Why Budgeting can be Dangerous

Over this weekend, we went down a Youtube rabbit hole: The One Rand Family. This was a Sanlam initiative (advertisement) during the month of July which was National Savings Month. The original version was The One Rand Man, which ran during July 2014. 

The big idea was that the participants got their whole salaries for the month in the form of one rand coins, and locked away their plastic money for the duration. This not only gave them a very visual sense of what was going on with their money (stacking up piles of coin-filled plastic containers makes you aware of the size of your car repayments on a very visceral level) but also made them think twice before spending. When you've actually got to dole out your last few piles of one rands, it makes you think more carefully about whether you really need whatever it is. And when you've only got a couple of hundred rands and 9 days left in the month... well, then you really start changing your spending behaviour, at least temporarily.

Watching all of their episodes, as well as some other interviews with the participants, it seems that the biggest challenge for them was not making use of overdraft/credit card facilities when the cash flow got tight at the end of the month. 

Even for those of us who aren't quite as extreme as the One Rand Tribe, using credit as an escape route when our money has vanished is a very bad idea, short of a once off emergency. Because unless we have saved a lot already, this means that we are spending next month's money this month, with no particularly wonderful prospect of making up for it next month. Borrowing for lifestyle expenses means that a month's salary is not enough for a month's lifestyle; and it definitely won't be enough for a month's lifestyle plus debt repayments. Ask yourself: what will be different next month? The sad truth is that next month we'll have the exact same problem except probably worse: after all, your salary won't be any bigger; it still won't be enough to pay for your lifestyle. 

If you aren't careful, you'll end up getting further and further behind, unable to pay the full credit card bill every month and therefore creeping further and further into debt.  As soon as you start paying the minimum payments rather than the full balance it is scarily easy to end up in a situation where you are constantly a month or more behind: and then half your income is going to disappear into repayments that hardly even touch the capital of your debt but instead scrabble around in the foothills of a massive interest rate. 

A truly alarming number of South Africans seem to be in this predicament.

The beast of the night called DEBT makes a guest appearance...
Photo credit: GotCredit at  www.gotcredit.com (CC-BY 2.0)

This got me thinking about BUDGETING: the process of trying to fit your lifestyle into your monthly income.

Here is the usual idea behind budgeting, one to which I have unfortunately subscribed for many years: 

1. List all the expenses you can't avoid, such as rent and utilities, tax, medical insurance and so on. These are usually the ones that bounce straight out of your bank account as soon as your salary arrives. You should know what they are. You probably can't do anything much about them. The exceptions to this are debt repayments, which also come off at this stage, and which you can definitely do something about (pay them off quicker!).
2. See how much money you have left. This is usually a lot less than any of us would like. Now allocate as much as  you think you will need for other essentials like food, petrol and school fees.
3. Whatever is left is for spending however you like. This is where you "budget" for eating out, clothing, movies and holidays: all the things you'd actually like to spend your money on.
4. If by exerting colossal effort you have managed to ensure that there is some money left at the end of the month, save it.

Now, budgeting like this is definitely better than not budgeting. At least you know where your money is going, and you have a reasonable expectation of not going into credit for the essentials of life. Depending on your self-control on step 3, this process will even prevent you from going into credit on the non-essentials: yay!

BUT

BUT 

BUT

Why Budgeting is Dangerous:

Step 1 shouldn't have any debt in it whatsoever. Making debt repayment come off like a normal expense makes it feel like it's okay. It is not okay to be in debt. Half of the reason South Africans are in such a debt hole is because of the perception that debt is like an awkward uncle: not ideal to have around, but everyone has one, so it's fine. If you have a debt, then budgeting should involve Step 1, Step 2 and NOTHING ELSE until the debt is paid.

Step 2 is open to (mis)interpretation. It is too easy to make yourself believe that something is essential, when it is actually a discretionary item. Here is an example: for the first three years after we got married, we had yoghurt with our breakfast muesli every morning. Once in a while we would look at the price and wince - because yoghurt is a lot more expensive than milk - but we convinced ourselves that it was good for us, and therefore necessary. In fact, once you look at the sugar involved in most yoghurt, the "good for us" premise is unlikely. And unless you have a very specific medical situation no-one would say that the yoghurt cultures (or whatever they are) are necessary for health. The main thing healthwise for ordinary people is the calcium: and that is available much more cheaply in milk. It takes a huge amount of self-control to be totally honest with yourself about the true essentials of life, particularly when it comes to food. A similar process often happens with petrol - we use too much of it, because we drive too much. "Allowing" this expense in our budgeting can make us feel like this is an acceptable situation.

