Take control of your finances by making a plan for where to put your money Here you will find posts about reducing your spending, and how to budget, so that you can put more of your incoming money to work for you.
Today is Amazon Prime Day. If you are unsure what that entails, the long and short of it is that Amazon has devised a way to clear space in their warehouses for the upcoming fall releases by selling off their less popular merchandise for discounted prices. To top it off, they are creating additional exclusivity around their offers by limiting them to those who are paying members of their customer program, Amazon Prime.
As someone who is prone to fall for the lure of a good discount, it is interesting to see just how skilled Amazon are at creating hype around their products with their promotional efforts, such as Prime Day. People went crazy this time last year, as the 2016 iteration of the special deals day was the company’s biggest day ever. TVs, toys and, curiously enough, Amazon’s own products like their Kindle e-readers and tablet, and the Echo, which powers their voice-based home assistant Alexa, were hot items. Amazon is, of course, happy to knock off some percentages to move additional units of their own goods, to tie customers into their ecosystem, and at the same time recruit more paying members to their loyalty program. At the same time, so many people completely misunderstand what a discount is, and the term “saving money” actually means.
A Dollar Spent is a Dollar Spent
A common phenomenon that marketers rely on to lure consumers to spend money they otherwise wouldn’t is the mental disconnect between the cost of purchase and the money saved from utilising a discount. One friend who worked at a national sporting goods store where people go haywire during sales told stories of people who had never been skiing their whole life, yet spent hundreds and hundreds of dollars on skiing equipment.
“With this 30% discount, I’m saving hundreds of dollars. It’s too good an offer to pass on!” the people would exclaim in their credit card-fuelled shopping haze. This type of misguided mental accounting, a mathematical sleight of hand, is one most of us have used to justify a splurge at one point or another. The result is often buyer’s remorse, a basement or an attic filled with stuff we just couldn’t afford to pass up the chance to buy, and a significantly thinner wallet.
While most people are already aware that the reasoning behind purchases like this is, at best, misguided, we will keep falling for it until we have seen the ridiculousness of it spelt out in black and white. So let us examine the faulty reasoning, so that we expose the marketers’ trick once and for all. First of all, it is important to define the two terms up for discussion here: Spending and saving.
You spend money when you purchase an item. You save money when you have money that you do not spend. It is that simple, and do not let anyone else try to convince you otherwise. If today, you were offered to purchase a TV that used to cost $1,000 for $800, how much would you have spent and saved if you took advantage of that deal? Yes, that is a trick question. The correct answer is that you have spent $800. Did your savings account increase by taking advantage of that promotional deal? If the answer is no, you did not save any money. People take the wrong turn here because it is so easy to draw the mental connection that spending less on a particular item equals saving more. But all you have to remember is that unless the savings account increases, you have not saved any money at all.
How To Make Sales Work to Your Advantage
As we have now established, sales and promotions are all about luring you to spend money that you didn’t originally intend to part ways with, by tricking you with apparent price reductions. Even if we overlook the fact that often advertised price reductions are compared to unrealistically high prices, you typically do not increase the balance of your savings account by purchasing something at a reduced price. The honourable exception to this is if you have made a purchasing decision ahead of time, and are waiting for the right time to make the deal.
Only if you have made the decision, and already allocated a certain amount of money to that purchase, will it make sense to take advantage of a good deal. The conscious consumer will always make their buying decisions independent of any advertised price. Instead, a smart buyer will decide what price a particular item is worth to them, and then try to acquire it at or below that price. If a good deal comes up at below the already specified maximum price, nothing is better than that, because then the difference can be allocated straight to the savings account. In other words, that person has actually saved some money, by acquiring something at less than the price they had budgeted and set aside for that item.
Further, there are tools you can take advantage of that will let you track the price of a particular item over time, and across many different online retailers. These services often differ from country to country, but a quick Google search will reveal which services are the most popular in your part of the world. By taking advantage of services like these, and always reminding yourself of the fact that the only way you can save money on a purchase is if it increases the balance of your savings account, you can make sure that savvy marketers will never dupe you again during sales season.
The concentration of wealth is a societal problem that society as a whole cannot afford to ignore, and it is not getting better. It recently emerged that the eight richest persons in the world possess as much wealth as the poorest half of the world’s population. Eight men hold as much of the world’s resources as 3.6 billion people.
Unfortunately, traditional media tend to conflate this increase of wealth among the very few at the very top with the demise of the western world’s middle class. The middle class, as the consumer, and product, of traditional media, generally tend to accept such tales of their demise. Doomsday prophecies, particularly those that affect your very own readership, are simply good business.
