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What is Reverse Budgeting and How Can It Help You Save Money?
[Prefer to listen? You can find a podcast version of this article here: E190: What is Reverse Budgeting and How Can It Help You Save Money?]
What feelings come up when you hear the word budget?
Chances are, it’s not positive. Budgeting is a charged term and a difficult process for so many of us.
There is no shortage of apps and tools available to help you maintain a budget and track your cash flow. My favorite one is You Need a Budget (YNAB) but there are plenty of other options, including spreadsheets and other manual methods.
But so often, no matter what fancy tools we use, most of us can find it challenging to stick with it.
It’s common to fizzle out and abandon budgeting at some point, which results in a lack of clarity around spending and cash flow.
Budgeting can be a difficult process for several reasons:
- Lack of Financial Literacy: Many people have not been taught how to create and maintain a budget, and the task can seem daunting without proper education or training.
- Fluctuating Expenses: Some expenses are fixed, such as rent or car payments, but many can fluctuate significantly from month to month. These can include utility bills, groceries, entertainment, and more, making it hard to predict and budget accurately.
- Irregular Income: Those with irregular income, such as freelancers or those in gig work, may find it hard to budget because their income can vary significantly from month to month.
- Impulse Spending: Many people struggle with impulse buying, or making unplanned purchases. This can quickly throw a budget off track.
- Emergencies and Unexpected Expenses: Life can be unpredictable. Emergencies or unexpected costs, such as medical expenses or car repairs, can disrupt a budget.
- Psychological Factors: Some people may have an aversion to dealing with finances or may find it stressful or overwhelming. Others may struggle with self-discipline or delayed gratification, preferring to spend money now rather than saving it for later.
- Prioritizing Expenses: Deciding which expenses are most important can be challenging. For example, should money be allocated to paying off debt, saving for retirement, or investing in personal hobbies? Each individual has unique financial goals and needs, which can make this balancing act difficult.
- Inflation and Price Increases: Over time, the cost of goods and services tends to increase. This can slowly eat away at a budget, requiring adjustments to keep it balanced.
- Long-Term Planning: Many people find it difficult to plan for the future and struggle with saving for long-term goals like retirement, a home purchase, or education.
- Cultural and Social Pressures: Social norms and expectations can exert pressure on individuals to spend beyond their means or neglect savings. For example, the pressure to keep up with friends or peers in terms of lifestyle can be a significant deterrent to sticking to a budget.
- Lack of Time: Proper budgeting requires regular tracking, review, and adjustment. Some people may find it difficult to devote the necessary time to these tasks.
It’s no surprise that traditional budgeting can be overwhelming and ineffective for many of us.
However, there is hope. Like many concepts in personal finance, there is not just one way to budget.
While traditional budgeting (which involves careful tracking of cash flow and spending) can work for some, it does not work for everyone.
This is why reverse budgeting can be a great alternative.
If you're struggling to stick to a budget, reverse budgeting may be the answer. This approach to managing your finances flips traditional budgeting on its head, allowing you to prioritize your savings goals and spend money guilt-free.
What is Reverse Budgeting?
Reverse budgeting is a financial management strategy that focuses on saving first and spending second.
Instead of creating a budget based on your income and expenses, you start by setting aside a certain amount of money for your savings goals. This could include building an emergency fund, saving for a down payment on a house, or investing for retirement.
Once you've saved your target amount, you can spend the rest of your money guilt-free, knowing that you've already met your savings goals.
How does Reverse Budgeting work?
Reverse budgeting, also known as the "pay yourself first" method, is a budgeting strategy where you prioritize saving or investing before taking care of other monthly expenses.
Here's a breakdown of how it works:
- Determine Your Saving Goals: Before you start reverse budgeting, you need to know your saving goals. Are you saving for retirement? A down payment on a house? An emergency fund? Determine how much you need to save and the timeframe in which you need to save it.
- Prioritize Saving: Once you have your saving goals, determine how much of your income you want to put toward them each month. One common rule of thumb is to save or invest between 10% and 20% of your income, but the exact amount will depend on your goals and financial situation.
