a "want" and therefore viewed as something that can be cut back on when other expenses come up. It's better to skip a dinner out than to skip a mortgage payment, after all. And that's what they do. They cut out date nights, for annual savings of $2400/year. They also reduce some other expenses, and manage to scrape out an extra $200/month of savings for another $2400/year. So annually, they manage to save $4800/year, or roughly 5% of their income. This is less than they need to save for retirement, but they feel stretched thin by the current budget and are already seeing financial tension in their relationship. While it's arguably better than saving nothing, their current plan is unsustainable for many reasons. This type of budgeting is akin to a crash diet, wherein you lose a lot of weight in two weeks, but subsequently gain it back having failed to make healthy lifestyle changes.

The second method of budgeting looks like this: In their monthly money meetings, Martin and Andi have decided that their top 5 priorities are 1) their relationship, 2) time with their kids, 3) freedom from financial stress, 4) taking at least one trip each year together as a couple, and 5) a path to early financial independence in 20 years.

These priorities lead them to keep their date nights, because weekly dates serve their number one goal and don't add up to enough money to jeopardize other priorities. They also decide they want to stop living paycheck to paycheck and build up a good cash reserve for their peace of mind. They are even willing to skip a couple years of traveling to meet this goal because freedom from financial stress (goal number 3) trumps their annual trip (goal number 4).

But then they realize they have a problem; they need to save $2400/month if they want to retire in 20 years. There's no way they'll be able to save that amount by cutting minor expenses here and there, even if they give up their date nights and their annual trip. Consequently, they worry that one or both of them will have to return to work full time, and miss out on time with their kids.

Luckily, the process doesn't end there.

Looking back over their expenses, they see a couple big items that aren't directly serving their top 4 goals: their large house, and new pickup truck. They originally bought their house ten years ago, before kids, when both spouses were still working full-time. At the time, they paid $650,000 for a big 5 bedroom, 3 bath place with some land. It was expensive, but perfect. Since then, however, they'd begun to feel overwhelmed by the work of maintaining the property. The same property they bought in anticipation of their growing family was keeping them from enjoying time with their kids! With 20 years left on their mortgage, and their other goals at risk, they decided to downsize.

Luckily for Martin and Andi, since buying their home, the property had appreciated at nearly 5% annually and they were able to sell the property for nearly $1,000,000. After paying off their mortgage, which had been paid down to roughly $450,000 by this time, they were able to purchase a new home in the suburbs for $500,000 cash. Better yet, a year after moving into the new home, they discovered their maintenance and utilities were costing them $500 a month less than they had been spending at the old place. This amount hadn't been expected, and it provided plenty of cash to keep the truck, in addition to their other goals.

To summarize, now that their only remaining house payments were property taxes and insurance, Martin and Andi were once again aligned with their financial priorities. Their relationship continued to thrive, especially with less financial stress. There was no need to resume full-time work, and both of them were able to spend abundant time with their kids. Too, because they were back on track for early retirement, they found that they could still take their couples trip each year, guilt free.

In summary, the power of budgeting comes from knowing what is most important, and what is less important. When you spend money in accordance with that, budgeting is fun, freeing, and purposeful. Even when you're saving money, you won't feel like you're missing out on things, or living in a state of scarcity or worry. These will have been conscious choices, things that you freely traded in for the things that matter most to you. And when it comes to enjoying your favorite things, it's even better. Spending on these activities becomes something you're supposed to be doing, instead of something you have to rationalize to yourself. It's all part of your plan, after all.

Budgeting, done right, is the difference between a state of scarcity and the state of freedom and abundance.

Disclaimer: The example above is hypothetical, and is not meant to serve as a template or set of recommendations for your financial situation. Your circumstances may differ in important ways that change the best advice for you.

This example also does not represent real people or convey actual financial situation about a specific person's finances. Any similarity is purely coincidental.

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