Step 3 is a disaster waiting to happen. We all know that the "I want" section is where budgets fall apart. When I was a student I budgeted to buy one soft drink per week, on my way to tutoring. This was my discretionary spend. But guess what? When I walked past the shop on other days, sometimes I brought myself a soft drink anyway, because what's one extra soft drink? Yet if I did this once per week, my discretionary spend would have doubled. Yes, this is a silly example, and probably made no difference to my financial health. But when you're earning more than a student pittance, the tendency is to repeat this pattern in an increasingly unhealthy volume. R400 becomes R600, because I've worked hard and deserve it. R300 becomes R450 because it was a special deal and worth every cent. R200 becomes R370 because I don't want to look stingy in front of my friends. Making it okay to spend some unnecessary money often opens the door to making it kind of okay to overspend - and even to use credit to fund your lavish lifestyle. 

Putting discretionary spend before savings is a major catastrophe: but it is a catastrophe that too many of us overlook in our monthly budgets. If your budgeting process looks like the one I outlined above, you are treading water. And yes, that is better than drowning. But at the very best, you are probably making a small contribution to your pension fund as required by your employer, and perhaps perhaps saving something at the end of the month. But over all, you are (hopefully) breaking even, and making little to no provision for the future. Yet you probably feel as if you are doing quite well. But if a wave comes along... you could too easily go under. News flash: your financial position may not be as awful as other people's. That doesn't mean you're in a good place.

Budgeting is the process of fitting lifestyle into cash flow, not the other way round!
Photo Credit: Tax Credits at taxcredits.net (CC-BY 2.0)

What does healthy budgeting look like?

Don't get me wrong, budgeting is a really important and helpful part of living a frugal lifestyle, fueling the independence engine and (hopefully) reaching financial independence. But we need to budget in a productive way. Here are some ideas for healthy budgeting:

1. Budget descriptively, not prescriptively. Budgeting should be a process of observing your own spending habits. This means that you can plan cash flow effectively, and work out if and when you will be able to afford those unavoidable large expenses. It also means that you can safely save your maximum without being afraid of accidentally running out of grocery money.
2. Save first. I've said this time and time again, but looking towards the future cannot be an afterthought to your month. Use your descriptive budgeting to work out how much it is possible to save, and get that amount out of your bank account ASAP, before you accidentally spend it.
3. Budget with a critical eye. When you look at your spending for last month, look out for danger areas. Perhaps when you look back you notice a gradual creep in expenditure on clothing. This enables you to cut back in those areas next month.
4. Don't budget for wants. If a "want" spending opportunity comes up, either do it or don't do it, based on careful consideration of that situation. Don't have a general rule like "up to R200 is okay for discretionary items", because the truth is that sometimes it is and sometimes it isn't. Make each choice deliberately, not automatically. (Imagine paying for it in one rand coins if you think it will help!)
5. Budget long term. Create a spreadsheet or plan for the next ten years. Where would you like to be? This helps you to keep an eye on the bigger picture, without getting too bogged down in month to month expenses.
6. Whatever you do, don't create a series of ineffectual and unrealistic budgets which you know you'll never be able to follow. This will just make you feel bad about yourself OR make you feel unhelpfully good about yourself while making no actual change to your financial health.

Overall, your budget should be a means of you (and your spouse/family) planning financial choices sensibly. It isn't a magic spell which will make all your financial problems go away. As with all financial tools, if a budget is used badly, it will have a negative impact on your financial situation. But used with caution, it can be enormously powerful.

Postscript/PostInvasion from Mr Cent(ri)frugal Force:

You may find some of these tools helpful for putting together a healthy budget:

Picking the right tool can make all the difference.
Photo Credit: Lachlan Donald (CC-BY 2.0)

