The Hard Limit: How to Stop Budgeting
You don’t need to care about where your spending money goes as long as the important, financially responsible work is happening in the background. Are your bills being paid? Are you saving enough to hit your financial goals? Great! Then you are living within your means and you have nothing to worry about. Spend away.
All you need is a line in the sand so you know when you can spend money and when you can’t. Yes or no. Green or red. Go or stop.
That line is something I call your Hard Limit. No, not in a Fifty Shades kind of way. Well, maybe a little. Think of it as your new financial safe word. The Hard Limit is the line in the sand that separates the money you cannot spend from the money you can spend. The Hard Limit is the answer to the question “Can I afford this?”
What Is a Hard Limit?
Let’s simplify. When it comes to money, there are only four categories to consider: Fixed Expenses, Meaningful Savings, Short-Term Savings and Spending Money. That’s it. Every single dollar you earn gets slotted into one of those categories. The key is to isolate the daily Spending Money from all the other money that has a job.
Fixed Expenses is money you must pay out whether you like it or not, every single month or year. Money set aside for Fixed Expenses has the job of paying your bills and other fixed obligations, things like rent, cellphone, utility bills, etc. It’s definitely not daily Spending Money.
Meaningful Savings is money set aside for increasing your net worth. Meaningful Savings has the job of improving your overall financial well-being—debt repayment, retirement savings, saving up to buy real estate. Also not your daily Spending Money.
Short-Term Savings is money set aside for spikes in your spending. Its job is to keep you out of debt when you need to spend money on Big Purchases, emergencies or travel. It’s not daily Spending Money either.
Spending Money is what’s left over. After you’ve put aside enough money each month or each payday for Fixed Expenses, Meaningful Savings and Short-Term Savings, the money left over is your daily Spending Money. It’s meant to be spent and has no job except to ensure that you’re fed, getting around and having fun. This money is your Hard Limit.
This is how setting up a Hard Limit works to signal what you can and cannot afford: It removes all the money that has a “job,” leaving you with money that you can blow down to zero every month without feeling guilty. If you splurge on groceries you don’t have to worry that the hydro bill won’t get paid; the work is already being done. There’s no need anymore to budget every single dollar you spend, because now you know the difference between the money you can spend on daily life and the money that you need to leave untouched. Respecting that division ensures that you are covering your financial butt.
When one of my clients says “If I know that I’m putting money into the kids’ education savings, I feel less guilty splurging on the loot bags,” I know what that translates into: when you know you are being financially responsible, you don’t have to feel guilty about how you spend your money.
The Hard Limit is awesome. Let’s figure out yours. (I’m actually stoked—nerd alert!)
How to Determine Your Hard Limit
Step 1: Calculate monthly after-tax income
First things first: you need to know what you’re working with each month. It’s crucial that you get this right. You don’t need the gross amount of your paycheque (that’s your annual salary divided by the number of paycheques). What you need to know is how much money actually drops into your bank account(s) every month—the net paycheque.
If you’re an employee, this is fairly simple. Look at your bank statements to see the amount deposited into your bank account. That is your net paycheque.
If you’re paid twice a month, you’ll receive 24 paycheques a year, or two per month. Multiply your net paycheque by 2 to get the monthly amount. For example, if your net paycheque is $1,500, your monthly after-tax income is $3,000 ($1,500 × 2).
There may be some variances in your paycheques. If you max out your Canada Pension Plan (CPP) and Employment Insurance (EI) in the first part of the year, your net paycheque could increase in the latter part of the year. My advice is to use the amount from when your net pay is at its lowest. Build your Hard Limit around that. Then for those last few months of the year, you’ll get “bonus money” each payday that you can use as you wish to top up Savings or top up Spending. As I mentioned above, if you’ve covered your financial butt with your Fixed Expenses, Meaningful Savings and Short-Term Savings, then it’s okay to use this end-of-year windfall as additional Spending Money.
There may be other variances too. For example, if you are paid biweekly, you’ll receive 26 paycheques a year. However, I suggest that you still multiply your net paycheque by 2, using 24 paycheques instead of the 26 to calculate your monthly after-tax income for planning purposes. Why? Because for 10 months of the year you will get only two paycheques per month, and you don’t want to overestimate how much money you’ll have to spend.
