So how did you do with your Christmas budget? Confession time for me: As I began shopping, I realized there were a number of things I left out of our 2009 Christmas budget. So we spent more than I hoped—but only with cash or debit card! And now we have a more complete budget for Christmas 2010.

Regardless of whether or not you avoided debt this Christmas, if you’re like most of America, you’re carrying an average of $10,679 in credit card debt (Nilson Report, April 2009, creditcard.com), as well as a hefty amount of student loans and a mortgage.

Don’t think debt matters? Consider this: Paying only the minimum payment on an $8000 credit card debt with an interest rate of 18% will take more than 25 years to repay and cost more than $24,000.

Not only does debt cost you more financially, but it can cause considerable emotional stress as well as strain your relationships. A friend told me recently that since she and her husband started following a budget with a plan to get out of debt, their fights were virtually eliminated.

Enter the debt snowball. Of course, for the snowball to work properly, you must stop accumulating debt. A budget helps tremendously with this. You must also have a $1000 emergency fund in the bank before you start snowballing. Why? Because if an emergency rears its ugly head and you have no cash in reserve, what will you default to? Credit cards. (You may even want to consider cutting up those credit cards at this point to remove the temptation…)

Here’s how to snowball:

• List all of your debts in order from the smallest balance to the largest, including the payoff balance and the minimum payment. (Save your mortgage until you’ve finished Baby Steps 3, 4 and 5.) Ignore interest rates at this point. Yes, mathematically speaking, it makes more sense to pay the debts with the higher interest rates first, but as Dave Ramsey says, good math isn’t what got you into this mess. The immediate gratification you get out of paying off the smaller loans will make you more likely to stick with it.
• Make the minimum payments on each of your debts, but pay extra on the smallest one. (Be sure to note on your pay stub that the extra should go towards the principal.) Is paying extra a stretch? Get mean: What can you and your family live without until you’re out of debt? Cancel your cable TV. Rent movies instead of going to the theatre. Eat beans and rice at home instead of dining out regularly. Avoid the mall like the plague. Take a few extra minutes and make your coffee at home instead of buying a $4 drink at Starbucks every day. I’m sorry to break it to you, but if you’ve racked up tens of thousands of dollars in debt, you don’t deserve a $4 drink at Starbucks every day. Cut out all of those extra expenses, and then have a yard sale. “Sell so much stuff your kids think they’re next!” Dave says. Finally, get creative and find some extra income. Clean house for your friends or neighbors. Mow lawns. Deliver papers before you go to your regular job, or pizzas after you get home.
• When you’ve paid off the smallest debt, add the amount you were paying on it to the minimum payment of the next smallest debt. Continue doing this until you’ve paid off all your debts and you are DEBT FREE!!!

With this method, your monthly cash flow remains the same, but as each debt is eliminated, the amount you are applying to your debts grows like a snowball rolling down a hill. (Hence the name.)

 
Example
Suppose your $10,679 credit card debt is broken down as follows:

After committing to making the minimum payment on all your debts each month, you scrimp and find an extra $100 per month. Add this to the minimum payment for your American Express credit card, for a total payment of $120 per month, and you’ll knock it out in the first month. You now have four debts left, with the following balances:

Now add the $120 you were paying to American Express to your JC Penney credit card, for a total payment of $145 per month, and you’ll pay it off in two months. The final payment will be only $80, so apply the extra $65 to your Macy’s card. You now have three remaining debts, with the following balances:

Apply the $145 you were paying to JC Penney to your Macy’s card, for a total monthly payment of $171, and pay this one off in three months. Your final payment will be only $15, so apply the extra $156 to Discover. You now have two debts, with the following balances:

Then apply the $171 you were paying on your Macy’s card to Discover, for a total payment of $206, and in another 3 months you’ll pay of the Discover card. Your final Discover payment will be only $187, so apply the extra $19 to Visa. You now have only one debt left, with the following balance:

Now apply the $206 you were paying on Discover to Visa, for a total payment of $306. At this rate, it will take more than two years to pay off your Visa. Now would be a good time to have that yard sale or get a side job!

At any rate, you see how it works. In just nine months, you paid off $2984 in debt and reduced your five debts to only one!

