Wednesday, March 20, 2019

Big Data - Budgets



My financial education began one afternoon when I was maybe twelve. My parents had divorced two years before. That event alone had shaken my view of our family’s position on the economic ladder. At school the year after, I paid reduced prices for lunch based on economic need. I remember the long looks and negative commentary from certain teachers in my elementary school. We qualified for free lunches but my mother refused to enroll us. She believed that we wouldn’t value something unless we paid at least something for it. I think part of her decision was pride.

Even that change didn’t sink in right away. My sister and I were kids. By the time we were both in middle school, my mother was working. We thought were back where we started. We weren’t. A teacher’s salary doesn’t replace an engineer’s even supplemented by child support.

That day, my sister was asking my mother to buy her something she wanted, clothes as I remember. She was a couple of years older than me, at an age when many girls begin to focus on their appearance and their peers. My mother told her we couldn’t afford whatever it was she wanted. My sister would just have to save her allowance until she could afford it. My sister didn’t believe her and said so.

My mother then did something unusual. Instead of getting angry or just telling my sister that’s the way it was, she sat us both down and laid out the household budget. She walked us through her take-home pay. She added in the child support from my father. She subtracted off the mortgage, the car payment, the utilities, groceries, gas, school lunches, our allowances and showed us what was left for all the other expenses of the month, like clothing. As I remember, it wasn’t a lot of money, and somewhere near the price of the item my sister wanted. I’m not sure my sister believed the math, but I did.

It is a lesson I have not forgotten. To this day I keep a budget, using only slightly more modern technology than my mother’s father. He kept an accounting notebook in his desk, recording each piece of information in neat, orderly columns. I use an antique spreadsheet program. Where he updated his budget every week, I update mine once a year.

At its very simplest, a budget is third grade math, addition and subtraction. You add all your income and subtract all your bills and payments. If your income is greater than your expenses, you have savings. If your expenses are greater, you’re living on borrowed time. It’s that simple.

It’s so simple, in fact, that most people never bother to write one out at all. Many people will tell you they know how much money they have to spend in any given month. A few can balance the numbers in their head. More just glance at their checkbook register, sometimes remembering what bills are due within the next week. And an amazing number of people never bother to even balance that register against their monthly statements. The majority get by with that ad hoc strategy all their lives, at least until a financial crisis hits.

If it’s so simple, why bother with it at all? Economics 101: Knowledge is power, and power creates money. (It’s probably not economics; it’s more politics, psychology or military strategy, but you get my meaning).

If personal finances are an adventure, a budget is the map. At the center is a signpost reading “You are here.” In reality, it is more like a GPS. It not only tells you where you are, but where you’ve been. And if you’ve programmed in a destination, it can help you get there, though it won’t call out directions unless you ask.

You probably have a good idea how much extra money you have in a month. But do you know how that varies month to month throughout the year? Does that depend on whatever crisis arises in any given month? Do you know how much you are spending on maintenance for your house in any given year? How much of a pinch rising gasoline prices put on you in 2007? Do you know whether that new calling plan is actually saving you money (yes, they still exist)? Does the cost of repairing your old car cover the loan payments for a new one or are you better off keeping the one you have? Does your Sunday paper pay for itself? Can you tell whether your water-heater might have a problem? Your AC? Your toilet?

(And what about the airspeed of an unladen swallow? Wait, it can’t tell you that. Aaaah!)

I’ve used two types of budgets in my life, short-term and long-term.

When I say budget, I mean backward looking rather than forward looking. Where money went, not a Soviet 5-year plan of where I want or plan for it to go. So based in reality rather than informed speculation. I see that as a critical distinction. Many people get frustrated when their (often unrealistic) projections don’t match reality.

I started keeping a long-term budget when Karen and I were renting a house back before we were married. We entered the experience as an experiment to see whether we could or wanted to afford owning a home of our own. Instead of relying completely on the landlord to do all the repairs, we took on some of the minor ones ourselves, did a little DIY like painting with their permission and noted the big things that went wrong.

This first long-term budget was a way to see if we really had enough money to afford the added expense a house brings, not just a mortgage payment but all the maintenance and upkeep that goes with it.

We found we did and bought a house after 18 months of renting that one. The house we’re still in now.

When I first started, I updated my budget at the end of every month. Over time as I grew more comfortable with where we were, I deferred updates to every quarter. Almost thirty years later, I only enter numbers into our budget spreadsheet at the end of the year. By now, I know our bills like a well-worn book. If one comes up looking odd, I pull up our spreadsheet and browse the historical data to see if something truly is amiss.