• Google Sheets - an online spreadsheet tool. I like to keep my descriptive budget in the cloud so that I have access to it anytime and anywhere - it's also easy to share it with others (once I've made a more user-friendly version of my spreadsheet I'll share it on the blog).
• 22Seven - this really cool company (now owned by Old Mutual) has an app (and a web version) that pulls in all your account balances from all your online accounts that you choose to link to your 22Seven account. You'll need to do your own research and choose how comfortable you are putting your passwords into their service, but their security appears to be pretty solid. Their software tracks your spending and categorises it for you - this is a very good way to see exactly where your money is going. Personally, I prefer to micromanage things so I like my spreadsheets and accounting software (see below). But I've been making use of 22Seven as well (mainly to decide if I'd like to recommend it on the blog) and I've been pretty impressed with them. They also have a blog which is pretty good - you should go check it out. One word of caution - the service is free, but they're probably hoping that you'll make use of them to save in a Tax Free Savings Account. The signup process looks ridiculously easy and the fees are not too bad (0,68%). But you can definitely find lower fees elsewhere - this 0,68% is a fee over and above the fees paid on whatever unit trusts you'll be investing in. Fees really matter so you'll want to do your research on this one. I'll try to do a blog post about fees soon.
• You could also make use of some accounting software. Back in the day I used to make use of Microsoft Money, but I found the "category approach" for income and expenses not as helpful or powerful as a proper "account approach" that one would use in accounting. This is when I switched to gnuCash which is free and cross-platform. You can even turn off words like "debit" and "credit" and make them display something like "money in" and "money out" if that helps you ;-)
• Other than the above I haven't dabbled in any other budgeting tools, apps or services. If you have had a particularly good experience with other apps let us know in the comments!

Happy budgeting!

jjdaydream & Mr Cent(ri)frugal Force

Choosing a bank

When you think about saving money, what's the first thing you think of? Well, probably the bank, right? Most of us believe that keeping a pile of cash under the mattress is a bad plan, so... we have to make use of bank accounts. 

However, the sad truth is that putting money in the bank does not always result in that money working for you. Sometimes, especially in South Africa, you can actually LOSE money by keeping it in a poorly chosen bank account - don't forget that the vampire of inflation is always on the move, and if you add in stupendous bank charges and low interest rates... well, sometimes the mattress starts to seem like a pretty good option.

Not really. Mattresses don't allow you to make payments over the internet. And of course rather vulnerable to theft! But the truth is that in order for your cash to work as hard as possible, you need to pay a lot of attention to where you bank.

Squirrels do well to hoard nuts in secret locations.
You also need to keep your money in the right location!
Photo credit Tomi Tapio K (CC-BY 2.0)

I have always paid considerable attention to bank charges - long before financial independence became a goal. My attitude towards bank charges and interest has always been along the following lines:

Banks exist to pay me money, not the other way around.

Banks should be honoured to have access to my savings in order to loan to others at a high interest rate. At the very least I should break even and the total of all bank charges should be less than the interest that I earn on my savings in a bank account.

Your personal banking package

It is useful to think of your overall "personal banking package" which could consist of one or all of the following components:

1. transactional account - the account from which you are able to perform transactions (deposits, internet banking payments etc.)
2. savings account - a linked account which usually earns higher interest than the transactional account, but has limited transactional functionality
3. credit card - dangerous, but they have their uses as discussed in our post on debt
4. rewards programme - some banks reward you for how you bank with them, how often and how much you use your credit (or debit) card with them such as uCount (Standard Bank), eBucks (FNB), Greenbacks (Nedbank) and Absa Rewards.

The above package may all come from the same bank or it could be something that you construct from different banks and financial institutions (this is the option that we have taken). 

The ideal banking package

Purely from a monetary perspective, the best package is the one that costs the least (if interest and rewards earnings are less than your bank charges) or the one that earns the most (if interest and rewards earnings are greater than your bank charges). Ease of use, location of branches and other features such as sms alerts, mobile apps etc. should not be neglected, but make sure you think very carefully about what you actually need out of a banking package as opposed to the nice extras that a bank will try to sell you or hook you with.

The following is what I consider the ideal banking package for my family:

1. Internet banking! Being able to make payments online is a non-negotiable for us.
2. A single account from which to transact that also earns interest at a high rate.
3. A simple fee structure at the lowest possible cost.
4. A credit card for managing cash flow - the actual interest rate on the card is not important as we never plan on paying interest on it. What's important is that we have at least one month interest free and that any costs involved are less than the interest we earn on the money that stays in our bank account.
5. A rewards programme if and only if it earns more than it costs and if it falls in line with our usual spending habits (how much money we spend, what we spend it on and where we spend it: in other words, so we don't spend more by trying to save money).

Fee structures

Most bank accounts have a fixed monthly cost in addition to costs per transaction. Some bank accounts are "pay-as-you-transact" (with a low fixed monthly fee) and others come with "bundled transactions" (a higher fixed monthly fee, but with either a near-unlimited or fixed number of transactions included).

In order to determine which is best for you, it is important to determine what types of transaction and how many of those transactions you would typically perform every month. The main transaction types to consider are:

1. External debit orders (retirement annuity contributions, credit card repayments etc.)
2. Internet banking payments / EFTs (rent, monthly donations etc.)
3. Cash withdrawals at till points (smaller amounts).
4. Cash withdrawals at your bank's ATM (larger amounts).