 
Different Approaches
This website, http://www.whatsthecost.com/snowball.aspx, allows you to enter all of your debts, their interest rates, and how much you plan to spend on paying them back. It will then calculate how much your debts are costing you in interest, how long it will take to pay them off, and what payback order makes the most mathematical sense.

It is true that if you are very disciplined, you will get ahead faster by paying off your loans in order from highest interest rate to lowest, but you should only use this approach if you are already highly motivated to eliminate your debt. For most people with a history of financial irresponsibility, the psychological reward of seeing the smallest debts paid off first is more beneficial than the math involved in paying lower interest rate loans first. Remember too that by paying the smallest debt first your snowball gains momentum faster. Moreover, the more minimum payments you eliminate will lower your monthly financial obligations and reduce your risk in the event of an emergency or lost job.
 

Snowballing vs. Consolidating
Debt is not a problem; it’s a symptom of overspending and under-saving. Debt consolidation treats only the symptom, not the problem. People who consolidate usually end up deeper in debt because they haven’t learned not to spend more than they earn. One debt consolidation firm reported that about 78% of the time, a client who consolidated his credit card debt will accumulate it right back.

Furthermore, debt consolidation costs you more in the long run. While it results in a lower payment, and perhaps even a lower interest rate, the term is extended so you end up in debt longer, meaning you pay the lender more interest. Dave Ramsey offers this example: Suppose you have a two-year $10,000 loan at 12% and a four-year $20,000 loan at 10%. Your monthly payments are $517 and $583, respectively, $1100 per month total. A debt consolidation company rolls your two loans into one and lowers your payments to $640 per month and your interest rate to 9%. Seems like a good deal, but now it will take you six years to pay off the loan, and cost an extra $5688 ($46,080, as opposed to $40,392 on the original loans). Debt consolidators make money off of you.

Snowballing is free, and it develops in you the character required for good money management. In order to treat the root problem, you must have a plan to stop overspending, pay cash for things, and save for the unexpected.

Questions or comments? Contact me here.

Other posts in this series:

• My Journey Towards Financial Freedom
• Dave Ramsey’s Seven Baby Steps
• How to Make a Budget That Works

Stay tuned for upcoming posts in this series:

• Myths About Debt: Why It’s Not a Wealth-Building Tool
• The Necessary Components of Every Financial Plan
• How to Calculate Your Net Worth
• Extra Wealth: This is What It’s All About!

 A brief recap: What does money management have to do with your health and well-being? Here’s my reasoning…

• Stress weakens your immune system, increasing your risk of illness.
• Money (or a lack thereof, whether real or perceived) is a top stressor.
• Responsible money management greatly reduces stress, thus reducing risk of illness.
• Like other areas of conscious living, personal finance is about 20% head knowledge and 80% behavior.

Why Budget?
“Suppose you want to build a tower. Will you not first sit down and estimate how much it will cost to see if you have the money to actually build it? Because if you lay the foundation and then run out of money, everyone who sees it will ridicule you, saying, ‘This guy started to build and ran out of money!’” Luke 14:28-30, paraphrased

10-year-old unfinished shopping mall in St. Lucia

While on our honeymoon in St. Lucia, my husband and I saw this unfinished shopping mall situated along the island’s major thoroughfare. Its owner ran out of money before completing it, and, as I recall, it has sat there for ten years or more, speaking every day to the owner’s poor planning.

“A budget is simply telling your money what to do instead of wondering where it went,” says Dave Ramsey. In the US in 2007, the median household income was $50,233. If you wanted to build a $200,000 house, you’d sit down with your builder and plan every detail of the house ahead of time. But you don’t know where the next four years of your income is going?

You hear it on the news: The housing bust and resulting economic downturn happened largely–not exclusively, but largely–because people made irresponsible choices in their personal finances. They failed to “first sit down and estimate how much it will cost to see if they actually had the money.”

A year ago I got laid off from a part-time job which was my main source of income at the time, and my most steady and reliable. But because I live within my means, know exactly how much money I have, and how much I need to live on, I didn’t panic. I don’t mean to sound self-righteous; I just want my experience to convince you, if it can, of the peace budgeting provides.