For example, my client Dan kept failing at the budgets he set up for himself because of this very problem. He had a net paycheque of $1,250 and was paid biweekly—26 paycheques a year. In order to set his budget, he multiplied 26 × $1,250 and came up with $32,500 a year as his annual after-tax income. Then he divided the $32,500 by 12 months and arrived at a monthly take-home income of $2,708. Great, right? Wrong.
Dan budgeted his life on $2,708 per month like this:
Fixed Expenses |
$1,150 |
Meaningful Savings |
$600 |
Short-Term Savings |
$200 |
Spending Money |
$758 |
But here’s the thing: for 10 months of the year he gets only two paycheques a month, which is only $2,500 ($1,250 × 2) per month. As a result he was $208 short of his expected Spending Money for 10 months of the year. That’s a lot! Dan ended up dipping into Short-Term Savings to cover regular life and so he constantly felt that he was bad with money. For him this became one more failed budgeting attempt—not the way you want to go. Building a budget or financial plan like this will set you up for failure, because you’re planning on having more money than there actually is each month.
Yes, if you’re paid biweekly you’ll receive two additional paycheques annually, but I suggest putting those towards Short-Term Savings (which I deal with in Chapter 7, so hang tight). And you may be wondering what happens if your mortgage payment comes out biweekly; I deal with that in Step 2. For now, just focus on what’s going into your bank account 10 months of the year. Similar issues can arise if you’re paid weekly as well. See the table below for examples.
Here are four ways that you can calculate your monthly after-tax income based on how often you are paid. Assume that the net pay is $1,500 for those paid bimonthly or biweekly, $3,000 for those paid monthly and $750 for those paid weekly.
Pay Frequency |
Net Pay |
Cheques/Month |
Monthly After-Tax Income |
Additional Cheques/Year |
Bimonthly |
$1,500 |
2 |
$3,000 |
0 |
Monthly |
$3,000 |
1 |
$3,000 |
0 |
Biweekly |
$1,500 |
2 |
$3,000 |
$1,500 × 2 |
Weekly |
$750 |
4 |
$3,000 |
$750 × 4 |
If you’re self-employed as a sole proprietor there’s a bit more work involved, because you’re going to have to forecast your income. Think about what you can realistically earn in the next 12 months, after you pay for business expenses and after putting aside sales tax and/or income taxes. For example, if you think your annual revenue or sales will be $60,000 (not including sales tax) and you anticipate $10,000 in business expenses, you will have a taxable income of approximately $50,000 per year ($60,000 – $10,000).
Use an online tax estimator to figure out roughly how much federal and provincial income tax and CPP you’ll need to put aside to pay your tax bill. For example, if the calculator suggests that your estimate of $50,000 in income will land you with an approximate bill of $14,000 for income taxes and CPP, you’re left with $36,000, or $3,000 per month ($36,000/12). Here’s how the calculations look:
Estimated revenue (excluding sales tax) |
$60,000 |
Estimated expenses (excluding sales tax) |
–$10,000 |
Estimated income (before income tax and CPP) |
$50,000 |
Estimated income tax and CPP |
–$14,000 |
Estimated annual after-tax income |
$36,000 |
Months in the year |
÷12 |
Monthly after-tax income |
$3,000 |
Step 2: Add up Fixed Expenses
Fixed Expenses are those that you must pay every month, quarter or year, and they tend not to fluctuate much. They are predictable, which means you can plan to put aside enough money to cover them. Here are some examples of predictable Fixed Expenses:
• mortgage payments or rent
• daycare
• consistent monthly pet walking or boarding fees
• condo fees
• insurance (car, home or renters’)
• consistent transit costs
• car payments
• life and living insurance
• debt or loan repayments
• utilities
• spousal or child support
• consistent gym membership fees
• subscriptions (cable, apps, print media)
• consistent monthly charitable donations
• bank fees
The key is that these are predictable and guaranteed expenses. Anything that fluctuates does not go in this category. Fixed Expenses should be approximately the same each month, regardless of what’s going on in your life. This is why you may see things like a gym membership in Fixed Expenses but not things like groceries, gas, ad hoc transit or parking. Even though these are expenses you likely must pay for every month, their costs fluctuate.