Think about how many transactions you really use, and whether the bundled transactions are worth it. Although each transaction may be cheaper if you transact a lot, the fewer transactions you make, the less likely it is to be worth  your while. This is certainly what we found when we switched to a much cheaper pay-as-you-transact account. Although each transaction was theoretically more expensive, we still came out ahead. 

Interest earned on your bank account

Surprisingly, most transactional bank accounts don't actually pay you interest (or pay a very low interest rate) on any money you have in them. Instead, the bank offers you a linked savings account into which you need to transfer your money and then you can earn interest on that money. But you can't easily access those funds directly: they first have to be moved back into the transactional account. 

What this system has in its favour, is that your money earns interest in a place that is slightly harder to access - so if you don't have very good money discipline (yet!) then this could be a helpful feature. However, this feature is also the biggest downside of this system. You need to estimate very carefully how much you actually need in the transactional account so that you can maximise the amount that earns interest in the savings account and you're usually limited to how many times you can transfer from the savings account into the transactional account. What a schlep! 

What we need is something simple - a single account from which we can transact and earns a decent rate of interest.

Credit cards

As mentioned in a previous post, we don't have the luxury of choice in credit cards that they seem to have in the US. So instead of choosing the card that gives you the best rewards we're looking for the card that costs the least. Things to consider when choosing a credit card:

1. Credit cards usually have a fixed monthly fee or a fixed annual fee. (Choose one that is zero! Credit cards aren't actually worth paying for.)
2. Make sure you have access to either internet banking or emailed statements.
3. Make sure that you have at least one month (most in South Africa give 55 days) interest free.
4. Using your credit card for cash withdrawals or for purchasing petrol will cost from the very first day - rather use your debit card for these.
5. If you get your credit card from the same place you have your bank account these are sometimes bundled together. Make sure that the bundled cost is less than the cost of a stand-alone credit card from one institution and a bank account from another.
6. Credit cards are often an integral part of banking reward programmes. Again, you'll need to perform some calculations to see if paying the associated fixed monthly fee in order to have access to the rewards programme is actually worth it. (Spoiler: in most cases, it isn't!)

Rewards programmes

It's important to perform the detailed calculations for yourself to see if belonging to a rewards programme is worth it. I'll give you some of the major things to consider here, but you'll need to factor in your own spending patterns. 

The best approach to calculating if a reward programme is worth it looks something like this:

1. Work out your ideal banking package and spending patterns while ignoring the existence of any possible rewards programmes. 
2. Then see how much extra joining the bank and the reward programme will cost.
3. See how much you would need to alter your spending pattern to get certain benefits from the rewards programme:
• Do you need to spend more than you would without the existence of the rewards programme?
• Will you be limiting your freedom because you're required to change most or all of your banking habits just to get certain rewards or achieve a certain level of rewards?
• Do you need to do your shopping somewhere inconvenient or further away? If you need to drive further away than your closest shopping centre then this will add to the cost of joining the rewards programme.

It is really important to remember that rewards programmes are essentially marketing tools. This means that in most situations, the company is going to make more money out of your participation in the programme - otherwise they wouldn't offer it. It can be win-win, but the company is always going to come out ahead; after all it is their game. 

Also, by their very nature these programmes reward consumption: something which we are trying to cut down on. If you are being very frugal, they will have nothing to reward you on. So you need to be very sure that you can game the system before going for a programme like this.

So what is our personal package?

We do our banking with Capitec and we have a credit card from Virgin Money. We haven't bothered with any banking rewards programmes.

Without actually specifically advertising either of these institutions (if their packages change we will always be willing to move) I'm happy to go through our logic about how we came to the above combination:

1. Capitec charges low fees, the fee structure is simple.
2. Capitec offers very good interest on your bank balance - and they don't bother with a separate transactional and savings account.
3. Virgin Money costs us absolutely nothing.
4. The combination of the above means that our banking package earns us more than it costs us which is just how I like it.
5. We'd need to adapt our spending far too much for any of the banking reward programmes to make sense for us - although they certainly are better value than they were a few years ago.

Something to note about your bank account: regardless of who you bank with, you shouldn't get too excited about their interest rates as only the essential day-to-day cash should be kept in your transactional account. The rest of your cash that is set aside to be easily accessible in case of emergency should be in a money market fund - safer and it will achieve slightly higher growth. Plus, it is never a good idea to keep all your eggs in one basket.