A long-term budget is what people think of as the classic budget, a month over month record of household expenditures. Mine is a grid. The left-hand column contains the following categories (with subcategories in parentheses, each on their own line):


Electric (kW-hours)
Phone
Water (gallons)
Trash
Cable (internet)
Groceries (coupons)
Credit Card
Gas
Insurance (auto/registration, dental, eyes, medical)
Property Taxes/Insurance
House Maintenance (AC, appliances, cars, exterior, interior, lawn service, pest control)
Pets (food, vet)
Charity
-----------
Total Expenses


Across the top of the budget are the months of the year (Jan, Feb, Mar, etc.). I just fill in the appropriate box for each month. In our spreadsheet most categories automatically add their subcategories into a total (House Maintenance, Gas) so I don’t have to. All the categories are added into the Total Expenses for each month.

In those first budgets the line for Property Taxes/Insurance was Mortgage or Rent (property tax and insurance was included in our mortgage payment). When we paid rent in apartments, things like trash and water were included but when we rented the house, those were ours to pay. At points, we’ve had other categories that no longer apply (Propane, Long Distance under Phone, Newspaper and TV). There are subcategories we could add now (Netflix and Amazon under Internet which used to be a subcategory under Cable).

Mostly, it comes down to what I think I might want to know going forward. As long as it covered all our basic expenditures, the only thing required is that the document fit my needs.

For us, House Maintenance (exterior) includes any gardening or landscaping (including Karen’s tools), structural repairs like a new roof, windows or doors, and outdoor painting. Interior includes things like wall paint, new furniture (even my throw pillows) and repairs or remodeling. Cars for us includes any repairs along with oil changes and other regular maintenance, basically anything that’s not gas. For Insurance (dental, eyes, medical), I’m not talking about the premiums that are automatically deducted from Karen’s paycheck, but our out-of-pocket co-pays and deductibles. If we paid premiums from her take-home, we would those to add that category. Insurance (cars) is our premiums as well as registrations and AAA.

A note on House Maintenance for those of you who don’t own a home. Most financial experts say to plan on annual house maintenance running roughly 1% of what you paid for the house. So that’s $1000 a year for each $100k of the purchase price. I’ve found that to be pretty accurate for us, though over time we have had to base it on the current worth of the house rather than what we paid. That only includes things that must be maintained or replaced, not upgrades, redecorating or remodeling. Of course, like the S&P returns I discussed in the first essay, these expenses don’t conveniently average out year over year. So as a rule of thumb, we try to keep an emergency fund on hand that covers at least the most expensive maintenance. For us, that is a new roof, followed by an AC.

From the beginning, we’ve used US Savings Bonds to cover this rather than keeping the money in a savings account for a couple reasons. First, there is less temptation to spend that money because it’s harder to get to. Second, those bonds earn more interest. We’ve used CDs in the past, but I don’t like the penalty for early withdrawal. Neither of those interest rates is anywhere near S&P returns, but again, both are guaranteed and not subject to the vagaries of the market. More on that in a future essay.

Some of you are probably asking yourselves, what do kilowatt-hours (kW-hours) of electricity and gallons of water have to do with our budget? Strictly speaking, nothing. But when I am reading numbers off of bills and typing them into a spreadsheet, one more really doesn’t take much longer.

These numbers allow me to compare things more easily from year to year. The cost of electricity goes up, but with kW-hours, I can tell if our consumption jumped in a given year. A big jump in summer might mean an AC problem. An average jump, slightly higher in winter, might point to an issue with the water heater. I can also tell how much of a difference setting the AC thermostat one degree higher or lower makes.

A jump in water consumption might mean a plumbing leak. When we were on a minute-based long-distance plan, I input minutes used so I could see if we were routinely over or under the allocation of our plan, and maybe change it to one that’s more cost effective. When we had a Sunday paper delivered, we could tell whether the grocery coupons inside paid for it and more. (Hint: they did for a very long time).

(Ah, maybe he’s not just number-crazy or anal-retentive. Ok, too early to judge).

As an aside, our power consumption (along with a nifty bar graph of our usage from the past year) and gallons of water consumed (with a less nifty column of numbers) are prominent on our electric and water bills respectively. Our grocery store prints our coupon savings right on the receipt (separate from sales and specials) which is convenient.

I have never had any entries in the budget for Income. That’s because in general, Karen and I have been salaried. If our take-home pay varied significantly month-to-month (if we worked hourly or freelance), I would input that as well. Currently I compare Total Expenses to Karen’s base take-home salary for the month.

Now, here’s the first trick I use with budgeting. Karen gets paid every two weeks. At different points in my engineering career, I was paid weekly, biweekly and monthly. Currently, we round our monthly income down to two paychecks. When I was paid weekly, I rounded it down to four. That leaves us two (biweekly) or four (weekly) extra paychecks a year as money we don’t see. What we don’t see we don’t miss.