There it is again: the “B” word. We don’t typically like the word “budget” because it conjures up images of living on beans and rice and never getting what we want. We equate it with deprivation. Maybe someone’s used a budget to abuse or control you, or you’re afraid of what you’ll find if you sit down and look at your real financial situation. (Been there!) But “you’ve got to learn to manage your money, or the lack of it will always manage you.” (another Ramsey-ism.) Budgeting is a way of living on purpose.

Maybe you’ve tried budgeting before, like I had, and it never worked, like mine didn’t. Reasons for this could be

• You left things out of your budget
• You made your budget too complicated
• You didn’t write your budget down
• You made a budget, but didn’t actually follow it 

If agreed upon by both partners and actually followed, a budget eliminates many of the money fights so common in marriage. A budget also removes the guilt or fear associated with some purchases; ever written a check at the grocery store and had a nagging fear that it might bounce?

I’ll assume you’re convinced and move on to the how-to’s. 

 
Track Your Spending
First write down everything you spend for a month, or at least two weeks. This will give you an idea of how much you spend on different things and enable you to make a much more accurate budget. The following chart is based on Dave Ramsey’s detailed budgeting worksheets, which helped me see where I’d left things out of my past budgeting attempts. Your spending might fall into any of these categories:

If you need to, add your own categories. Be as thorough as possible. This exercise can be surprising! What you spend your money on reveals what you value.

 
List Your Income
List all your sources of income. Besides your regular salary, do you expect a bonus? Have a side business? Receive interest or dividends on a regular basis? Receive rent, alimony or child support? Unemployment or social security? A pension payment? Disability income? Money from a trust fund? Add up how much money you expect to receive this month. (I know, my income is irregular too; I’ll talk about that in a few paragraphs.)

Now use what’s called a zero-based budget to “spend” every dollar on paper before you get it. Use your month of tracking what you spent to create a personalized budget using the same kind of worksheet you tracked your spending with. Add up what you plan to spend in each category, subtract your total household income, and it should equal zero.

If it doesn’t, you have some recalculating to do. Is it a negative amount? You’ve spent more than you earn. Is it a positive amount? You have more to spend. Don’t just leave this extra—plan how to use it.

  
Lump Sum Payments
Some items you don’t pay for every single month, like real estate taxes, homeowners or renters insurance, maybe car insurance, certainly car repairs (unless you have a clunker), probably vacations… Estimate how much you spend on each of these items per year, then divide that number by 12 to determine how much to budget for them each month.

How to Keep Track
Now you need a tracking method for how much of the money in your bank account belongs to each category. Quicken is a popular one, but I just use a plain old Excel spreadsheet. Whether you use handwritten notes, a spreadsheet or something more technologically advanced, find a method that works for you and that you can stick with.

Whatever you use, be sure to balance your checkbook regularly and reconcile it with your bank statement. Fail to do this and you’ll inevitably end up with less money in the bank than you thought you had. (Been there!) Occasionally you find more in the bank than you thought you had. (Been there too! It’s much more fun than the former scenario…)

  
Recommended Percentages
You’ll notice the column on the far right says “Percent of Income.” The following recommended percentages work for most budgets.

• Charitable Gifts 10-15%
• Saving                   5-10%
• Housing                25-35%
• Utilities                 5-10%
• Food                      5-15%
• Transportation  10-15%
• Clothing               2-7%
• Medical/Health 5-10%
• Personal              5-10%
• Recreation          5-10%
• Debts                    5-10%

These are just generalizations. If your income is low, a higher percentage goes toward necessities. If your income is high, put a higher percentage in savings.

 
The Envelope System
Studies show that people spend more—in one study, 47% more!—when using credit cards; it “hurts” less than watching the cash in your wallet dwindle. To counteract this, try using the envelope system. Each time you get paid, withdraw the budgeted amount of cash for say, groceries, and put it in an envelope marked “Groceries.” Whenever you shop for groceries, only pay for them out of that envelope. Consider using the envelope system for the categories marked with an asterisk, since it’s easy to overspend on these.

 
Budgeting to Blow
Notice the category called Blow. This money serves four purposes:

1. You will have an unexpected expense that may not qualify as a full-blown emergency.
2. You will overspend.
3. You will make mistakes in your calculations.
4. At the end of the month, if you haven’t had any unexpecteds, overspent or made any mistakes, use this money to blow on something fun and reward yourself for your discipline!