I'll admit, constructing the "optimal personal banking package" can be quite a complicated and demanding task. The "best package" can also change from time to time as the banks compete with each other and change their offerings. Don't let the perfect be the enemy of the good - find a banking solution that works for you and gives you only what you actually need. If the offering with the next bank is only slightly better, the hassle of switching banks is probably not worth it. 

But if the differences become significant, don't be afraid of going through the motions of switching. Don't be suckered by special platinum cards or loyalty rewards: a bank is a business, and you are a customer. If they are not fulfilling your needs, you need to move.

Going through the above process of evaluating your banking solution can be time consuming, but the potential savings are worth it. You can bank on it.

The Beast of the Night called Debt

EMERGENCY POST!

While cycling to work this week I saw a newspaper headline telling me that South Africa is "the world's most indebted nation". I was going to post something about where to bank or where to invest in South Africa this weekend, but debt is such a serious emergency that this post cannot wait any longer!

The Beast of the Night Called Debt
Photo credit Pablo Piedra (CC-BY 2.0)

To see why debt is such a terrible thing. Let's take a look another look at the formula that tells us how how our investments grow with compound interest:

which we can compare to the formula that tells us how our debt grows:

See any difference? You shouldn't, because they're the same. That's right, the same power of compound interest that can help you buy freedom when you invest, acts against you when you're in debt.

When you have an investment it grows exponentially and when you have a debt it also grows exponentially - according to the same laws of mathematics. It is said that "Those who understand compound interest, earn it. Those who don't, pay it." My true hope is that you will come to truly understand compound interest. If you can't wait for what I plan to write in a future post - begin your studies here and work your way up.

The current prime lending rate in South Africa is 9,25%. Credit card rates are anywhere between 14% and 23%. Borrowing money at any of these rates can only lead to real financial difficulties. If we take inflation into account, then the prime lending rate is effectively about 4,25% and credit cards are between 9% and 18%. If you have any debt at these rates, then paying off this debt gives you a guaranteed real return (above inflation) equal to that rate. So paying off debt fast and aggressively is the wisest thing you could do.

Good debt? Rare and risky if it exists.

People often talk about "good debt". I'm not going to completely refute this idea, but I do feel the need to highlight the only conditions under which debt can be "good":

1. The interest rate that gets paid on the debt is low. This automatically excludes all credit cards as well as borrowing money for a car. Oh, and buying anything on hire purchase is a seriously bad idea.
2. The borrowed money is being put to good use. This means that you're not borrowing money for general life expenses or leisure expenses. Putting the borrowed money to use means you're using it to earn more money (a concept referred to as leveraging). This can definitely be profitable, but you really need to know what you're doing. The borrowed money could be to start a business or to inject additional capital into an existing business.

Personally, I don't like debt at all. I believe that you should up for anything you want to buy with cash. Yes, even a house. But I do acknowledge that money might need to be borrowed in order to produce an income with which to do the saving (as in the business example above).

So credit cards... what role do they play in our quest for financial freedom? Firstly,

Credit cards are not for borrowing money. 

They are for managing your cash flow better. Most credit cards in South Africa give you about 55 days interest free (the actual number of days is not important, only that it is more than one month). This means that when you use your credit card to buy your groceries and pay for strictly necessary expenses the actual cash you have earmarked for these expenses sits in your bank account earning interest! As long as you pay your credit card in full, every month, then you will never pay interest. This is the only way to use a credit card! Never pay only the minimum amount due (it's a trap!). Never let a month go buy without paying the full amount owing. If you don't have the self discipline to do this then you should not have a credit card.

We aren't fortunate enough in South Africa to have the types of credit card rewards programmes that they have in the US. So we might not be able to actually earn money from credit cards, but we can shop around and choose a card that will cost us the least.

The best card that I could find is from Virgin Money - there are no monthly, yearly or admin fees. Internet banking with this card is free. They do have some other rewards, but none of them are really relevant to our family's needs.

I'll do another post on the rewards programmes that we do have in South Africa, but in the meantime I'll share my conclusion: they're not worth it. Now this conclusion depends on your individual spending patterns and circumstances so you will have to do your own calculations, but in most cases the rewards escalate with spending. If you're planning on living a frugal lifestyle to generate fuel for your financial independence engine then rewards programmes won't benefit you because the very thing they reward is consumption.

For more takes on just how serious debt is, let me point you towards Mr Money Mustache who tells us that "debt is an emergency" and jlcollinsnh who says that "debt is an unacceptable burden".

So to summarise:

1. Don't get into debt in the first place.
2. If you already have debt, pay it off as fast as possible.
3. Use credit cards wisely and not for their advertised purpose.

Now go forth and defeat the Beast of the Night called Debt!