The key to building wealth over the long term is a combination of the following three steps:
- Increase your income
- Decease your expenses, and
- Invest regularly
Before pursuing any investment opportunity you will need to know how much you can afford to contribute. The easiest way to identify your savings capacity is to establish a budget.
A budget is simply an estimate of your cash flow (income and expenses) over a set period of time.
Cash flow can be positive, negative, or neutral:
Positive — indicates that income is greater than expenditure
Negative — implies that expenditure is greater than income
Neutral — expenditure is equal to income.
It is only through achieving positive cash flow that savings capacity can occur.
Budgets are perceived to be complicated or time consuming but this does not have to be the case. Below are a few tips to help you get started.
Frame your budget
When starting to formulate your budget it’s best to look at an individual 12 month period. Preferably a full financial year, i.e. 1 July to 30 June.
List income and expenses in a frequency that is practical
Although you will need an annual snapshot of income and expenses it’s not an ideal timeframe to work with week to week. You may find it easier to manage your budget week by week if your annual cash flows are also listed in the frequency in which you get paid.
For example if your annual vehicle registration is $612 per year then you will be required to put aside $51 per month ($612/12) from your pay to cover this cost before it falls due.
Separate Income and Expenses into Categories
Ultimately your cash flows will fall into one of three main categories:
This represents funds paid to you (i.e. salary less tax*, interest, dividends, rent received)
*if you are receiving salary from an employer, tax is automatically debited from your pay. If you are self-employed or have a complicated tax return you may have to adjust your budget to cover forecast income tax liabilities.
Are living expenses you must incur on a regular basis (i.e. home loan repayments, utilities, insurances, groceries, healthcare, professional memberships)
Discretionary expenses (i.e. entertainment, leisure activities, gifts, travel, alcohol, fashion)
This represents non-essential or lifestyle expenses that you choose to incur.
Set a limit to your discretionary expenses
The majority of your income and fixed expenses can be easily identified via bank statements and past bills however discretionary (non-essential) expenses are much harder to track and will vary based on how social you are or how much you like to spend on lifestyle expenses.
As this figure is difficult to forecast, try setting yourself a limit instead. For example; if your income after tax is $100,000 per year, fixed expenses are forecast to be $60,000 and plan to save $25,000 then limit your discretionary expenses to $15,000 per year. If your discretionary expenses exceed $15,000 then you will be eating into your savings goal.
Use technology were possible
Unless you are using cash to pay for everything, a trail of fixed and discretionary expenses will be tracked by your credit and debit cards. Use EFTPOS facilities where possible and limit cash withdrawals as there will be no record of where these funds are spent!
A number of the large banks provide their customers with online budgeting tools that source data straight from your accounts. There are a large number of apps also available to track expenses. Investigate these options and if they suit your needs, utilise them first. Otherwise I have found downloading your account data and using a spreadsheet will provide you with all the flexibility you need.
Summarise your findings
Once you have forecast income and expenses using the above mentioned categories you can now use this information to:
- Estimate how much you are spending per pay & per year (total expenses by category)
- Estimate how much you will most likely save per pay & per year (income less total expenses)
- Estimate how long it will take to save to meet your goals (savings capacity per pay & per year)
- Control your discretionary expenses by knowing how much you can allocate towards them per pay & per year
Glenn & Maggie require a $70,000 deposit to purchase an investment property.
Glenn & Maggie’s combined income per year is $120,000 (after tax) and they have fixed expenses of $50,000. They have decided to set a limit of $30,000 for discretionary expenses. This results in a savings capacity of $40,000 per year and therefore it would take them approximately 1 year and 9 months to achieve their goal.
Maintain your budget and monitor your progress
Once you have established a working budget, the majority of the hard work is done. All that is left to do is to update income/expenses and check your progress along the way.
For example, if after 6 months Glenn and Maggie found that they had only been able to save $10,000 (instead of a projected $20,000) then they would need to revisit their budget and identify what additional expenses have impacted their savings capacity.
As you can see, a working budget can provide critical information that will help you take the first step towards building wealth over the long term.
Remember, a sound budget will ensure you have enough money for the things you need so you can save for the things you want.
Should you require further information on the benefits of budgeting or wish to discuss long term wealth building strategies please don’t hesitate to contact a qualified financial advisor.
About the author:
Aaron has recently become a father of one and is a Financial Advisor at William Buck. He’s good listener and eager to help clients achieve peace of mind no matter what their financial circumstances are or stage of life. Aaron enjoys travelling and digital photography.