When deciding which expenses are Fixed Expenses, it comes down to the nature of the expense. Predictable versus unpredictable; it has nothing to do with important versus unimportant. One month you may spend $800 on groceries, the next $1,000 because you hosted a party. There’s no way of knowing exactly how much you’ll spend. It’s potentially the same with your transportation costs. I’m not saying that getting to work is optional; I’m saying that the cost each month may vary wildly. Perhaps sometimes you bike or walk and sometimes you drive. Sometimes the price of gas is up and sometimes down. The point is, as with groceries, you may not be able to predict your monthly transportation costs, and that’s why you may not need to include them in Fixed Expenses. This doesn’t mean that they are optional expenses; it simply means that they are not predictable. Fluctuating but necessary expenses like groceries, gas, toiletries and transportation are dealt with in depth in Chapter 9. For now, focus on figuring out your Fixed Expenses according to these criteria—predictable and guaranteed.
Have a look through your bank statements. Make note of which expenses are repeated, predictable and guaranteed. It’s also helpful to check your credit card statements for repeated transactions, especially in an age when many services charge monthly membership or subscription fees.
It can be easy to miss some Fixed Expenses when you’re eyeballing your statements, so be specific when you’re adding them up. Be sure to pay attention to how often the payments come out of your account. For example, if your mortgage comes out biweekly, then there will be 26 payments a year. You need to multiply your mortgage payment by 26, then divide by 12 to get the monthly amount. Don’t simply multiply your payment times 24 (i.e., twice a month for 12 months), as this won’t give you enough money to cover the extra payments that come twice a year, when two months each have an extra week.
Remember to think about annual or quarterly expenses as well. For these, add up the annual cost and divide by 12. If you’re worried because some of your costs, such as the hydro bill, are more in the summer than the winter, they are still considered Fixed Expenses because they are, for the most part, predictable. For bills that may fluctuate a bit based on the season, add up the entire previous year and then divide by 12 to get the average monthly amount you need to squirrel away. This way you’re putting more away than necessary in some months so that you can use it in other months when you need it. You’ll see that the way we handle cash flow for your Fixed Expenses will neatly leave the extra untouched.
Let’s use a simple example. Imagine that these are the transactions from your bank and credit card statements:
Monthly Transactions |
||
Phone |
$60 |
predictable/guaranteed |
Rent |
$1,130 |
predictable/guaranteed |
Grocery store |
$200 |
not predictable |
Clothing store |
$50 |
not predictable |
Gym |
$45 |
predictable/guaranteed |
Grocery store |
$15 |
not predictable |
Car insurance |
$125 |
predictable/guaranteed |
Loan payment |
$10 |
predictable/guaranteed |
Bank fees |
$5 |
predictable/guaranteed |
Gas |
$40 |
not predictable |
Parking |
$10 |
not predictable |
Grocery store |
$25 |
not predictable |
Other Regular Transactions |
||
Gym membership |
$22 biweekly |
predictable/guaranteed |
Renters’ insurance |
$300 yearly |
predictable/guaranteed |
Hydro |
$600 average |
predictable/guaranteed |
So your monthly Fixed Expenses would be:
Rent |
$1,130 |
|
Hydro |
$50 |
($600/12) |
Renters’ insurance |
$25 |
($300/12) |
Phone |
$60 |
|
Car insurance |
$125 |
|
Loan |
$10 |
|
Bank fees |
$5 |
|
Gym |
$45 |
|
Total |
$1,450 |
|
Keep in mind that the items that make up your Fixed Expenses can change over time. You could move, cancel your gym membership or reduce your bank fees. That $1,450 represents the predictable, guaranteed expenses in your life right now that you know you have to pay and aren’t planning to change. That $1,450 per month is already promised to someone else. It cannot be spent on anything else but these expenses.
In my practice I have found that if your Fixed Expenses are higher than 55 percent of your after-tax income, you will likely struggle more to make ends meet. When Fixed Expenses are higher than 55 percent, most of your after-tax income is not yours anymore. When your paycheque hits your bank account, more than half is already spent, promised to someone else. In our example you can see that you would not be overextended. Your Fixed Expenses are only 48.3 percent of your after-tax income of $3,000. Yay!
If you’re worried because you’ve just tallied up your own personal Fixed Expenses and they’ve come out at well over 55 percent, don’t worry. We will look at this kind of situation in more depth later in Part Three. Just breathe. It’s okay, trust me.