- Automate Your Savings: To ensure you stick to your saving goals, consider automating the process. Set up automatic transfers from your checking account to your savings or investment account each month.
- Cover Essential Expenses: After you've prioritized your savings, the next step is to cover your essential expenses. This includes rent or mortgage payments, utility bills, groceries, and any other necessary costs.
- Discretionary Spending: After saving and paying for essential expenses, the remaining money can be used for discretionary spending such as entertainment, dining out, shopping, etc.
The concept of reverse budgeting is fundamentally about paying yourself first. It's a strategy to help you prioritize long-term financial goals over short-term wants and needs.
It can be an effective strategy for those who have struggled with traditional budgeting methods, as it simplifies the process by prioritizing savings and fixed expenses over discretionary spending.
Why reverse budgeting works
Reverse budgeting can work well for several reasons:
- Prioritizes Savings: The fundamental principle of reverse budgeting is to "pay yourself first." This approach ensures that savings and investments are prioritized over discretionary spending, which helps individuals meet their financial goals faster.
- Simplicity: Unlike traditional budgeting methods, which require detailed tracking of every expenditure, reverse budgeting focuses on saving a fixed amount first and then allows for more flexibility with the remaining money. This makes it easier to manage and less time-consuming.
- Automatic Savings: In many cases, reverse budgeting involves automating the savings portion. This removes the potential for forgetting or neglecting to transfer funds into savings, which can lead to higher savings rates over time.
- Psychological Benefits: When you pay yourself first, you're telling yourself that your future is important. This positive reinforcement can motivate individuals to continue saving and making wise financial decisions.
- Less Temptation to Overspend: By setting aside savings immediately, you reduce the amount of money available for discretionary spending. This can help control impulsive buying habits or overspending in non-essential areas.
- Promotes Financial Discipline: Because saving becomes a non-negotiable part of your budget, this method inherently promotes financial discipline. Over time, this can lead to better money habits.
- Adaptable to Income Fluctuations: With reverse budgeting, your saving rate can be adapted to changes in your income. If you earn more, you save more, maintaining the priority of savings in your financial life.
Remember, the key to successful reverse budgeting is to make sure your savings goals are realistic and manageable. You still need enough money to cover your necessary expenses and have some left over for discretionary spending.
It's about creating a balance that works for your unique financial situation.
Set savings goals
One of the key components of reverse budgeting is setting specific savings goals. This could be anything from building an emergency fund to saving for a down payment on a house.
By setting clear goals, you'll have a better idea of how much you need to save each month and can adjust your spending accordingly.
It's important to make sure your goals are realistic and achievable, so you don't get discouraged and give up on your budgeting plan.
Remember, even small amounts of savings can add up over time and help you reach your financial goals.
Adjust your spending habits
Once you have set your savings goals, it's time to adjust your spending habits to make sure you can meet them. This may mean cutting back on unnecessary expenses like eating out or buying new clothes, or finding ways to save on essential expenses like groceries and utilities.
One helpful tip is to track your spending for a month or two to see where your money is going and identify areas where you can cut back.
Remember, every dollar you save is a step closer to reaching your financial goals.
Downsides of reverse budgeting
While reverse budgeting has many benefits and can be an effective way to prioritize savings, it also has a few potential downsides:
- Overlooking Detailed Expenses: The simplicity of reverse budgeting can also be a drawback for some people. Because it doesn't require tracking every expense, it's possible to overlook spending habits that could be adjusted for even more savings.
- Lack of Flexibility: With the emphasis on saving a set amount, some people may find that there isn't much flexibility left for unexpected expenses or changes in monthly bills. If the set saving amount is too high, it could cause financial strain.
- Risk of Overspending: While the method can limit overspending by reducing the available funds, it can also potentially encourage it. After setting aside money for savings and covering fixed expenses, some may view the remaining money as free to spend without keeping track, which can lead to overspending.