Here, I will present seven charts based on income, savings and consumption data from the United States over the past thirty years. My hope is that these charts will make you think twice before unconditionally accepting the narrative that the richest few are stealing the wealth of the majority, the middle class. Or at the very least, show you that you have a choice in whether or not you want to give your money to those at the very top.
Americans Save Less Money Than Before
The average rate of saving as a percentage of income in the United States has dropped from around 11% in 1984 to around 6% in 2015, after bottoming out at less than 3% in 2005. Surely this should be used as an argument for a grand scale deprivation of the middle class, as declining saving rates can only be a result of decreasing real wages for the general population?
Average income, as measured by the median, adjusted for inflation dropped since peaking at around $58,000 in 1999. The trend has however reversed in recent years, and for the period measured, from 1984 to 2015, it has increased by around 16%. The average American is, in other words, earning more and saving less.
Servicing Loans Is Not The Problem
One reason often cited for the reduction in saving rates is the increase in housing prices, supposedly far outpacing real wage growth (it is, in some areas, but not by much for the whole country on average) resulting in higher mortgage payments that in turn reduce the average American’s ability to save.
That claim does not have a base in reality. As the chart above shows, the average mortgage debt service payments as a percentage of disposable personal income were lower in 2015 than it was in 1984. Unsurprisingly, it did peak at just above 7% in 2006, but the trend for the whole period is more or less flat.
If mortgage payments aren’t to blame for the reduced rates of saving, then surely the increase in student debt and the cost of servicing those debts are the reason? At least, that what you would believe if you drew your conclusions from looking at headlines. The actual numbers, however, tell a different story.
The trend for consumer debt service payments, which includes student loans, as a percentage of disposable income, is near identical to the one we saw for mortgages. In fact, over the observed thirty year period, the rate has indeed decreased.
The Real Reason Why Americans Save Less
I promised you seven charts. From the first five, we have established that average real income has increased over the past thirty years. We have seen the decrease of average saving rates, but the cost of servicing debt does not offer an explanation. The final two charts make it abundantly clear what is the actual cause behind the average American’s reduced rates of saving is.
Increased personal consumption is the reason why the average American saves less money than they did 30 years back. And before you jump in with “well, of course, that is because everything is much more expensive than it was back then” remember that we saw above that the average person has more money to spend today than back then. In real terms, after inflation. Logically, the conclusion that follows is that the average American is consuming more than they did 30 years back.
I want you to study the above chart carefully, and observe and take in the point it conveys. It shows two graphs we’ve seen before plotted against each other: The development of the real median wage against the ratio of consumption as a percentage of income, and the trend of these two graphs are nearly identical over the observed period.
What this means is that every increase in real income is being spent entirely on consumption, thus increasing consumption ratio. While saving some of that extra income might sound like a good idea, in principle, the data shows that the average American ends up spending it on personal consumption instead. Thus, the average rate of saving decreases.
Our seventh and final chart shows that the saving rate and the personal consumption rate are near perfectly inversely correlated. And, as we saw above, consumption increases with increases real wages. If the middle class is being robbed, it is of their own accord. Or rather, they are, consciously or subconsciously, willingly spending their increased purchasing power.
Have you ever lied awake at night, too caught up in worrying about money to fall asleep? Thinking about how those dollars you spent on that thing was entirely unnecessary, a complete waste of money that plunged you deeper into that pit of poorness? Have you ever planned to take control of your spending, only to slip up because whatever trick you tried to stash away some cash always ended with you raiding your savings account?
I have. Which one, you ask? All of the above. And if you answered yes to any of the questions, and you are still facing these struggles, I have good news for you: There is a way out. As hopeless as it might feel right now, do not despair, because if I could turn it around, then you absolutely can, too. I am going to share with you how I did it and give you every detail you need to implement the same system in your life.
As everyone who has read The Basic Principles of Personal Finance is well aware of, the fundamental axiom of building wealth is to spend less than you earn, and invest the difference. I am mindful of the fact that for many, getting to that point is the obstacle, rendering every advice on what to do after moot. In fact, as already mentioned, I know it well because I used to have that problem myself.
A few years back I was living from paycheck to paycheck, always worried about whether or not I would be able to afford whatever it was that involved spending money. I knew I had a decent income compared to many of my peers, but I just didn’t know where it all went. I still don’t know for sure, but I remember that as soon as money came in, I rationalised spending most of it before it got any time to feel at home in my bank account. And, when my bank account was emptied out, it felt wrong to deny myself any pleasures or purchases I was inclined to enjoy or consume. Enter expensive credit cards, and going down a road nobody with any hopes of financial stability should even contemplate venturing.