Step 3: Identify Meaningful Savings
Meaningful Savings are the savings that will move you forward financially. These are savings that will increase your net worth by reducing debts that you owe, adding to the assets you have, or accomplishing a larger financial goal like paying for your child’s education. Examples include—
• paying down debt (of any kind) above the minimum payment
• saving for retirement
• saving for a down payment
• paying down your mortgage
• saving for your child’s education fund
This is money being put aside to make you financially secure—your nest egg. When you know that you’ve got savings dedicated to improving your financial situation now or in the future, you don’t have to worry anymore, because you know that you’re covered. Ahh, a sigh of relief.
I usually see people budgeting by assessing how much they spend each month on bills and discretionary purchases and then saving what’s left over. But often what’s left over is not enough. It’s important to set your financial savings goals first, letting the goals drive the amount that you’re aiming to save, rather than your bills and spending.
When setting Meaningful Savings goals, ask yourself:
• How much money do I need to save in order to accomplish this goal?
• How many months will it take to achieve it?
Debt Repayment
If you want to put money towards debt—credit cards, lines of credit or your mortgage—start by figuring out how much you owe and how quickly you want to pay it off. Once you’ve set those, it’s best to use a debt-repayment calculator like the one described in the Resource Library (page 303) to calculate how much you need to put away each month. This calculator will help you understand the role that interest pays in your debt-repayment plan. Simply dividing the amount of debt you have by the number of months won’t work.
It’s a two-step process. If you have a $6,500 student loan charging 5.2 percent annually with a $65 minimum payment and you want to pay it off over 5 years (60 months), you input that information into the Debt-Repayment Calculator, which will tell you that $123.26 (let’s call it $125) needs to go towards your loan each month. To figure out how much to put into your Meaningful Savings, first subtract the monthly minimum payment of $65, since that’s a Fixed Expense (Right? You remembered to include it there?) and not Meaningful Savings. In this example, the $125 total loan payment needed, minus the $65 minimum payment, comes to $60 extra. So the Meaningful Savings you’d put towards your student loan debt would be $60 per month. Repeat this for any and all debts that you are looking to pay down.
Major Financial Accomplishments
If you are saving for a major goal like a down payment, home renovation or your kids’ education, after you’ve established the amount you will need, your next step is to figure out your time horizon—how quickly you want to achieve that goal.
For Meaningful Savings goals that have a short time horizon (up to three years), set your savings target by simply dividing the amount you want to save by the number of months to your time horizon. For example, if you want to save $21,600 towards a down payment over the next three years (36 months), you’ll need to save $600 per month ($21,600/36).
Even though you’ll be setting this money aside in a savings account, I would assume a zero rate of return for Meaningful Savings goals that have such a short time horizon. Why? Money that is needed within the next three years should not be invested in the market. Investment returns vary—your savings might go up but they might also go down, and you don’t have time to leave them in the market long enough to even out. The money you are saving for these goals should be in a safe, liquid savings account. Sure, it may earn some compound interest, but that interest is likely to be nominal, so you don’t need to bother including it in your calculations.
If, however, the time horizon for your goal is longer than three years, it may make sense to include interest or investment returns in your calculations. Since the money will be invested for a longer time, you can take on a bit more risk and therefore more potential reward. For example, if you wanted to save $34,000 towards your child’s education over the next 15 years (180 months), it’s likely that you would choose to invest your money. Invested money will hopefully give you an average rate of a return over the long run, which means that you can save less each month but still reach your goal.
For example, without investment returns, in order to reach $34,000 in 15 years you’d need to save $188.88 per month ($34,000/180 months). But if you added in a 4.2 percent net rate of return on your investment—the amount earned on average after fees—you’d only need to save $139.41 each month! That’s a big difference, and one that could make the likelihood of hitting your Meaningful Savings goal much more realistic.
So how do you calculate that on your own? There are savings calculators for exactly this purpose. Just plug in your savings goal amount, the number of years, and your estimated net rate of return (I think 4.5 percent is safe to use if you’re invested in a balanced asset mix over five years), and they’ll help you calculate your monthly payment. Check out the Savings Goal Calculator in the Resource Library (page 305) to see how compound interest and investment returns affect how much you’ll need to save.
