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An Overview of Flow-based Budgeting
[Prefer to listen? You can find a podcast version of this article here: E199: An Overview of Flow-based Budgeting]
Budgeting is both incredibly important and extremely difficult.
It's no secret that I love budgeting. As a YNAB Certified Budget Coach, I'm pretty bought into a method of budgeting that involves tracking every dollar and following a very detailed structure. It speaks to my nerdy brain very well.
But not everyone loves this type of budgeting. Luckily there are budgeting alternatives for people who don't like to budget. Some of these can be used with varying levels of success.
However, I recently had an opportunity to learn about a method of budgeting that I found extremely practical and useful. It's called flow-based budgeting.
Natalie's presentation was stellar and it really demonstrated a budgeting system that could be a great fit for many people, especially those who struggle with traditional budgeting.
What is flow-based budgeting?
Flow-based budgeting is a method of managing cash flow that uses a simple operational account structure to maintain the "guardrails" necessary to manage money. It's a response to the common issue most people have with budgeting, which is that they avoid it.
Budgeting usually involves tracking spending and getting very detailed with the numbers. This can be difficult for many people to keep up due to a number of reasons:
- Time: Many people simply don't have time (or aren't willing to make the time) to keep up with a detailed budget. For this reason, apps like YNAB etc. don't always work since they require focus and attention.
- Avoidance: We all have Money Scripts that affect how we relate to money. The "Money Avoidance" script can cause some people to shut down when they get too detailed with budgeting.
Flow-based budgeting is an alternative take on budgeting that uses an operational account structure to implement guardrails, rather than strict accounting.
How it works
Let's get into the nuts and bolts of how flow-based budgeting works.
The "bones" of this budgeting system involve using three bank accounts: fixed, flex, and non-monthly. The system can also be used with credit cards but we will start with using bank accounts as an example and then discuss how it's used with credit cards.
The accounts are used as follows:
This account is for any expenses (or investments/savings) that are predictable and regular. This can include mortgage/rent, internet, streaming services, phone bills, insurance premiums, etc.
It also includes things like Roth IRA contributions, transfers into investment accounts, savings goals, and other fixed transfers. The important thing is not the type of expense or transfer, the key is that it's fixed and predictable.
Anything that is the same (or almost the same) every month is paid from this bank account.
And more importantly, everything coming out of this account is set up for auto-transfer. There should be no manual intervention required for every transfer to happen automatically. The mortgage is on auto-pay. If you rent, then your online banking is set up to auto-pay the rent. Your internet, phone, and insurance premiums are all on auto-pay. If you can get your utilities on fixed billing and set up on auto-pay this is also good.
All your household income gets deposited into this account. So paychecks, owners draw from businesses, everything. If it's income, it gets deposited into the fixed account.
Once this is set up, Natalies refers to it as a "carousel" that is running on its own. Since income gets auto-deposited into this account and all expenses and transfers automatically come out, it's self-maintaining and should require little to no oversight. It's a "passive" account.
As part of the automated transfers, you will also need to set up regular weekly transfers into your "flex" account. Which is...
The second bank account is called the "flex" account. This is for things that are variable. This can include things like groceries, eating out, entertainment, household supplies, and anything else that is unpredictable and irregular.
This account is monitored and is an account used for "active" spending. So how much can you spend from this account?
The flex account uses a weekly feedback loop. You first need to get a weekly spending number that is your target for flex spending. You will calculate this by taking your household income, subtracting the fixed expenses, and then using the number you get to determine your weekly spending number.
For example, let's say your household income is $100,000 per year. After taxes, 401(k) contributions, and other withholdings, let's say you bring home $75,000 net (we're just using round, made-up numbers).
Using this number, we divide by 12 to get a total monthly net of $6,250. Next, we determine that mortgage, insurance premiums, internet, and other fixed expenses come to $3,100 per month. This is your fixed account number. So $3,100 worth of expenses needs to be set up on auto-pilot to come out of your fixed account.
Now we need to get a flex number for spending. Since we will be using a weekly feedback loop (more on that shortly), we need to get a weekly amount to allocate to this account. Since the number of weeks in a month can sometimes vary, we will calculate it by first multiplying our monthly fixed number by 12 to get the value annually. In this case, $3,100 * 12 = $37,200. Then we subtract it from our total net income to get the flex amount as an annual number: $75,000 - $37,200 = $37,800.
