For a long while, I’ve been an advocate of You Need a Budget, which is a software package and philosophy that I use for budgeting. I’ve used it for years.
The core idea behind You Need a Budget is represented in these four rules:
Rule One: Give Every Dollar a Job
Rule Two: Save for a Rainy Day
Rule Three: Roll with the Punches
Rule Four: Live on Last Month’s Income
The first three are pretty straightforward and make a lot of sense no matter what your personal finance philosophy is. In their own way, most personal finance books and most personal finance gurus subscribe to those key ideas. Use your money wisely and in a forward-thinking fashion. Have an emergency fund. Don’t panic when things don’t go perfectly. It makes sense.
The challenge comes in with that fourth point. Live on last month’s income? What does that even mean? And how could you do it?
Here’s their explanation for how it works:
Spend this month, what you earned last month. How? Save enough money to go an entire month without touching your regular income. Then the next month, spend last month’s income while earning this month’s income. You’ll spend this month’s income next month.
And how you can get it going:
We’ll use an example with simple math. Let’s say you take home $5,000 per month. Before finding YNAB, you spent $5,000 per month and lived paycheck to paycheck. Now, you’ve seen the light (hallelujah!).
Now, because you’re budgeting and really working hard to live on last month’s income, you’re only spending $4,000. That means you’re saving $1,000 per month toward the Buffer. We capitalize Buffer around here because it’s important.
If you save $1,000 per month for five months, you’ll have saved a total of $5,000. So at the beginning of the sixth month (remember, you used the first five months to save that $5,000), you’re essentially sitting on a month’s worth of pay. You’ll use that money for the sixth month, earn $5,000 during the sixth month, then use that $5,000 for the seventh month.
That’s it. You’re there. You will, forever and always, be living one month ahead.
So, why would you do this? I find that there are four big advantages to this strategy.
First, it reduces financial stress. I really don’t worry at all about paying the bills because I know I’ll always have money sitting there to pay the bills with. The income I earned in March is what I use to pay the April bills, so since that money has already arrived and is just sitting there, I don’t have to worry about it.
Second, it eliminates the need to “time” bills. The only bill “timing” I do is based on the due date of that bill, as I try to submit payment shortly before it’s due. I don’t have to wait around until the end of the pay period to pay bills. I don’t have to worry about being late for bills if things run short.
Third, it sets a strong precedent for spending less than you earn. If you manage to reach this point without dipping into credit, you are actively spending less than you earn. That’s an incredibly strong financial precedent.
Finally, it makes monthly budgeting really easy. I know exactly how much to budget for each month. That money is sitting there in my account on the first of each month, so I can directly put that budget into action. If I plan on spending $400 in food this month, it’s all ready to go at the start of the month and whatever’s left is in the account at the end of the month. Doing this brings budgeting to life.
So, how do you get there? Here are five steps I recommend.
Step One: Have an Emergency Fund in Place
The thing to remember is that this type of plan essentially functions as a one-month emergency fund. If you follow this plan, you’ll always be one month ahead of your actual income.
So, it makes sense that the first step for getting started is to establish a small emergency fund in a separate savings account. Your goal is easy: Put aside a small amount each week until you have at least $1,000 in that savings account. You should ask your bank to do this automatically. The larger the “small amount,” the better.
What you’ll find is that you won’t miss that small amount at all, but you will definitely be happy to have that $1,000 if an emergency strikes. It will also provide a backup for you as you try to transition to this new plan.
If you do that, you’re spending less than you earn, which is the truly important part of all of this.
Step Two: Pay Off High-Interest Debts
Once you’ve reached that $1,000 threshold, you’re going to start focusing on your high interest income. Just like before, take it one step at a time with just a small amount out of each paycheck.
Your plan should involve continuing to make minimum payments on all of your debts as part of your normal monthly spending, while continuing to spend less than you earn. The remainder should be applied as an extra payment to whichever current debt has the highest interest rate.
In general, I recommend that people eliminate all of their debts with an interest rate above 8% or so as quickly as possible. Once you get to that level, you should still work on your debts, but you can allow other financial priorities to step up to the plate, like establishing a larger financial cushion, saving for retirement, and so on.
If you find that you need to tap your emergency fund in order to deal with a crisis, move back to step one. Refill your emergency fund before moving forward.
Step Three: Create a Checking Account “Buffer”
Once you’ve eliminated your high-interest debts, you’re going to redirect that extra money from each paycheck toward building a “checking account buffer.” Unlike last time, you shouldn’t have any more credit card bills breathing down your neck, so you can actually chase this goal with a lot more focus than before.
Save this money in your checking account. Ideally, you should be in a situation where, at the end of each month, you have a higher checking account balance than you had at the end of the previous month.
Step Four: Keep Going Until Your Buffer Equals One Month’s Total Budget
Since you should wind up with more money in your checking account at the end of each month than at the start if you’re following this plan, it’s only a matter of time before the money sitting in your account at the end of a month is equal to your monthly budget for the coming month.
When that happens, you’ve essentially achieved your goal.
Step Five: Build a Better Monthly Budget with New Savings Goals
The next step is to then consider what your monthly budget actually looks like. What are your savings goals for the future? Do you want to continue to focus on eliminating debt (which reduces your overall monthly bills)? Do you want to save for retirement? Do you have other financial targets that are important to you, such as saving for a down payment or for a child’s education?
Whatever your new goals, design a budget that incorporates at least some savings toward those goals. You may find that this “inflates” your monthly spending a bit – and that’s okay. Go back to step four until you’ve got enough to cover this new budget.
The key thing to remember here is that living off last month’s income is essentially the same thing as having a one-month emergency fund. If everything were to fall apart, you’d have a month’s worth of living expenses just sitting there waiting for you.
The big advantage of having that emergency fund actually sitting in your checking account in this way is that it allows you to easily budget. You can look at what’s sitting in your checking account at the start of the month, use that amount to budget for the whole month, and then immediately sock away some of that money into various savings accounts. You still have plenty of money to eat and pay for all of life’s ongoing expenses from what’s left over.
Being in a situation like that is incredibly freeing. It gives you a strong sense that your finances are really working for you rather than serving as an obstacle between what you want to do and what you have to do.
Is this a “required” thing for financial success? Not really. It’s just something that Sarah and I find to be quite useful in managing our finances. If you’re careful about spending less than you earn, it’s not too hard to build up to that point, either.