Retirement Savings
Goal-oriented savings like paying down debt or saving for a major accomplishment can seem easy enough to estimate, since you know how much you want to save. But a lot of people freeze when it comes to the retirement question, because they aren’t sure how much they should be saving for the long run.
A tried-and-true rule-of-thumb is to ensure that you saved at least 10 percent of your gross income for retirement. Your gross income is your annual salary before deductions; it’s not your take-home pay. For our simplified example, let’s say that you are 35 years old and earn $50,000 per year (gross income). If you wanted to save 10 percent per year, you’d need to save $5,000 each year, which is approximately $416 per month ($5,000/12 months). As your income rose over time with inflation, so would the dollar amount you put in, so if you got a raise to $55,000, you would increase your savings amount to $5,500. Assuming a 5 percent rate of return on $5,500 per year that will increase with inflation at a rate of 2 percent per year, your savings could build to approximately $483,286 in 30 years (use the Long-Term Savings Calculator for detailed calculations; see page 306).
While I believe the 10 percent rule is still a good check-in, it really depends on your age and situation. If you’re between 25 and 35 years old and are starting your retirement savings, putting away 10 percent of your gross income could be a good jumping-off point. For someone older who is just getting started, though, that may not be enough.
Unfortunately I can’t tell you an exact amount you’ll need for retirement. I know that may sound like a bit of a cop-out, but everyone’s situation is different. How much you need to save for retirement depends on so many variables. Things like your lifestyle expectations, government pensions, life expectancy, whether you own your home, and potential inheritances all affect that amount. You may need to save way more than 10 to 20 percent of your gross income, or perhaps a lot less. For instance, if you’ve just inherited $600,000, then perhaps you don’t need to tuck away 20 percent for retirement in each of the next 20 years. Maybe sticking with 10 percent will get you where you need to be. Or, if you want to retire early or travel a lot in retirement, 10 percent at any point in your life may simply not be enough.
Rules-of-Thumb for Minimum Retirement Savings |
|
Age at Which You Are Starting to Save |
Recommended Amount |
25–35 |
10–15% of gross income |
36–45 |
15–20% of gross income |
46 + |
20% or more of gross income |
Maybe you’re thinking, This is impossible. Between the mortgage, bills, car payments and groceries, there’s no way I could put aside 20 percent. Welcome to real life. As I said above, these are only guidelines, rules-of-thumb. Don’t give up or feel frustrated if they don’t feel doable right now in your life. There are other measures down the road that you may be able to take (we will tackle those in Part Three). For now, focus on the ideal solution.
When in doubt, the answer to how much you should save for retirement is simple—as much as you can, even if it falls short of these guidelines. Something is always better than nothing, and a little bit goes a long way.
Step 4: Work out Short-Term Savings
Short-Term Savings are perhaps my favourite type of savings. Having a Short-Term Savings account is the best (and only) way to stay out of debt permanently and truly take control of your cash flow. I have seen it so many times: clients who have solid Short-Term Savings consistently stick to their financial plan, and they worry way less about money than those without Short-Term Savings. I want that for you too.
The money saved to Short-Term Savings is the money that you put aside today in order to pay for things that will spike your spending down the road. This money isn’t actual savings; it is glorified Spending Money. Yes, you’re “saving” money, but it’s earmarked for something that won’t increase your net worth. It’s not going towards debt, a down payment or retirement. Instead, you’re preparing yourself for spikes in spending—the good ones, the bad ones and the ugly ones.
Spikes in your spending aren’t a budgeting problem until they are. Ever felt like you’re on track with your finances, doing okay with your “budget,” and then boom, a huge expense comes out of nowhere and totally throws you off course? Budgeting fail. Maybe the brakes need repairs, a destination wedding invite comes in the mail, summer camp fees are due. It can feel like it never ends.
Over the years I’ve found that these types of spikes in spending are the number one reason why people go off track and feel out of control when it comes to their money. So let’s kick that stress out of your life for good.
