Budgeting is important because following a budget will tell you exactly how much money you are able to put towards your goals and give you an idea of how long it will take to reach those goals.
Do you know how much money you spend each month on various categories like rent/mortgage payments, gasoline and food? Do you also know exactly how much money you are saving at the end of each month? If you don’t, you are not realizing the benefits of creating and following a budget.
As mentioned here, the formula for your excess or free cash flow is simply your income less your expenses over a given period of time (e.g., a month or a year).
Income – Expenses = Free Cash Flow
Most people know exactly how much money they earn. What many people don’t know is exactly how much money they spend, which means they also don’t know how much money they are saving at the end of the month, their free cash flow.
Knowing your free cash flow is important because this represents the money you have left over to have available to put toward your goals. This process begins with estimating and categorizing your monthly expenses. It can help if you spend a few months tracking how much you spend so you already have an idea of how much money you spend each month. Once you estimate your expenses, you will have both inputs in the formula above (income and expenses) and will be able to estimate your free cash flow. Next, the hard part comes in tracking and following your budget.
A budget is entirely worthless unless you track your spending and make efforts to stick to your budget. To do so, create a spreadsheet to track your spending. Save your receipts or review online statements periodically and update your spreadsheet with your actual spending. By doing this, you can see how your actual spending compares to your budget and make changes as necessary. For example, if you see you are spending too much money in restaurants and bars, you try cooking at home more to meet your budget goals. Alternatively, you can always adjust your budget amounts up or down when you see your initial estimates were unreasonable.
As mentioned above, your free cash flow represents money you have saved at the end of the month that you can put toward your goals such as buying a house or investing in the stock market. However, knowing this amount can also tell you the time it will take to reach your goals. For instance, if you need $10,000 for a down payment on a house and your free cash flow at the end of the month is $1,000, you know that if you stick to your budget you should reach your goal in 10 months. Knowing the time it will take to reach your goals can also be used to adjust your budget. Continuing with the previous example, let’s assume you are currently renting and apartment, and your lease ends in 8 months. However, at that time you want to purchase a house instead of looking for another apartment for two months. In this example, you will need to save $1,250 per month to get $10,000 in 8 months. Therefore, to reach your goal of saving a down payment in 8 months, you’ll have to adjust your budget to save an additional $250 per month.
Budgeting is often overlooked, but the importance of creating and following a budget should not be underestimated. Following a budget will tell you how much money you have available to reach your financial goals and how long it will take you to get there.