Preparing a budget is an important step in controlling personal finances. A person can know their income, write down their main monthly expenses, and then make a plan on how to distribute their income (after taxes) and thus ensure that all bills are paid, including an emergency fund.
Julie Everett, financial planner at the impartial firm Financial Finesse, says: ” A budget ensures that you can do the things you want to do while working toward more serious financial goals.”
The hardest part might be sticking to this budget, especially for people with a tendency to spend. Therefore, the envelope method is a way to track money on a monthly basis , and could help limit spending by cutting down on the amounts available.
What is this method about?
The envelope method involves dividing the net salary into expense categories : payment of rent, services… and labeling each one, in order to correctly plan the money that is intended to be dedicated each month to each of them. Thus, when something included in one of the groups must be paid for, the assigned budget will be used .
“The idea is that if you run out of your planned budget for something, you don’t spend more in that category until the next month ,” says Amy Lins of credit counseling agency Money Management International. This system of budgeting can help regulate expenses, since users who use cash tend to develop a more emotional connection with their money .
How does it work?
The first thing is to check the amount of money that is entered month by month, after deducting taxes. Here you can see where money is usually spent, in order to distribute adequate amounts for each category. It should be said that the labels must deal with the most important expenses to be amortized, and that they can add categories of “whims” . Fixed expenses such as debt payments or insurance should not be included.
An example is the “50/30/20 rule” : dedicate 50% of the net salary to housing and services, 30% to activities such as travel or entertainment, and 20% to pay off debt and for savings . Generally, expenses such as rent, utilities or other debts are not reflected in the envelope method budget.
Thus, with a monthly income of 2,000 euros, the expenses would be divided as follows:
-1,000 euros for fixed expenses.
-600 euros for variable expenses and entertainment.
-400 euros for debts and savings.
Four steps must be followed to complete this savings system (for which you can use envelopes and cash, or spreadsheet-like applications):
1. Calculate the net salary
The first thing is to review the bank statements, to know exactly the monthly fixed income that is obtained after taxes and payroll deduction . All sources of income must be included, from regular salary to investment income.
If you have income that varies according to the month , you should calculate the average (for example, adding the total amount received in the last year, and then dividing by 12).
2. Create budget categories
When defining variable expenses, a simple review of the latest account information helps to make an accurate calculation. Although they vary by person, the most common categories are: groceries , gasoline , eating out , entertainment , pet care , personal care , family needs .
After that, it will proceed to review whether each expense is necessary, and in the case of finding ‘luxury’ expense categories, then it is decided whether it is worth keeping them or not . Julie Everett states, “I see a lot of people unsubscribing at this point.”
Returning to the example of the 2,000 euros per month , by subtracting the 1,000 of fixed expenses and the 400 of payment of debt and savings, there would be 600 euros to divide between the different categories in envelope .
3. Assign a budget for each envelope
The third step is to decide the amount of money that will be awarded monthly to each envelope. This is a possibility to divide the 600 euros available (once again, taking into account the same example of the 2,000 euros):
– Food : 210 euros.
– Gasoline : 30 euros.
– Meals away from home : 120 euros.
– Entertainment : 120 euros.
– Pet care : 30 euros.
– Personal care : 50 euros.
– Family needs : 40 euros.
4. Monitor expenses
In each month cash will be withdrawn (in this case the 600 euros) and will be divided among the envelopes thought. The initial amount must be noted on the package . A list should also be prepared for each purchase. Thereafter, a constantly calculated total of the remaining money will be kept within each envelope. And later the games will be reviewed regularly.
” If you spend less than you budgeted in a month , make sure you save the remaining amount for a time when you’re tighter,” advises Amy Lins. ” The difficulties appear when you are busy and do not write everything down , when you leave it out of your thoughts and therefore out of supervision, as well as when you do not get into the habit of reviewing the budget regularly.”
Finally, if it is discovered that the allocation for an envelope considered important is usually not enough , it could be a good time to re-examine the distribution (of those hypothetical 600 euros). One possibility is to subtract a certain amount from “entertainment” and add it to “eating out”, if that is the chosen priority.
The main pros of this method
The main one is to help people who want to keep their monthly expenses under control , and who believe that they are not able to maintain these items. Other benefits it provides are:
– It helps to spend less : when using cash, people tend to spend less money, since according to Lins: “Something that has to do with distributing money physically makes it cost us more to spend.”
– Reinforces personal discipline while granting that control : when agreed limits are established, waste and impulses to spend could be reduced.
– Provides knowledge about one’s spending and consumption habits : after a few months, the main ways in which money is spent will be known, and problem areas will be identified.
What cons does it have?
Envelope budgeting also comes with some drawbacks, all of which are cash-related . However, if you don’t want to carry or store cash, you can use budgeting apps as well as spreadsheets.
– It implies spending time : in the case of opting for envelopes and cash, then the process of getting the cash from each payment and dividing it each month may be tedious.
– Cash increases the risk of theft and loss : the home insurance may cover these losses, but it will depend on the limits contracted. It is obvious that digital cards and wallets provide greater security, but at the same time they imply zero responsibility in case of authorized payments, in most cases.
– Credit card benefits not available : Many cards include rewards programs and built-in coverage. The use of cash, therefore, will not bring fraud detection, extended warranties or purchase protection.