Calculating Your Short-Term Savings
There are two types of Short-Term Savings: savings for predictable spikes in spending and emergency savings. Predictable spikes in spending include things like—
• vacations
• kids’ camps
• large purchases (furniture, a new deck, a boat, ATVs, unicorns)
• holiday spending
• wedding season
Emergency savings cover things like—
• home repair and maintenance
• health costs
• car repair and maintenance
• job loss
In order to figure out how much you need or want to put towards your Short-Term Savings, you have to identify the predictable spikes in spending and separate them from the emergency savings. Predictable spikes in spending are relatively easy to forecast. You know they are happening because you’re planning for them or you’ve RSVP’d an invitation. You are able to set limits based on what you want to spend and what you think is reasonable.
For these types of spikes, set the amount that you will need to accomplish the goal and then divide it by the length of time you want to accomplish it in. For example, if you want to spend $2,400 on vacations every year, you’ll need to save $200 per month ($2,400/12 months). If you want to spend $540 on a new mattress in nine months, you’ll have to put aside $60 a month ($540/9). If you know that every May brings Mother’s Day, four family birthdays and your wedding anniversary, which usually cost you $360 over two weekends, put aside $30 a month ($360/12 months).
For our example, let’s say that you are most worried about the holidays, since the money you spend during December usually ends up chilling on your credit card for all of January and most of February. In the past few years you’ve spent an average of $600 during the holidays. Imagine how great it would be if you had $600 sitting in a savings account at the start of the holiday season. You could spend money guilt-free! In order to do this, you’d need to put aside $50 per month ($600/12 months) for a year in advance. If you didn’t think of this until June and had only six months, you’d need to put aside $100 per month ($600/6 months).
The other type of Short-Term Savings is not as predictable or easy to plan for. Your emergency savings account is the key to Worry-Free Money and peaceful nights. You’ll know that you will have enough money available for emergencies without going into debt.
When planning your emergency account, you may need to take four things into consideration, if they apply to you: home repairs, car repairs, health care and job loss. Your home repairs account, if you own your home, does not include renos, furniture or decor. I’m talking termites, leaks, mould and other nasty surprises. If you have a car, your car repairs account is for the repair and maintenance you have to put into your car to keep it on the road. Health care means thinking about how a medical emergency could impact you financially, including treatments not covered by provincial or private insurance plans. This doesn’t mean a massage at the spa that you want to treat yourself to (that would be Spending Money). I’m talking about health-care emergencies. Last, job loss. You should aim to have at least three months’ worth of living expenses saved, or five if you’re self-employed or in an industry where finding a position is difficult if you’re laid off. Your emergency account will likely be big, and it should be. When it comes to car repairs, home repairs and health care, you may have to continually replenish your emergency account if you used the money.
The only way to set a savings target for an emergency account is to work out an average based on your spending history. For car-repair, health-care and home-repair emergencies, the amount you had to spend over the past two or three years can be a good indicator of what’s to come. For example, if you spent about $12,000 over the past three years on home repair and maintenance, $4,000 a year ($12,000/3 years) is a good estimate for annual home-repair emergencies. Some years you may spend only $2,000, and others $5,000.
As for job loss, you need to first figure out how much you need per month to pay for your Fixed Expenses, then add up the amount of money you need for basic life: groceries, necessary transportation and limited spending money. Basically, how much would you need to keep your head above water if you lost your job or had no work? Multiply by three to five months, and that is what you need to set aside as your minimum.
In our example, your monthly Fixed Expenses are $1,450. Let’s say that you need $800 for basic life ($400 for basic groceries, $50 for minimum gas and $350 for realistic daily spending). If you lost your job, you would need a minimum of $2,250 ($1,450 + $800) each month for at least three months, which is $6,750 ($2,250 × 3).
Keep in mind that this amount could potentially be reduced by any money that you’d still be able to collect even in the event of a job loss—things like your partner’s income, government pensions, spousal or child support, or Employment Insurance (if you qualify). For our example, let’s assume that you qualify for $1,450 per month Employment Insurance and that you have been laid off from your job. Your emergency savings for job loss will be reduced from $6,750 to $2,400 because the $2,250 per month you need will be reduced by $1,450 in Employment Insurance, and therefore you only need to cover $800 each month. If you are planning on coverage for three months, this amounts to $2,400 ($800 × 3 months). To build up your savings towards job loss over a year and have $2,400 in your emergency account, you need to put aside $200 per month ($2,400/12 months). It’s important to note that Employment Insurance can take several weeks to kick in and that not everyone qualifies. Be sure to find out!