How I Budget On an Irregular Income
As a self-employed massage therapist, wellness coach, freelance writer, and now blogger, I’ve probably never earned the same amount of money per month. Here’s the system I developed that has worked for four and a half years.

I can pretty well predict a baseline of how much I expect to earn in a given month. (It helps that I’ve paid attention for the last four and a half years!) I use that baseline to create my zero-based budget, and then I plan how to spend any extra money that comes in. (A debt snowball, my emergency fund, a trip, a big-ticket item I want, a category I overspent on the month before…) Naturally, it’s more helpful to underestimate than to be overly optimistic.

Next, I divide the amount I plan to spend in each category by my baseline expected income to get a percentage. For example, say my baseline expected income is $3000 and I plan to spend $500 on groceries.

Each time I get money, I plug in those percentages to determine how much to put towards each category. To continue my example, say I earn $1200 at one time out of my expected $3000 for the month.

I have $200.40 to spend on groceries until the next time I get money. I repeat this step for every category in my budget.

Here’s another example: I spend $10 every three months on a prescription for thyroid medication. It’s only ten bucks, right? It’s tempting to just budget for it once every three months, but I’ve found it easier just to budget for it all along. So,

I round it up to $4, and the third month I’ll only need to budget $2.

Continuing the $1200 example from above,

As I write this out it sounds pretty nerdy. But hey, it works, and it’s gotten me to where I am today, so nerdy it is!

There are advantages to budgeting as a self-employed person on an irregular income. When I make a budget and I see that I’m going to need or want more money that month, I’m motivated to try to get more clients or sell another article. On the flipside, I can see how little I can get away with working and still meet my financial goals.

I’ll add here that I’ve used the same budgeting technique on my business finances, and for four and a half years my business has remained debt-free and built up a small emergency fund.

 
Conclusion
It sounds like a lot of work, doesn’t it? I read recently that a space shuttle uses 67% of its total fuel in the first 2 minutes and 12 seconds after launch. This principle carries over to nearly every area of life: Far more energy is required to get something going than to maintain it. It will take time to get your personal finances going, but think of it as an investment. At this point, I only need to spend about an hour each week maintaining ours.

In the first few months, your budget will not be perfect! You’ll forget things. You’ll underestimate. Don’t worry about it, you’ll get better. I still underestimate sometimes, but I’ve stuck with it for four and a half years and it somehow works out.

My earnest desire is for you to find that “freedom to fly” by exercising discipline!

Questions or comments about this article? Contact me.

Other posts in this series:

• My Journey Towards Financial Freedom
• Dave Ramsey’s Seven Baby Steps

 
Stay tuned over the next few weeks for upcoming posts in this series:

• How to Do a Debt Snowball
• Myths About Debt: Why It’s Not a Wealth-Building Tool
• The Necessary Components of Every Financial Plan
• How to Calculate Your Net Worth
• Extra Wealth: This is What It’s All About!

A brief recap: What does money management have to do with your overall health and well-being? Here’s my reasoning…

• Stress is a top contributor to a weakened immune system and resulting illness.
• Money (or a lack thereof, whether real or perceived) is a top stressor.
• Hence, good money management can greatly reduce stress, thus reducing risk of illness.
• Like other areas of conscious living, responsible money management is about 20% head knowledge and 80% behavior.

Here are Dave Ramsey’s Baby Steps, as taught in his Financial Peace University seminar.

Baby Step 1: $1000 in the bank as an emergency fund.
Your goal is to achieve financial freedom, so wouldn’t you want to get right down to paying off your debt? Yes, but this first step is critical.

Look at it this way. Up to now, what’s been your MO in emergencies? If you’re living paycheck to paycheck and don’t have much of a savings, chances are credit cards have heretofore been your emergency fund. In order to break that cycle, it’s crucial that you have at least $1000 in the bank so you won’t default to those credit cards anymore. (If your household income is less than $20,000, a $500 emergency fund is probably acceptable.)

