Budgeting is an important part of managing your money. You can figure out how much you earn, record all your major monthly expenses, and then set up a plan to allocate your after-tax income to make sure those bills are covered, including an emergency fund.
“A budget ensures that you’ll be able to do the fun things you want to do, while working toward more serious financial goals,” says Julie Everett, Certified Financial Planner at Financial Finesse.
But the hardest part might be sticking to the budget you make. And if you regularly spend too much, you might not achieve the financial goals you set for yourself. The envelope budgeting system is a way to track your money each month, and it can help you limit overspending because it limits what you have.
What is the envelope budgeting method?
The envelope budgeting method is a budgeting system that was popularized by personal finance author Dave Ramsey. The method is to divide your take home pay into expense categories (eg, rent, utilities, etc.), label an envelope for each category, and put the money you plan to spend in the envelopes. When you have to pay for something in one of these categories, you take money from the appropriate envelope to cover that expense.
“The idea is that once the envelope is empty, you don’t spend more in that category until it’s time to replenish the next month,” says Amy Lins, vice president of corporate learning. at Money Management International, a non-profit credit counseling agency. .
This budgeting system can help you regulate your spending because cash users are more likely to form an emotional connection with their money.
How it works?
You’ll start by checking how much after-tax money you take home each month, determining where you typically spend money, and allocating the appropriate amount to cover each expense category.
Spending categories are your big expenses that need to be covered each month, and can also include additional “fun” categories. So they include things like groceries, restaurants, gas, a vacation fund, and personal needs like haircuts and clothes. Since housing costs, utilities, insurance, and debt repayment are generally fixed expenses, they will not be included in the envelope categories.
If you want a guideline, you can split your money using the “50/30/10” rule. You would spend 50% of your take home pay on needs like housing and utilities, 30% on wants like travel and recreation, and 20% on debt repayment and savings. Let’s say you make $55,000 a year from a job and take home $3,400 a month. Your expenses would be broken down as follows:
$1,700 on fixed needs
$1,020 for variable needs and expenses
$680 on debt repayment and savings
Typically, expenses such as your rent, utilities, and other debts are not included in this budgeting method.
How to create your own budget using this method
Want to set up the envelope budgeting system yourself? You can either use cash and actual paper envelopes or take a digital approach using spreadsheets and apps like Goodbudget.
Here are the steps you can follow.
Step 1: Calculate your take home pay
Check your bank statements to see how much you take home each month after taxes and withholdings. Include all sources of income, such as earnings from employment, side businesses, or investments.
If your income varies each month, calculate the average by adding your total income for the past year and dividing the amount by 12. In our example above, you bring in $3,400 per month.
Step 2: Create budget categories
When setting your variable expenses, check your most recent bank or credit card statements for an accurate calculation. Everyone’s categories will be different, but the main ones usually include:
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Check if each expense is necessary. If there are luxury spending categories, you’ll need to decide which ones you can afford to keep or cut back on. “I see a lot of people cutting back on their subscriptions at this point,” Everett says. Going back to our previous example, your total monthly expenses are $2,380 per month for fixed needs ($1,700), debt repayment, and savings ($680). That leaves you with $1,020 ($3,400 – $2,380) to split between envelope categories.
Step 3: Assign a budget to each envelope
Now that you’ve determined your net pay, envelope categories, and how much you can spend, you’ll decide how much to allocate to each category. Here’s an example of how you might divide your remaining $1,020:
Step 4: Track your spending
Each pay period, you will withdraw cash, or $1,020 in our example, and distribute it among your envelopes. Write the starting total on the envelope and list each purchase each time you spend money. Keep a running total of how much money you have left in each envelope for the month. Then, review your budget regularly.
“If you’re spending less than planned one month, leave that money in the account for the month you need a little more,” Lins says. “Challenges arise when you’re busy, not writing it down, putting it in sight and mind, or making a habit of budgeting.”
If you regularly run out of money in an envelope that’s important to you, Everett says, it might be time to re-evaluate what you’ve budgeted for the category. For example, you can transfer money from your “entertainment” envelope and add it to your “dining out” envelope depending on your priorities.
What are the advantages and disadvantages of the envelope system?
So, is this budget approach right for you? It all depends on how you spend and manage your money, and how well this strategy aligns with that. Ultimately, understanding the pros and cons of the envelope budgeting system can help you decide if you want to try this approach.
The envelope budgeting system may be suitable for people who want to track their expenses and need help sticking to their monthly allowance. Here are some other benefits:
It can help you spend less. People tend to spend less when using cash. In a 2016 Federal Reserve study, the average value of a cash transaction was $22, compared to $112 when paying electronically, such as with a credit card. “Something about having to physically part with money makes it harder to spend,” Lins says.
It builds discipline and you will know how much you are spending. When you set firm limits on your spending, it can help limit overspending on impulse purchases.
It gives insight into your consumption habits. After a few months, you’ll be able to see how you’re spending money and identify problem areas.
The envelope budgeting system has a few drawbacks, but they all relate to the use of money. If you want the benefits and structure of the envelope system, but don’t want to carry cash, consider using a spreadsheet or budgeting app.
It may take time. If you decide to use cash and envelopes instead of digital tools, you’ll need to cash your paychecks and distribute the money each pay period. It can get tedious.
Cash is vulnerable to theft and loss. Homeowners or renters insurance can cover you if your money is stolen from your home, but only up to your policy limits. It’s usually around $200 to $300. Credit cards, debit cards and digital wallets offer more security than cash and include $0 liability for unauthorized purchases in most cases.
You are missing the benefits of the credit card. Many credit cards come with rewards programs and built-in coverage, such as fraud detection, extended warranties, and purchase protection. You won’t get these benefits if you stick to cash.
The take-out sale
The envelope budgeting system is a tangible cash-based approach that can help you track your expenses and limit your purchases. But since cash is vulnerable to theft and doesn’t have the benefits of credit cards, you can also use virtual envelopes or a spreadsheet for a cashless approach to this method. You can also consider other budgeting strategies, such as self-pay or zero-based budgeting. If you’re still struggling with overspending, you might want to talk to a credit counselor at a nonprofit agency, such as the National Foundation for Credit Counseling. They can help you find a budgeting approach that works for you and your financial situation.
This story was originally featured on Fortune.com
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