MONEY MANAGEMENT STRATEGIES AND SKILLSmyresource.phoenix.edu › ... › FP101R5 ›...

Starting Point

Go to www.wiley.com/college/bajtelsmit to assess your knowledge of moneymanagement strategies and skills.Determine where you need to concentrate your effort.

What You’ll Learn in This Chapter▲ Document organization, storage, and safekeeping▲ How to use personal balance sheets▲ How to calculate personal financial ratios▲ How to create a budget and track spending▲ How money psychology impacts household financial decisions

After Studying This Chapter, You’ll Be Able To▲ Develop a system for organizing and maintaining your financial records▲ Calculate your net worth by using a personal balance sheet▲ Summarize your current inflows and outflows of cash by using a personal

cash flow statement▲ Use personal financial ratios to evaluate your current financial position▲ Develop and implement a household budget▲ Calculate your budget variance and develop a plan for meeting expenses

2MONEY MANAGEMENTSTRATEGIES AND SKILLSPutting Your Financial House in Order

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Copyright © 2012 John Wiley & Sons, Inc.

104 MONEY MANAGEMENT STRATEGIES AND SKILLS

INTRODUCTIONThe skills taught in this chapter provide the foundation for successful moneymanagement. You’ll learn to organize and maintain your financial records andhow to use personal financial statements to see how you’re doing financially.You’ll also learn how to calculate the financial ratios that determine your creditworthiness and how much you are saving. These tools will help you on yourroad to financial success.

2.1 Collecting and Organizing Your Financial Information

Although some people love to file and organize, most people do not. The olderyou get, the more stuff you accumulate, and it doesn’t take long for a small pileof paperwork to grow to fill several file cabinets. The earlier you develop a sys-tem for organizing your financial records, the easier it is to maintain order asyour life becomes more complex. The Personal Financial Planner that can befound in the Appendix and online includes a worksheet to help you get startedorganizing your records.

2.1.1 Why You Need to Save Bills and Documents

The first rule of organization is that there should be a particular purpose foreverything you save and file. Although this list is not exhaustive, some possiblereasons for keeping particular documents are

▲ Paying bills.▲ Tracking your budget.▲ Preparing for tax reports.▲ Making investment decisions.▲ Making insurance or warranty claims.▲ Ensuring prompt access to essential records.

2.1.2 How Long You Should Save Documents

Of course, you need not keep all your documents forever. How long you shouldsave each item depends on what you will use it for. Documents necessary forbill paying and budgeting have only short-term usefulness. Thus you need tosave receipts for ATM withdrawals and deposits and for cash or credit purchasesonly until you receive a statement verifying that your account was correctlycharged. You should keep bills for utilities, car expenses, and other irregularexpenses that are not tax deductible for a full year so that you can accuratelyreport the costs in your budget and personal cash flow statements.

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2.1 COLLECTING AND ORGANIZING YOUR FINANCIAL INFORMATION 105

You should file any documents that support tax deductions with your taxrecords. Although most Internal Revenue Service (IRS) audits occur within threeyears of the filing of a return, they can also occur later, so it’s generally recom-mended that you keep tax records for seven years to be safe. The IRS audits about1 out of every 174 returns, and most audits occur in the first year following filing. Audits in later years are usually the result of irregularities discovered inauditing earlier returns.

2.1.3 Where You Should Keep Documents

You can keep your personal financial documents anywhere, as long as you caneasily access them when necessary. A system of file folders kept in a file cabinetor box is effective for most people. Although computer filing is also a possibility,most bills still exist on paper, so even if you can use your computer for somefiling purposes, you still need to store paper copies as well.

You should keep important personal documents and valuables, particularlythose that are difficult to replace—passports, birth and marriage certificates,Social Security cards, stock certificates, wills, and deeds—in a safe deposit boxor fireproof lockbox. A safe deposit box is a secure private storage area (usuallya small locking drawer) maintained at a remote location, often at a financial insti-tution’s place of business. A lockbox, which is a fireproof keyed safe that youkeep in your home, is not as secure as a safe deposit box because it’s usuallymovable, and any thieves that break into your house are likely to look for itright away. The primary purpose of a lockbox is to prevent loss or damage tothe documents in the event of a fire.