Note: in this example, fixed expenses are around 50% of the budget. This is pretty common if you are looking for some rules of thumb as a reference.
Now to get a weekly spend, we divide the annual flex number by 52 weeks in a year: $37,800 / 52 = $726. In order to be more conservative and to make it easier with round numbers, we want to round down to $700.
Now we know that our weekly flex goal is to spend no more than $700 per week. Your fixed account will have an auto-transfer set up to send $700 each week into your flex account and this is what you have for spending.
To monitor it, you will simply look at your bank balance each day and see where you are. You will spend from the debit card attached to your flex account and pace yourself throughout the week.
If you're single, it's pretty straightforward. If you are married or in a committed relationship in which finances are combined, you and your spouse or partner will both spend from the same account and monitor (and communicate) throughout the week.
It's also important to know that the week begins on Saturday for the purpose of this system. This is because we tend to spend more on the weekends and so it helps to avoid getting to the weekend and having no money left (which is a bummer).
The weekly feedback helps maintain focus because you have a frequent feedback loop and a shorter (and more manageable) period of time to stay on pace before it resets again.
The flex account is funded from your fixed account. Every week, a transfer automatically moves the money from fixed to flex to fund your flex account for the week (we will get to credit cards soon, I promise).
The third account you need is a non-monthly account. This is for infrequent, irregular things like vacations, major auto maintenance, larger purchases, and of course your emergency fund.
This account should eventually (or sooner) have a pretty large balance. You want to get enough in there to have an emergency fund and then beyond that you will use it for larger purchases that don't fix into fixed or flex.
The logistics of how to get this account funded will vary. If you already have enough cash in this account, then you can go on auto-pilot and set up a regular deposit from your fixed account (which is then counted as a fixed expense).
If you are starting from zero or it's not well-funded yet, you may want to find some other ways to kick-start it (sell some stuff, dramatically cut spending for a few months, etc.). Either way, you will start an auto-transfer into this account from your fixed account so it continues to get replenished.
Now you can use the non-monthly account to make decisions on how to allocate money for irregular purchases. It can help you decide when to take vacations, when to buy a new car, and how to pace your spending on other major items.
What about credit cards?
As promised, let's talk about credit cards. This system works just as beautifully with credit cards. The system is set up exactly the same way, only instead of using a debit card for flex spending, you use a credit card. And instead of monitoring your bank balance to keep it above zero, you monitor your credit card balance to keep it from going above your weekly spending limit (in our previous example, $700).
Then, you set up your card to auto-pay the balance every Friday from your flex account. Yes, you really can pay off your credit card weekly (it may even help your credit score).
You can even go a step further and eliminate the flex account altogether and instead have your credit card bill auto-paid from your fixed account. This is effectively the same thing and with fewer moving parts so this may be more appealing.
Remember that the card gets paid off every Friday and your week resets every Saturday.
It's also important to remember that if you are in a household with combined finances, both of you need to use the same credit card account. You will spend on your own cards but they are attached to the same credit card account so you can stay in sync and monitor your balance.
Using the system in real life
You may have some questions at this point. And Natalie had some great feedback on some of the concerns brought up about this system.
One question was related to the perceived "inaccuracy" of the system. If you're not tracking every dollar, how can you trust the numbers? Natalie explained that it is not necessary to be exact. This is a "flow", not a spreadsheet. There is room for course correction so that the system can stay on track.
For example, what if you overspend one week? The solution is to under-spend the following week to get back to the right flow. It's ok to self-correct.
Flow-based budgeting can be a great option for many folks who have struggled with budgeting in the past because focuses on the level of in-the-moment influence that you have over spending. It works the way our brains work, by managing what is immediate and tangible right in front of us. It’s like reverse budgeting with a feedback loop.
After learning about Natalie's system, I was blown away by its elegant simplicity. It also helped me hate credit cards a little bit less since the cards are paid off weekly, although I still have concerns about the psychological effects of credit cards on spending.
So if you have struggled with budgeting in the past and you are looking for something that "goes with the flow" a bit more, flow-based budgeting system may be the method you've been looking for.