And note that I said base take-home salary. That’s the second trick I use in budgeting. I never consider any overtime or bonuses. We have each occasionally gotten one or the other, but I never included either in my income calculations. Again, all that becomes bonus money. So if we didn’t receive a bonus one year, or our overtime got cut, we were never caught short. Believe it or not, I worked with a number of engineers who depended on 10 hours of overtime a week just to pay their mortgages. They ran into a real problem when the contract ran short of money and overtime got slashed.

By basing my calculations on our base take-home salary that is two to four paychecks short, I’ve created a 7.8% annual buffer for emergency funds, savings or just bonus money. Money I can put to better use.

If you remember from the first essay, 7.8% is pretty close to my 10% S&P marker. And essentially created out of thin air. Ok, it’s actually an illusion. But as I said in the first essay, part of our philosophy is that if you don’t see it, you won’t spend it which actually does free that money up. That psychology is important. You will see it becomes a theme.

As well, that 7.8% is the entry point of living below our means, which as I said, I see as the key to our financial independence. Yes, it’s an illusion. But as long as it’s an illusion we want to believe, we will. And that’s all magic is, wanting to believe.

Another aside on the way we organize income. This is more esthetic than functional. But it does have an impact on the way we see our money.

When Karen and I bought the house together, we weren’t married, so we treated the arrangement in the same way we had as roommates. We each had our own separate checking and savings accounts but for ease we opened a new checking and savings account for the house. We each placed a set amount per month into that joint account. We based that number on our record of expenses from renting the house before along with adding in our new expenses. We paid all our shared bills from that account. Basically, all the items I listed off in the budget above.

We each contributed half to household expenses, including building up a small reserve in our joint savings as an emergency fund. We did this with automatic transfers from our personal accounts where our individual paychecks got deposited so we didn’t have to think about it (again, if we don’t see it, or in this case have to think about it, we won’t spend it). Anything each of us had left over at the end of the month was ours to spend as we pleased.

When we got married, that changed. We shifted the arrangement so that all of both of our paychecks were deposited into the joint account and then created automatic transfers of an equal allowance to each of our separate accounts.

We did this because when we were living together, we saw it as a limited partnership. Without that marriage certificate, each of us was free to walk away at any time. Keeping separate books and paying our share out of separate accounts made sense to both of us. Any overtime or bonuses were ours to spend alone.

After we got married, we shifted our view to something more like a corporation. Everything from both divisions got pooled together for operating expenses, with each of us getting enough side cash to buy gifts, treats for ourselves or lunches out without having to consult the other or potentially disrupt the joint accounting. If we ended up with extra money in house savings over time, we jointly decided how it got spent.

There is a distinct psychology behind all this that I’ll get into a bit more in a future essay.

As I said, I tally our budget out once a year using an Excel spreadsheet that Karen and I designed (which started in Lotus 1-2-3. I told you it was an antique). Now there are numerous other programs, off-the-shelf or online, which do all that but at the time this was our best option. We already owned a license for Lotus from work Karen did. I could have just used pencil and paper with a calculator as long as I double-checked my math, the same as I do with our taxes.

It usually takes me 2-3 hours at the end of December to input the data for the year. I sit down with all the bills from the previous year, sorted into piles by company and category, then input the numbers. Anymore, Karen reads them off for me. For the few items which don’t have statements, I pull what we paid out of our checkbook register.

As a final aside in case you are wondering, a year’s worth of paper bills for us takes up a 9” x 12” x 2” tray plus a standard envelope for the grocery receipts. We keep the grocery envelope by the bill box and put in receipts as we get them. We used to have another for Home Depot receipts for the house, but now we just pull them off our credit card statements, along with highlighting a number of other categories.

Each year, I have to make sure the spreadsheet doesn’t double charge for line items we pay for with the joint credit card (like groceries and most maintenance). But in the end, the budget just an estimate, not a financial ledger. In general, better an overcharge than an undercharge.

Most financial experts recommend you keep a full set of bill receipts for at least a year. I keep filed bills for one full year (the year before current) and shred the prior year’s unless there is a dispute (which I hang onto for five or longer). House maintenance receipts for major work we keep forever (things like AC repair or carpet replacement where we want to know who did the work, when it was done and how much it cost). We also keep a book with notes by year on what was done, mostly to satisfy our curiosity when one or both of us can’t remember.

All that, along with our financial account statements, easily fits in a two-drawer file cabinet. I could likely cut it down to one if I had to. And yes, I still stick with paper copies everywhere I can. We don’t pay bill electronically, mostly from momentum. Though as a side benefit for us, it’s harder for an anonymous stranger to hack an air-gapped paper file cabinet.

But as I said, when I started this, I didn’t have a full year’s bills saved. I just input as many months as I had, at the time only one or two. I built it from there forward. I’ve found a year is the best baseline because some bills, like electric, vary significantly month to month, while others, like home or car insurance, only get paid once or twice a year. For us, the water bill only comes every other month. Trash only bills us every three. I’ve known several people who get caught short when they forget something like their car registration, insurance or property taxes are due in a given month.

