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Synopsis

We use a technique called “envelope budgeting” to help you manage your money. Read on to understand what it is, why it’s useful, and how to get started.

Envelope budgeting primer

So you make $40,000 per year, but your bank balance isn’t growing each month. So you’d like to learn how to change that. The number one thing you should do is make a plan. Then try to stick to that plan as best as you can. You need to plan because life is too complicated to just wing-it. Suprises will come up, so you need to be ready for them. While there are lots of planning techniques you can use, the one we’ll discuss in this article is called envelope budgeting. This technique is very simple to understand and implement, which makes it easy to start using right away. It is also extremely effective once you get some practice, which means that you can keep using it to grow your wealth.

The concept is simple, but let’s make sure it sinks in by starting with a very simple example. Let’s pretend that you don’t have any bank accounts. All the money you have is in your pocket. Here’s how you would plan with envelope budgeting if that were the case:

  1. Take the cash in your pocket, and put it into an envelope. Then write the word “Available” on the front of the envelope.
  2. Next, think about every bill that you need to pay between now and payday. For every bill you think of, grab an envelope, and write the bill’s name and amount on the front of it. For example, if rent is $50 and is due tomorrow, get an envelope and write “Rent - $50” on the front of it. If the cable bill is $20 and is due soon, grab another envelope and write “Cable - $20” on the front of it.
  3. Now, start taking money out of the “Available” envelope (from step 1) and move it into each of the bill envelopes you created in step 2. For example, take $50 out of the “Available” envelope and move it into the “Rent - $50” envelope.
  4. When the bill is due, take it out of it’s envelope and pay the bill with that money.
  5. Next time you get paid, put the money into the “Available” envelope and start over at step 1.

That’s it. The goal is to try to leave as much as possible in the “Available” envelope. If you get paid and consistently leave a little extra in that envelope, your wealth will start to grow. By following these simple steps, you’ll find that you will always be able to pay your bills when they are due. Or you will find out that you don’t have enough money to pay your bills (i.e., you have a bill due, but don’t have any money available to pay the bill). If that happens, you have three choices:

  1. Don’t pay the bill (e.g., cancel the service).
  2. Don’t pay some other bill (e.g., I need to pay rent, so I’ll cancel cable).
  3. Borrow (i.e., pay the bill with a credit card or a loan).

While the last choice is an option, you should try to avoid it. It should only be used as a last resort and for things that are very important (e.g., food, shelter, etc.). The reason it is not a good choice is because:

  1. Now you have less money to use for future bills. For example, pretend the only two things you pay for are rent and groceries. Rent is $50 and groceries are $25, so your total bills are $75. If you only have $65 because that’s how much you get paid, you have to borrow $10 to pay for groceries this month. But next month your bills have gone up! You now have $50 in rent, $25 for groceries, and $10 + interest for your credit card (so let’s call it $11). Your total bills are $86, but you still only make $65! So now you have to borrow again, but this month you have to borrow $21 instead of $10. This cycle will repeat until you are eventually bankrupt.
  2. As mentioned in the last bullet, you will be charged interest for any money you borrowed that you do not pay back immediately. So not only do your bills go up next month, but they go up even more than you are borrowing. This can be a very viscious cycle and make it very difficult to start saving money.

The other two steps represent much better choices. They also represent the type of planning that we’re trying to achieve! By deciding now to make a change while you still have the money and have not paid for any of these bills, you can make better decisions. Is it more important to you to pay for rent or for concert tickets? Is it more important to get the newest phone or buy the clothes you want? Etc. You get to prioritize where your money goes.

More than cash

Now that you have the basic idea down, we can expand on it a bit:

  • Instead of just counting the cash you have in your pocket, count up all the money you have in each of your bank accounts.
  • Instead of putting all your available cash into a physical envelope, create a “digital envelope” to put your money into. E.g., create a spreadsheet and type “Available” into cell A1, and put the total amount of cash you have in the bank into cell B1.
  • Instead of creating physical envelopes for your bills, just create more “digital envelopes” in your spreadsheet (or whatever software you use). E.g., starting in row three of your spreadsheet, start listing out your bills. You’ll subtract each of these from your available cash to see if you’re going to overspend or save.

Software can make this a lot easier. If you want help getting some practice, check out our free envelope budgeting tool. To use it, type a current balance into the “Current Cash Balance” cell. After you type your current balance in, you can drag the income/expense accounts (i.e., “envelopes”) into the calendar to see your balances change over time. Note that the graph shows your daily cash balance and will update automatically. If you see red bars, it means you are overspending!

Budgeting in Add Rabbit

If you’re really serious about getting started, download Add Rabbit and go to the “Budgeting” section. The first thing you’ll need to do is give the budget a name (anything you want) and then decide what accounts you want to use in this budget. You need to choose which accounts go into the budget because you can create different budgets for different asset or credit card accounts. For example, pretend you had a regular checking account for most spending, but you also had an HSA account for medical expenses. You would want two separate budgets so that you can track the spend in each account separately.

After you create a budget, you can start entering how much you think you’ll need to spend for the various categories (e.g., $25 for eating out, etc.). The report at the top tells you if you’re going to overspend (and if not, how much additional wealth you’ll be creating if you stick to your budget).