Friday, April 27, 2007

The plan that revolutionized my budget

My budget underwent a series of radical changes over the past 2 years. Many of my ideas came from modifications of plans set forth in The Complete Cheapskate by Mary Hunt. It's a fantastic book that I recommend anyone read. Moreover, it is a guide (among the easiest reads in this category) for debt reduction and reevaluation of where you spend your money. The most important idea that I drew from reading all of the debt and money management books I did was this: run your home finances like a business.

That simple thought paved the way for a whole host of budget plans that really allowed me to manage money in a way I had not considered before. Income became revenue, bills were expenses to be tracked and funded through allocated accounts or virtual accounts (splitting up dollar amounts in a single account with software such as Excel). Spending money? Just another expense account.

However there is one idea that revolutionized how I ran my home business: the Readjustment Account. The name is rather ambiguous. The RA is essentially a pool of money for which a calculated amount is put in with each paycheck, much like a savings fund where you take a percent of your paycheck and drop it into a savings account. The RA is a fixed dollar amount that accumulates over time and funds large irregular expenses.

An example is auto insurance. This bill typically comes every six months. Readjusting that amount per year and diving by 12, then by 2, we get the amount that needs to come out of each paycheck. Over the course of a year, the account accumulates enough money to pay the bill when it comes due. Now add a dozen other bills like your home insurance, HOA dues, hair cut appointments, vehicle them into a spreadsheet, add them all up to give you a total cost per year, divide by 12, divide by 2. Set aside that money each paycheck, and when those items come due you simply pay them out of the RA. Chart your electricity and other utilities. Utility costs generally vary with the seasons. If you figure last years total electricity costs, divide by 12, you get your full monthly cost of the year. Divide that by 2, there's your RA payment. When your bill is lower than your adjusted monthly payment, the excess goes into the RA, when it is higher the extra money comes out of the RA.

What's the point? It normalizes your budget. Our budget is no longer tight when we get a hot summer electric bill for $150, when we are used to paying around $75. No scrounging for money when the auto insurance is due (and, more importantly, no fees if we need to set up a monthly payment plan to them instead).

Anything and everything that does not come up every month, or is not a fixed amount every month, needs to be recalculated as a payment into the Readjustment Account. This makes a lot of sense. Your bills vary wildly from month to month, but your paycheck doesn't. Averaging them out for the year and saving up for them is, in my opinion, one important part of a solid financial plan.

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