It’s a good idea at this point to sit down and define the word “emergency.” You may have only a few months of budgeting discipline under your belt, and the clearance rack at DSW or a big sale at Best Buy, might be calling your name. But sales do NOT count as emergencies! For us, “emergencies” are defined as things like repairs to the car, house or major household appliance that couldn’t have been planned for. Unforeseen medical expenses for us or our pets. Ongoing expenses in the event that one of us lost our income. Since I live on the opposite side of the country than most of my family, an unexpected trip due to an illness or death in the family. Ransom money in case one of us gets kidnapped. (Just making sure you’re paying attention!) You get the idea.

Write down these definitions on paper, and if you’re married, make sure you both agree on them. If you’re single, give a copy to a friend who will hold you accountable.

Now you’re ready for step 2.

Baby Step 2: Pay off debt (credit cards; car, student or home equity loans; medical bills; etc.) using the “debt snowball” strategy.
I was lucky enough to have very little debt when I went through FPU so I never really got to do a debt snowball. Now that we’re married, we have my husband’s student loans and a mortgage, so I get to snowball! It’s fun to watch the balance go down: We’re tackling the smallest student loan first, and in less than six months we’ve paid down the balance by 34%.

I’ll go more into the debt snowball in a later post, but here’s the general idea:

• List all of your debts in order from the smallest balance to the largest, including the payoff balance, the minimum payment and how many payments you have remaining.
• Continue making the minimum payments on each debt, but pay extra on the smallest one as you are able to.
• When you’ve paid off the smallest debt, add what you were paying on it to the minimum payment of the next smallest debt. Continue doing this until you’ve paid off all your debts and you are DEBT FREE!!!

Baby Step 3: Save 3-6 months expenses for a fully-funded emergency fund.
In this economy, if your job security is at all at risk, it doesn’t hurt to have more than six months expenses saved.

Revisit your list of agreed-upon emergencies. Ironically, the larger your emergency fund, the fewer emergencies you have! Dave calls the emergency fund “Murphy Repellant.” This is partly because as your budgeting improves, you save for things like doctor visits or to replace or repair your cars, so those expenses won’t have to come out of your savings. As you watch the money in the bank grow, you become reluctant to dip into that hard-earned savings at all. When you do have an emergency, you get creative at finding ways to pay for it without using your savings. (No credit cards though!)

It’s worth noting that there is no “get rich quick” scheme here. As Dave puts it, he’s in the crockpot business, not the microwave business. Consequently, I have yet to get past baby step 3 in my personal journey! So these last four baby steps are uncharted waters for me, topics I know less about.
Baby Step 4: Invest 15% of your household income into Roth IRAs and pre-tax retirement funds.
Baby Step 5: Save for your kids’ college educations.
Baby Step 6: Pay off your mortgage early.
Baby Step 7: Build wealth!
As I learn more I’ll write more about them.

I’m eager to get to the “build wealth” part.

Questions or comments about this article? Contact me here.

Other posts in this series:

• My Journey Towards Financial Freedom
• How to Make a Budget That Works

Stay tuned over the next few weeks for upcoming posts in this series:

• How to Do a Debt Snowball
• Myths About Debt: Why It’s Not a Wealth-Building Tool
• The Necessary Components of Every Financial Plan
• How to Calculate Your Net Worth
• Extra Wealth: This is What It’s All About!

You might wonder what a series on financial freedom has to do with wellness. Here’s my train of thought:

• Stress is a top contributor to a weakened immune system and resulting illness.
• Money (or a lack thereof, whether real or perceived) is a top stressor.
• Hence, good money management can greatly reduce stress, thus reducing risk of illness.
• Like other areas of conscious living, responsible money management is about 20% head knowledge and 80% behavior.

I always sort of played at money management, but my journey towards financial freedom began in earnest my senior year of college.

As you may already know from reading elsewhere on my blog, I graduated from college in 2003, and, two days later, embarked on a four-month hike on the Appalachian Trail. Saving for this adventure required more hard work, determination, discipline and delayed gratification than anything I’d ever done before. The hard work was probably one of the best lessons I learned from the whole experience—and there were many.

Shortly after ending my hike, I headed to Norway (the 5^th most expensive country in the world) to volunteer for a year at a health center, where I received a $100 a month stipend. By setting a few goals for myself, I managed to return home with about $200. I saw my loyal massage clients for two weeks that November, then spent six weeks driving around the country reconnecting with various family and friends after my year overseas.