Turning Around Your Personal Finances
I am sharing this story with you to show you that there is a way out. Back then I knew little about personal finances and even less about the methods and vernacular employed throughout the online personal finance community. Despite this, with a little help in the shape of motivation and some concrete tips on how to do it from a girl, the girl, I turned my situation around. These days, I am in control of my finances. My money works for me, and I enjoy a financial stability I could only dream of a few years back. The road here from there has been long and filled with missteps, but the “how” of it is simple and entirely possible for you to implement as well.
Step 1: Know What Comes In
The first step to taking control of your finances is knowing how much money you have coming in each month. This number is your absolute upper limit for how much money you can spend in a month, and without knowing it, you will never get control of your finances. So, if you are not sure what your number is, sit down and go through every payslip you’ve received over the past few months. And for good measure, check your bank statements to see if you have any other money coming in on a regular basis that you should include in your calculations.
If your income fluctuates from month to month, your number is the least amount of money you feel reasonably confident that you will bring in even in the worst of months. You want to be realistic, but not too cautious to the point of pessimism.
Now that you have your number write it down. If you are familiar with a spreadsheet, use that. If you don’t feel comfortable with spreadsheets, write it down in a text document, or on a piece of paper. We are going to do some calculations eventually, but it’s nothing more complicated than addition and subtraction. In fact, I will let you in on a little secret: When it comes to math in personal finance, just knowing how to add and subtract is pretty much all you need to do the important things.
Step 2: Know What Must Go Out
I want you do divide the process of figuring out what must go out every month into two discrete steps. Start with listing out everything you must spend money on every month and how much, simply from memory. Write down each of these expenses, and your best estimate of their sizes.
The next step is the most boring and tedious of all of them, but if you want to gain control of your finances, it is essential: Go through your bank and credit card statements for the past year and write down every necessary expense. I am not talking about what you spent on buying a new TV, a pair of skis, or a nice vacation. You should note down only the indisputably necessary expenses you have incurred over the past year. Rent or mortgage, insurance, utilities, loan payments. Only the essentials to survive and necessary, minimum loan payments. Oh, and also, don’t think about the cost of food and eating out here. We will look at that a bit later.
Some bills arrive on a different schedule than monthly, and that is why it is important to go through a full year of statements to make sure that you don’t miss out on any essentials. You will likely find that you forgot some of these when just writing down your expenses from memory, and you have undoubtedly felt the pain of an unexpected yearly bill arriving just after thinking you had a bit of control.
… you have undoubtedly felt the pain of an unexpected yearly bill arriving just after thinking you had a bit of control.
With our system, those bills are not a problem. We just need to know they exist and account for them in our monthly budget. In our document, whether a spreadsheet or a piece of paper, we will note the monthly sum necessary to pay these expenses when they are due. You will need a bit of division to do this, but feel free to use a calculator! If the bill comes yearly, divide by twelve to find how much it costs you every month. Divide by six if it comes twice per year, and so forth, and note down the number.
At this point, you should have a list of everything you need to spend money on, and how much you need to set aside every month to cover that expense, regardless of whether the bill arrives monthly or yearly. As of now, only one expense should be missing from this being a complete overview of what you need to live, and that is your food costs. The reason I told you to leave these out when looking through your statements is that what you have spent before on food doesn’t matter here.
What is important is how much you should be spending on food. To estimate that number, I want to you to do a simple google search for “standard food cost for a single/two/three person household in your country/state” and find your number. If other people in your area can live on spending that amount of money on food, so can you. Eating out is a luxury, and an expensive on at that, and not a necessary cost for anyone. Taking the time to learn how to shop economically, and make good, healthy food is, in this day and age, completely free. In other words, there is no excuse for spending more than the average on food every month, unless you are swimming around in dollars, and can afford it without even thinking about it.
Step 3: Evaluate Your Monthly Cash Flow
At this point, you have control over the two most critical numbers of your finances: How much goes in, and how much goes out every month. Take the first number and subtract the last. What is the result? If the number is positive, you are in the clear. At the very minimum, you should have 10% of your monthly salary left. That is the bare minimum necessary to have any wiggle room within your finances, and the ability to build a cash buffer to prepare for all those unexpected expenses.
If on the other hand, you end up with a negative cash flow after deducting your bare minimum living costs from your monthly incoming money, all alarms should be going off. You are living a life that is financially unsustainable, and you need to take action immediately. Realistically that will entail looking for a higher paying job, adding a second job to cover expenses in the short term, or moving to somewhere cheaper. I cannot stress how important it is that you take action at this point. Do not close your eyes and hope that everything will sort itself out because you are currently the sole pilot of a plane that is going down, and fast.
If your monthly income is insufficient to cover your minimum cost of existing, as you have now calculated, there is nothing anyone else can do to help you take control over your finances. You need to look at every single option: Cut back on any expense that can be slashed, reduce costs of living by downsizing your living space and reducing your food costs to the minimum. And, of course, look at how you can increase your income.