When I’m done inputting numbers, I print out a one-sheet summary, compare it to the year before and file it with other summaries dating back almost thirty years. The summary contains all the categories I listed above, where I have the program average the expenses monthly. If I see something jump from year to year, Karen and I discuss it, first to try to see if we can understand why, then to see if it is something we can or need to change.

I compare that summary to our income in a few different ways as a redundancy check.

First, I look at our joint savings at the end of the year to see if it has grown or shrunk. In general, it stays stable or grows a little. Because it’s a closed system with no other eternal inputs other than her paycheck (and her intermittent flexible savings account payments plus any tax refund), that is a good, instantaneous health check.

Next, I compare the monthly average to what I know goes into our joint savings and checking each month (based on two biweekly paychecks). The budget averages should be equal or lower.

Finally, I work our W2s backwards, taking her gross salary, subtracting off Social Security, Medicare, taxes, retirement savings, and insurance premiums (but not her flexible savings account money since we get that back), and dividing what’s left by 12. That should be greater than or equal to the monthly average from the budget. Ideally, I should be able to divide that number by 13 (to account for the 7.8% buffer) and have it come up the same, greater than or equal to the monthly budget.

Fortunately, for us, comparing those numbers has never come up in the red. That would have meant we were either underwater, or, with the 7.8% buffer I talked about earlier, skating a very thin line. Neither would have been acceptable to me. Both would have required either cutting back expenses or expanding our income.

But there have been individual years we’ve had to dip into savings to keep on an even keel, whether from replacing a roof, an AC, a car, or upgrading the windows. Which is exactly why we keep an emergency reserve. The real trick is remembering after drawing it down to build it back up.

In general, we dip into joint savings four times a year, when we pay property taxes and homeowners insurance, fund our IRAs (more on that in a future essay), and at Christmas. This is where that 7.8% buffer comes in. But in the end, it all has to balance out with the numbers in the black.

With that long-term budget, I had a baseline for what we were spending to see where we could cut back if we needed to when we transitioned from two incomes to one. I used it again when Karen was under threat of being furloughed for 30 days a year without pay, which would have meant losing one full month of her salary. I’ve used to as a baseline to determine where we’ll be when Karen retires, and will use it again when she actually does. A lifelong exercise.

Now that I have a map telling me exactly where we are, I can use its newfound wealth of information to navigate the shoals and shorelines to get to where we want to be. In the next essay, the real adventure begins.


© 2019 Edward P. Morgan III


3 comments:

  1. --------------------------------
    Notes and asides:
    --------------------------------

    Interestingly, we each divide our allowance differently between personal checking and savings in our separate accounts. More interestingly, the one who puts less into savings each deposit is the one with more personal savings by almost double.

    At this point, even updating the annual budget is more of an intellectual exercise than a financial necessity. Some of that discipline I mentioned in the first essay.

    I find keeping a full year budget is also easiest to compare to our annual earnings from our W2s at the end of the year.

    And yes, we balance all three sets of checking and savings accounts every month. I think only once in my life have I caught a bank in a mistake and that was a long time ago. More than once I’ve caught companies who misread the amount on a check when they cashed it. Many more times, I’ve caught one of us slipping a digit that created a $1, $10 or $100 error, which is why we keep a self-imposed minimum buffer in our accounts. But then there was the time that Karen caught the bank mistakenly assigning someone else’s BMW loan to her account.

    I suspect a lot of people will stop reading after this essay because they don’t see the benefit. Most people know what they have to spend in a month and whether they are ahead or behind. That may well be true. But knowing exactly where our money comes from and where it goes is the foundation upon which the remaining financial structure rests.

    The thought of a budget seemed tedious and self-evident until I actually put the numbers on paper. Only at that point, with hard evidence not guestimates, could I make rational decisions. If nothing else, that is what this adventure has been all about, as you will see in the upcoming essays.

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  2. Picture Notes:

    Our budgets, sort of. The printouts for our budget left too much white space between one year's page and the next. So, I reconstructed the list, made the font a little bigger and margins as small as possible. Then I laid them out on my desk next to the window. Each page is was actually only a half of a sheet (two years per page, then cut) to use less paper. The picture focuses on the 2018 budget, but there are pages all the way back to 1998 in the layout. After that all I did was crop it a little.

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  3. Very similar system here, although I keep track monthly since freelancing is far more of a roller coaster. We also set out a budget of "big stuff" at the beginning of every year that could be optional, but we'd really like to do--trips we'd like to take, a professional development convention, non-critical house renovations, that sort of thing. It becomes part of the overall annual "nugget" calculation. The day those things are covered, everything else is officially gravy. And by gravy I mean socking it away for the next nail-biting plummet in freelancing. :D

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