Hierarchical Budgeting

Earlier this week I had a discussion with one of the finance group members. Of course we get to the discussion of personal finances and he asked me how I handled my budgeting. This required a lot of thought due to the fact that I never formulated a method behind my budgeting madness. After some serious thought, I have decided to write this blog article to explain my budgeting principles.

1. Pay off all bills on the day that income is received, not when the bill is due.

One of the critical priorities of budgeting is allocating the money prior to spending it. A huge downfall that I at one time had, was that I would put money aside (logically) for a bill I knew I had to pay and end up spending the money prior to actually paying the bill. I typically forgot about the bill and when the bill's due date rapidly approached, I had to scramble to get the money to pay the bill on time.

To improve this process, I just started paying all my bills on the day I got paid. This simplified things for me because the money was there and my bills were always paid on time. Due to the convenience of the Internet, one can easily log online and check an online statement to see exactly how much is owed on the bill prior to the statement ever being mailed.

In addition to that, one can just as easy log onto their banking site and use the nifty (and typically free) bill pay feature to send a payment to the bill company directly from the bank. I find this to be very convenient as it allows me to avoid fees that some companies charge for paying online as well as postage and a trip to the mailbox to deliver a check. At the initial implementation, I ran into two common problems...

• What to do if my first check did not cover all of my expenses
• After I paid all of my bills with my first check, I had to figure out how I would live for the next two weeks until I received my next check.

2. Always have an intermediate savings account at a certain level to provide cushion in between pay periods.

The next step in the hierarchical budget is having a "buffer" account to help through the time in between pay periods. When my first check did not cover all of my expenses for the month, I would take a mini-loan from my intermediate savings account to cover the bills. Also, I could use that same mini-loan to live off of in between paychecks. One of the benefits about loaning yourself money is that you decide your own interest rate to charge for borrowing against yourself. (And yes, you can charge youself 0%).

This particular account is kept with the same bank that I keep my checking with. This was done so there would be no delays when I needed to move money between the accounts. I roughly opened this account with one pay period's salary because I could comfortably pay my remaining bills as well as have enough to live on for the next two weeks. If you need more than an extra pay period to pay the rest of your bills and live off for those weeks, you may want to put 1.5 pay periods in this account.

*Please note: Call your bank to check if they charge fees for not having a minimum savings account balance or for doing too many account to account transfers in a month. Some banks are sneaky and will nickle and dime you every chance they get*

3. Prioritize your accounts to ensure proper funding at all times.

In order for this process to work, I had to stick to the routine to replenish this account to its original level immediately when I received my second paycheck. Any money that I had left over was then divided among different accounts such as checking, emergency savings account, investments, etc. This is great in theory but after I replenished my buffer savings acount, I did not have a lot money left over for budgeting. To improve on my decision making for fund allocation, I had to categorize the difference between my necessities and wants.

4. Divide expenses into categories (Necessities vs. Wants)

In order to help create more money to have after replinishing my buffer account, I had to divide my expenses into necessities and wants. Some examples of my necessities are mortgage, electricity, gas, groceries, natural gas, internet, phone, tv, etc. These things are the most basic "I need to have this for my regular life" expenses that requires regular allocations.

To contrast this, I have my wants which are things like a Roth IRA, Emergency Savings Account, other investment accounts, discretionary, etc. To optimize my money, I had to learn how to justify each expense. My thoughts behind justifying an expense is very complicated and will be discussed in detail in a separate post.

As mentioned before, my way of doing things may not work for every situation. Please share with us some of your budgeting techniques that work for you. As always, Stay Disciplined!