Unfortunately, I didn’t receive payment (reimbursement from my clients’ health insurance company) as soon as I anticipated for my two weeks of work, so I used my credit card to pay for my road trip and accidentally ended up with a carryover balance for the first time in my life. I also owed my parents money for my car—a loan they graciously put on hold while I was overseas. When I heard about Financial Peace University in February of 2005, I had $4800 in debt. I may have had $1000 in the bank, but I didn’t really know, and my records from back then are sketchy!

Eagerly, I signed up for the seminar and ate up everything Dave Ramsey teaches. I’d tried for several years to live on a budget, but it never lasted more than a month or two before I got tired of keeping track of what I spent, my irregular income fluctuated too much, or some unexpected expense blew my good intentions out of the water. (Usually a car repair or something I really, really wanted!) Somehow though, Ramsey’s simple budgeting technique made sense and was easy to keep up. Or maybe I was just in a better state of mind to absorb that kind of information than I had been in the past. Plus I find him highly entertaining. Whatever it was, I learned to not only expect the unexpected, but to plan for it.

More than four and a half years later, I’m still on a budget.

Now, if the word “budget” feels like a straitjacket to you, let me tell you about the freedom it’s given me.

Growing up, my family was by no means rich, but we were plenty comfortable. Still I somehow always had this feeling that, “We can’t afford for me to go on a ski trip…” “A leather jacket is too expensive…” “A formal dress you only wear once costs too much… Find something more practical.” Don’t get me wrong, I don’t feel deprived when I look back on my childhood. But that “too expensive” feeling carried over into my early adult life.

Until—I met Dave Ramsey.

Julie Andrews said, “Some people regard discipline as a chore. For me, it is a kind of order that sets me free to fly.” It didn’t take many months of budgeting to notice that, thanks to the thoroughness of Ramsey’s zero-based budget, I felt like I had more money! I budgeted for gifts, and I actually had money to buy birthday gifts for friends. I budgeted for cosmetics, and sometimes I had extra to blow on a new lipstick or fingernail polish. I budgeted for clothes and shoes (though this budget still never seems big enough), and could buy things I needed and wanted without guilt. I budgeted for things I wanted in my apartment and got to actually decorate it cute. I budgeted for entertainment, and had money to do fun things without feeling guilty. I budgeted for car repairs, and when I needed to have some work done on my car I had the money instead of a crisis—what a concept!

I learned that if I wanted a big-ticket item, I just had to plan for it and save for awhile. Sure, on my just-getting-started-self-employed income it might take a long time to save up for something, but nothing is ever too expensive if you just plan for it! This was the most freeing concept and remains my favorite thing about being responsible with my money. As long as I stay on top of my finances, I never have that miserable self-pity hanging over my head, “I can’t afford that…”

That’s not to say I always get to spend as much as I want on clothes or shoes or decorating the house, or want to wait that long to buy things, so I’ll admit that every now and then I’ve rebelled against the discipline of budgeting. Have I stayed within my self-imposed spending guidelines perfectly for every one of the last 56 months? Certainly not. But I get back on track pretty quick.

Within the first ten months of living on a budget, I increased my net worth from $3400 to nearly $11,000, and soon paid off my debt. That may not sound impressive to you, especially considering that I was building up almost from ground zero. But I’m proud of it, because I know what my spending habits were like before Dave Ramsey. Oh, I always paid my bills on time, but beyond that I pretty much spent whatever extra I had.

When I got married last April, I was still 100% debt-free. Now, although my husband and I have debt (a mortgage and his old student loans), we’re budgeting, and already our net worth has increased by about $2000 in the first six months.

Many more stories, most of them far more impressive than mine, come out of Financial Peace University. I highly recommend the seminar; enrolling in it was the best hundred bucks I’ve ever spent.

Other posts in this series:

• Dave Ramsey’s Seven Baby Steps
• How to Make a Budget That Works

Stay tuned over the next few weeks for upcoming posts in this series:

• How to Do a Debt Snowball
• Myths About Debt: Why It’s Not a Wealth-Building Tool
• The Necessary Components of Every Financial Plan
• How to Calculate Your Net Worth
• Extra Wealth: This is What It’s All About!

Comments or questions about this blog post? Contact me here.