Going forward, the rest of this article assumes that your monthly incomings exceed your minimum monthly spending and that you have at least 10% left over each month.
Step 4: Categorise Your Money
Now that you have control over what comes in, and what should be going out, it is time to implement the system that will allow us to stay in control. What we want is a foolproof way of stating which dollar is reserved for what purpose. The way to do that is by categorising our money as soon at is comes into our possession.
You can divide your spending into as many categories as makes sense to you, but at the very minimum you should have these four categories:
Bills and other necessities
The next step is to log on to your online bank and create a new account for each category. Your primary or checking account will serve nicely as your “Fun” account, but you need at least three more accounts or however many categories you defined.
With full control over how much money you need for bills and other necessities and food, you know exactly how much money must be deposited into these two accounts every month when you get paid. And the magic of the system is, of course, that you are utterly and entirely aware of that the money deposited into these accounts have a job, a purpose. “Stealing” money from one of the accounts to spend on something else means that you won’t be able to pay your bills when they come due. You have assigned a purpose to your money, and for all intents and purposes, these dollars have already been spent. Thus you cannot touch them.
Once you have your system in place, I recommend that you automate the process as much as possible. Set up an auto transfer from your checking account to your bills and food accounts on your payday, and use autopay on all bills where it is possible. That way you can rest well at night, knowing that you have covered your base living expenses without needing to spend any time pondering the hows and the whys. As for the food account, get a debit card attached to that account and don’t use that card for anything but necessary food. I shouldn’t have to remind you that eating out is a luxury, and you should not be using your food card on luxuries!
Step 5: Save and Spend
With all your expenses covered, and a system in place to safeguard that the money is always there to cover food and other expenses, what is left can be saved or spent on luxuries. The key to being able to save money is to employ the same system we use for food and other expenses, and that is why we have a separate savings account.
You now know exactly how much you have left each money after covering every upcoming bill, and I want you to determine right now how much of that money you want to save each month. I don’t care if that is $50, or 50% of your salary. You are reading this because, like me, a few years back, find yourself unable to save any significant money. What matters at this point is that you get into the habit of saving money. Once you conquer that habit, adding more money on top of the amount you set for yourself right now is easy.
Have you decided how much you should be saving each month? Great, now log into your online bank and set up another auto transfer on your payday. This one is, of course, the amount of money you decided to save each month, from your checkings account to your savings account. And once that money is in the savings account, it is as untouchable as the money in the bills account, and the money in the food account. Because just as you need money to pay bills and money to pay for food, you need savings to be in control of your personal finances. You need savings to handle unexpected expenses, and you need savings because eventually, you want to start letting money work for you. Building your savings account is the very first step.
You need savings to handle unexpected expenses, and you need savings because eventually, you want to start letting money work for you.
Now, then, on payday, you have assigned a particular job for all of your money, whether it is to pay bills, buy food or sit in your savings, jumps straight to where it should sit. That means that whatever is left in your checking account is the money you have left to spend. And that is the real beauty of this system. When you stash all your money in your checkings account, you have to mentally account for future expenses every time you make a decision on whether to spend money or not. Most people, myself included, are not very good at doing accounting on the fly, and what’s more, we want that new gadget, so we end up estimating that we probably can afford to purchase it.
With this system, you just need to look at your checking account and see how much is there. If you want to buy those cool sneakers that cost $250, and you have $260 in your checking account, you know right then and there that it means you have $50 to spend until your next payday. And what’s even better, you know that even if you fall for the temptation, and spend every single cent on your checking account, you can still afford to pay every bill, buy food, and save money!
Persistence is Key in Personal Finance
The process and method of money management described here is, almost to the letter, the way I managed, and still do manage my money, to get out of debt, start saving and eventually investing money. I maintain that it is an entirely foolproof way for everyone to take control of their finances, and a method to go from being financially disorganised to being in complete control.
That said, I would be lying if I claimed that the process above is the hard part. Getting control over what you need to spend money on, on setting up the system described here is the easy part. The hard truth is that if you don’t have control over your finances, you are probably spending more than you should, and will have to change your habits. My system is only a guide and a framework for obtaining and maintaining control over your finances. But, as soon as you abandon the system, and start thinking that borrowing a little money from this account to treat yourself to a vacation, or from that account to buy those new sunglasses, the system can’t help you.
Stay true to the system, and prioritise living within your means. I promise it is not something you will ever regret. And also, when you eventually slip up, because you will (and yes, I did, and I continue to do far too often), don’t be too hard on yourself.
If you have any questions or comments regarding this post, don’t hesitate to use the comments field below. You can also reach out to me over on Twitter, or Facebook if that’s what you prefer.