- Not Suitable for Low-Income Individuals: For those who are living paycheck-to-paycheck or have low income, there might not be much left to save after covering basic necessities. In these cases, other budgeting methods or financial strategies may be more effective.
- Neglecting Debt Repayment: The focus on saving might distract some people from prioritizing debt repayment. High-interest debt should typically be paid off before or alongside saving, as the interest cost could outweigh the benefits of saving.
- Dependence on Regular Income: Reverse budgeting works best for those with a regular, predictable income. For individuals with irregular incomes, such as freelancers, the amount available for savings may fluctuate significantly and make this approach more challenging.
Automation is key
Automation plays a crucial role in implementing reverse budgeting successfully for several reasons:
- Consistency: Automated transfers ensure that you're consistently moving money into your savings or investment accounts each month. This consistency is key to reaching your savings goals.
- Simplicity: By automating your savings, you reduce the number of tasks you need to remember or actions you need to take each month. This simplifies the process and reduces the likelihood of forgetting to make the transfer.
- Behavioral Advantage: Automation takes advantage of human psychology. When savings are transferred automatically, it becomes an "out of sight, out of mind" scenario. You're less likely to miss or want to spend the money if it's moved into your savings account before you have a chance to consider it.
- Reduces Impulse Spending: If you have a tendency towards impulse purchases, automation can help curb this habit. The money is removed from your disposable income before you have the opportunity to spend it, thereby reducing the available funds for impulsive buying.
- Timeliness: Automation ensures that your savings are set aside immediately when your paycheck arrives, reducing the risk of spending the money before you get a chance to save it.
- Adapts to Income Changes: If your income fluctuates, automated savings can adjust with it. Some banking services allow for automatic savings as a percentage of each deposit, meaning you will save more during higher income periods and less during lower ones.
To automate your savings, you can set up automatic transfers with your bank to move a certain amount of money (or percentage of your income) from your checking account to your savings or investment account each time you get paid.
It's a simple way to stick to your savings goals without having to think about it each month.
Is reverse budgeting right for you?
Like any budgeting method, reverse budgeting won't work for everyone. It's important to consider your financial situation, habits, and goals when choosing a budgeting method.
Deciding if reverse budgeting is right for you involves assessing your financial situation, your income stability, your financial goals, and your personal habits and preferences. Here are some factors to consider:
- Income Stability: If you have a stable, predictable income, reverse budgeting might be a good fit for you. This method is more challenging for those with variable or unpredictable incomes.
- Financial Goals: If you have clear long-term financial goals, such as buying a home, retiring early, or building an emergency fund, and you've been struggling to reach these goals, reverse budgeting could help by prioritizing savings.
- Spending Habits: If you're prone to impulsive spending, reverse budgeting might be beneficial, as it "hides" a portion of your income in savings before you have a chance to spend it.
- Current Debt: If you have high-interest debt, it might be more advantageous to focus on paying that off before committing to a savings-focused budget. The interest on such debts can often outweigh the potential gains from saving or investing.
- Personal Preference: Some people prefer detailed budgets that allocate every dollar a job, while others prefer a simpler, more flexible approach. If you fall into the latter category, reverse budgeting might be a good fit.
- Emergency Fund Status: If you don't have an emergency fund, or it's insufficient, reverse budgeting could be an excellent way to build one. Having an emergency fund for unexpected expenses is a fundamental part of financial security.
- Financial Stress: If budgeting stresses you out or if you find it challenging to stick to a traditional budget, reverse budgeting might be a more comfortable approach for you.
- Personality: This is arguably the most significant. If you are detail-oriented and good at sticking to a plan, then traditional budgeting may work well for you. However, if you find it difficult to focus on details and often feel overwhelmed and scattered when it comes to money, reverse budgeting could be a style that works well for your personality.
It's a good idea to try different budgeting methods and see which one suits you best. Personal finance is personal, and what works best for one person might not work for another.
Remember, the goal of budgeting is to help you control your money, not to control your life. It should be a tool that aids you in achieving your financial goals, whatever they may be.