In our example, your Short-Term Savings would be $250 per month: $50 per month for holidays and other predictable spikes and $200 per month for emergencies. Preparing a Short-Term Savings account is critical to feeling that you are in control of your finances. It’s how you avoid those moments when the budget falls apart. Consciously putting aside money that is earmarked for spikes in spending and emergencies is important so that you know the difference between money you can spend today and money that you will spend later, furthering your control over your cash flow.
Step 5: Calculate your Spending Money Hard Limit
You’re so close. Here’s the final step. Add up your Fixed Expenses, Meaningful Savings and Short-Term Savings and deduct them from your monthly after-tax income. Everything left over is your Spending Money—your Hard Limit.
In our example, $2,116 is money you cannot spend (Fixed Expenses of $1,450 + Meaningful Savings of $416 + Short-Term Savings of $250). Therefore, $884 is money you can spend, your Spending Money. This is the only “budget” you ever need, the line in the sand between money you can spend (Spending Money) and money you cannot spend (Fixed Expenses, Meaningful Savings and Short-Term Savings).
As long as you are paying your bills and putting aside money for savings, who cares whether the rest of your money is spent on takeout or grooming or contact lens solution? Your life will change unpredictably from month to month, just like everyone else’s. As long as the money you spend stays within your Hard Limit, it doesn’t matter if it’s budgeted, tracked or forecasted.
Your numbers will fluctuate over time to make room for new bills, additional savings goals and perhaps raises, but the concept remains the same. Every year you should check in with your Hard Limit to account for rising costs of living, raises in your pay and changes to your savings targets. Go through the process you’ve just finished. Check all the numbers and add in any new costs, removing any that don’t belong anymore.
By spending money only within your Hard Limit, you stop the cycle of guilt and fear that keeps you worrying about money all the time. If you were worried that you’re not saving enough, the fact that you’ve siphoned off enough money from each pay period to cover all your bills and savings, as well as money towards future spikes in spending, you can relax, knowing everything is covered. There is enough! Phew!
Your Hard Limit is your financial “safe word.” It’s money you know you can safely afford to spend each pay period without fear, allowing you to live your life guilt-free because you’ve covered your butt financially, giving you peace of mind.
I know calculating your Hard Limit requires some work upfront, but establishing it is one of the most important things you can do for your finances. It’s the very first step in getting control over your money so you can stop budgeting and start living without fear for the future. It’s so worth it—I promise!
Let me show you an example of how much it helped my client Jesse. His is a relatively simple example. We will examine a more complex case in Chapter 8, but Jesse’s story is a great place to start.
Meet Jesse
Jesse Age: 30 Relationship status: single (but looking, in case you know anyone) Kids: 0 Annual gross household income: $55,000 Assets: $3,000 in emergency account Liabilities: $6,500 in student debt |
The first time I met Jesse, he was frustrated about his finances. “I never know if I can afford something or not. I mean, I make a living and I don’t have a ton of expenses, but some months I’m taking on debt and others I feel like I’m okay. It’s feast or famine and I’m always second-guessing myself. Can I afford to go away with my friends on a trip or not? And sometimes I use my credit card because I’m afraid my debit card will come up ‘insufficient funds.’ I’m 30 years old and I feel broke. I don’t want to live like this anymore.”
Jesse’s problems were twofold. He didn’t know what he could and couldn’t afford, and he felt as if his cash flow was all over the place, feast or famine. No control. No strategy. A perfect example of the Spending Vortex. In order to solve his first problem, we calculated his Hard Limit.
Step 1: Calculate monthly after-tax income
Since Jesse’s paycheque amounted to $1,875 twice a month (not biweekly), he received 24 paycheques a year. His monthly after-tax income was $3,750 ($1,875 × 2).
Step 2: Add up Fixed Expenses
We went through Jesse’s bank accounts and credit card statements looking for the repetitive, predictable and guaranteed Fixed Expenses each month.
Jesse paid $1,500 annually for car insurance, so we divided that amount by 12. “You’ll want to put aside $125 each month so that in March you’ll have $1,500 ready to go. That way it won’t feel like a surprise,” I told him. We added up his other Fixed Expenses:
“Okay,” I said, “you have to put aside $1,650 each month or else you can’t pay your bills.”
“Is that bad or good?” Jesse asked.
