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

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!