Update #2: I posted a follow up on this article for a reader question. That article included more images to help everyone understand what is going on.
Update: Hello, Reddit!
If there is nothing else I can share with you on this blog, let it be this: keep a one month income buffer. This has been the key to our budgeting success. (We are no longer living paycheck to paycheck thanks to this system!) This concept is so important, I fear I will explain it incorrectly. Please don’t hesitate to comment with questions or concerns. Again, I honestly think this is the most important thing I can offer to you.
Here’s how it works: don’t spend the money you earn this month. You are going to spend it next month based on your monthly budget. That means you should be living this month on last month’s income. It sounds confusing, but it really isn’t. I think it is a simple system if you can get your head around it. How about an example?
A Simple Example
You earn $3,000 after-tax every month. Your direct deposit is sent twice per month on the 14th and 28th. You have three expenses: rent ($800), food ($300), and utilities ($200). Rent is a fixed cost — it shouldn’t change until your lease runs out. Food and utilities are variable — they change each month. Some months you eat out more, some you cook more. Some months of the year it is cold and you use the heat more, other you are using very little heat. On average, your expenses total $1,300. This leaves you $1,700 to do with as you please, preferably savings.
Now your typical person will take the money they receive on the 30th of the previous month to pay the next two weeks worth of expenses. Then when the check comes in on the 15th, it pays for the next two weeks of expenses. If you used 100% of the money every two weeks, you wouldn’t have any savings. Doing this is called living paycheck to paycheck. That is, if your paycheck doesn’t arrive in two weeks, you can’t pay your expenses. Bad news.
What We Do
We take all of the money in month one, say March, and leave it in our checking account. It’s in the account, but we don’t touch it. Every time we get paid in March, we simply put the money aside and hold onto it. At the end of the month our budgeted amounts for food, utilities, and the like should be pretty low. That’s okay, it’s the end of the month. Hopefully we aren’t in the red, either (for the budgeted categories, not for our checking account in general). Remember, we’ve got all of March’s earnings sitting in the account waiting to be utilized for April.
Using the above example, this is how it might look:
- March 1: Just getting started
- Total in checking: $1,300 ($1,300 budgeted for March, $0 earnings from March)
- March 8: Buy groceries for $50, pay electric bill of $100.
- Total in checking: $1,150 ($1,150 left for March, $0 in paychecks from March)
- March 14: Get paid $1,500; buy groceries for $50
- Total in checking: $2,600 ($1,100 left for March, $1,500 in paychecks from March)
- March 16: Pay gas utility bill $100
- Total in checking: $2,500 ($1,000 left for March, $1,500 in paychecks from March)
- March 21: Pay rent $800, buy groceries $100
- Total in checking: $1,600 ($100 left for March, $1,500 in paychecks from March)
- At this point we are getting pretty low on our budgeted money for March. Hopefully we don’t have too much more expense to incur as we don’t want to dip into our paycheck money if we can keep from it.
- March 28: Get paid $1,500, buy groceries $100
- Total in checking: $3,000 ($0 left for March, $3,000 in paychecks from March)
- March 31: We don’t spend any more money this month. We now re-allocate our paycheck money for April’s expenses.
- Total in checking: $3,000 ($0 left for March, $1,300 budgeted for April, $1,700 left from paychecks in March that should be moved to savings)
Note that every time you spend money in March, it doesn’t affect the money you’ve earned in March. It only affects what you’ve budgeted for March.
Now rinse and repeat for April. Save your paychecks in April, and live off of your $1,300 budgeted for the month. Any excess at the end of the month (hopefully near $1,700 or so) goes towards savings.
I hope all of that made sense. Essentially, you are setting aside your budget at the beginning of the month and only using that money for that month. The money you earn during the month goes towards next month.
Above all other things, this concept has helped us move towards financial freedom.
It Takes Time
I’m not saying it is easy to get to this point. If you are currently living paycheck to paycheck you may not have a lot of wiggle room. If your monthly expenses are $1,300 and you only have $25 left to your name at the end of every two weeks ($50/month), you have an uphill battle to climb. If you don’t make any other changes to your life, it is going to take you 26 months to save up a one month buffer. Even if it took you that long, it’s worth it. You might consider cutting your expenses or increasing your income to speed up your process. Of course, if you had $1,700 left at the end of every month then you can try this next month.
Living on last month’s income gives you some flexibility in your finances. If you spend $350 on groceries this month (versus a budgeted $300), your checking account doesn’t go into the red. If your utilities bill were slightly higher than expected, you aren’t having to choose which one to pay first. That overage can be covered by your excess money, and perhaps you adjust your budget for the next month.
Again, there has been nothing, nothing, more crucial to our success in managing our finances than this concept.
Stop living paycheck to paycheck. Stop trying to time when you pay your bills. Live off last month’s income this month. Try it one month, and I think you’ll be convinced. We absolutely love it.
* * *
To answer a question from a comment on how I came up with the numbers — I made them up.
“Why didn’t you include a car payment, or this, or that?” It makes the example extremely complicated very quickly. Having a handful of expenses simplifies things. I do understand that you probably have 10-20 different expenses you need to track.