Jesse made $3,750 after tax and had $1,650 in Fixed Expenses.
FIXED EXPENSES: Money You Cannot Spend |
|
Rent |
$1,000 |
Phone |
$100 |
Subscription |
$10 |
Student loan minimum payment |
$65 |
Car payment |
$350 |
Car insurance ($1,500/year) |
$125 |
Total |
$1,650 |
We divided his Fixed Expenses by his after-tax income and found that 44 percent of his after-tax income was going towards Fixed Expenses each month, which is less than 55 percent, the affordability cut-off. “You’re living within your means as far as Fixed Expenses go, so that’s a win!” I told him.
Step 3: Identify Meaningful Savings
“This is the fun part,” I said. “What are you saving for?”
“I’d like to pay off my student loan by the time I’m 35,” he said. “And I’d like to start saving $6,000 a year for retirement.”
Jesse had a $6,500 government student loan that charged 5.2 percent interest. In order to pay this off in five years, he would need to put approximately $125 per month towards his debt for the next 60 months (5 years × 12 months). Since he was already making a $65 minimum payment, an additional $60 per month was needed ($125 – $65). To calculate this, we used the Debt-Repayment Calculator in the Resource Library section (page 303).
Since Jesse earned a salary of $55,000, saving $6,000 per year towards retirement was more than the 10 percent minimum of his gross income that I would suggest. In fact it was 10.9 percent—way to go, Jesse! To hit this Meaningful Savings target, Jesse had to save $500 per month ($6,000/12 months). Therefore, Jesse’s total Meaningful Savings were $560 per month: a combination of the $60 extra that he would put towards his student loan and the $500 to retirement savings.
MEANINGFUL SAVINGS: Money You Cannot Spend |
|
Retirement savings |
$500 |
Extra money towards student debt |
$60 |
Total |
$560 |
Step 4: Work out Short-Term Savings
One of Jesse’s problems was that he had feast-or-famine months when unexpected spikes in spending would happen. He had an emergency account with $3,000 in it that was earmarked for job-loss emergencies, but he didn’t want to dip into that for things like holiday spending.
Jesse typically spent around $480 annually for his car repairs and he figured it would be about the same for the upcoming year. We calculated that he needed to keep saving $40 per month ($480/12 months) towards his emergency savings for car repair. In addition, since he anticipated spending $300 on gifts in the next 12 months, he also needed to put aside $25 per month ($300/12 months) for predictable spikes.
All in, Jesse needed to put aside $65 per month towards Short-Term Savings so he would never again be blindsided by a large purchase.
Car repairs ($480/year) |
$40 |
Gifts ($300/year) |
$25 |
Total |
$65 |
Step 5: Calculate the Spending Money Hard Limit
“So, Jesse, $3,750 comes into your bank account each month: $1,650 for Fixed Expenses, $560 for debt repayment and retirement savings and $65 for Short-Term Savings. That leaves you with $1,475 each month in Spending Money!”
Monthly after-tax income |
$3,750 |
FIXED EXPENSES: Money You Cannot Spend |
|
Rent |
$1,000 |
Phone |
$100 |
Subscriptions |
$10 |
Student loan minimum payment |
$65 |
Car payment |
$350 |
Car insurance |
$125 |
Total |
$1,650 |
MEANINGFUL SAVINGS: Money You Cannot Spend |
|
Retirement savings |
$500 |
Student loan above-minimum payment |
$60 |
Total |
$560 |
SHORT-TERM SAVINGS: Money You Cannot Spend |
|
Car repairs ($480/year) |
$40 |
Gifts ($300/year) |
$25 |
Total |
$65 |
SPENDING MONEY: Hard Limit |
$1,475 |
“So out of all my money, I can really only spend $1,475 of it each month?”
“Yup,” I said. “But I don’t care how you spend it. Spend it on whatever you like. As long as you’re fed, getting around and having fun, you’ll be fine. There’s no need to budget.”
“Awesome! I never thought about not budgeting my spending money, but this is great. As long as I don’t spend more than $1,475 each month, I’m safe to spend my money, so why bother categorizing?”
He paused, then asked me one of the best questions ever. “So when I get paid, how do I know what is Spending Money and what is not? Do I have to take out this $1,475 in cash or something?”
“Hell, no,” I said. “You need a strategic banking plan.”