If you use your home computer for managing your finances, you shouldbe sure to regularly back up the information on a disk and store that diskin a separate location, such as a friend’s house, your place of employment,or a safe deposit box. You need to ensure that your electronic records willbe safe in the event of theft, fire, electrical outage, or water damage. The bestway to do this is to back up your records immediately whenever you makeany major changes to the files, such as when you pay bills or revise yourbudget.

1. Explain the difference between a lockbox and a safe deposit box.

2. List the types of information you should store.

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2.2 Using Personal Financial Statements

After you’ve collected and organized your financial information, you can use itto begin evaluating your financial condition. Personal financial statementssummarize your financial information in a way that makes it easy to see whereyou stand and to plan for where you want to be in the future. Just as compa-nies make regular reports on their financial status to their shareholders, youshould make a financial report to yourself.

Others might request the information contained in your personal finan-cial statements (e.g., financial companies considering your application for aloan, organizations evaluating your qualifications for a scholarship, financialadvisors helping you with your personal financial plan). In this section, you’lllearn how to develop a personal balance sheet to estimate your financial networth and a personal cash flow statement to evaluate your cash inflows andoutflows.

2.2.1 Preparing a Personal Balance Sheet

How much are you worth today? In other words, how wealthy are you? Thiscalculation is a good starting point for financial planning. A personal balancesheet is a financial statement that details the value of everything you own andsubtracts what you owe to others to arrive at your net worth, or the amount ofwealth you would have left after paying all your outstanding debts. A personalbalance sheet shows your assets and debts:

▲ Assets are the things you own. Assets include liquid assets (such ascash), personal property, real estate, and investments.

▲ Debts, or liabilities, are the amounts you owe. Debts include both short-term obligations, such as unpaid bills and credit card debt, andlong-term debts, such as student loans, car loans, and home mortgages.

To prepare a personal balance sheet, you start by making a list of everythingyou own, beginning with the most liquid assets—cash and near-cash assets thatcan easily be converted to cash without loss of value—and ending with the leastliquid. Checking and savings accounts are examples of liquid assets; your auto-mobile and home are not liquid because it would take time to sell them, andyou would incur transaction costs such as advertising fees and commissions. Ifyou needed cash in a hurry, you would probably also have to discount the priceto make a quick sale.

The next step in constructing your personal balance sheet is to make a listof your debts. As with your assets, you start with short-term debts, such as cur-rently unpaid bills, and end with long-term debts, such as your student loansand home mortgage.

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2.2 USING PERSONAL FINANCIAL STATEMENTS 107

FOR EXAMPLE

A Personal Balance SheetDanelle, a senior at a large university in the Midwest, is graduating with abiology major. She says, “I’m also getting a teaching certificate so that I canbe a high school biology teacher. My parents helped out with my first twoyears, but now I’m supporting myself with a part-time job, financial aid, andstudent loans. Although I think I’m in pretty good financial shape, I knowI need to get better organized. My biggest problem is that I’m so busy—with my schoolwork and job responsibilities, it’s sometimes hard to evenfind the time to pay my bills. To be totally honest, I also have a tendencyto avoid financial matters because I’ve never particularly liked math. One ofmy financial downfalls is that I love to shop for clothes and can’t resist agood sale. So my credit card balances have increased. I’m a little nervousabout how I’ll be able to pay them off, especially since I’ll have to start pay-ing my student loan once I graduate.”

This section walks through how to create a balance sheet that itemizesDanelle’s assets and debts, as shown in Figure 2-1. You can create your ownpersonal balance sheet by using the worksheet provided in the PersonalFinancial Planner.

2.2.2 Valuing Your Assets and Debts

How do you go about assigning a dollar value to each asset and debt? Your mostrecent bank statements give you the value of your checking and savings accounts.For other assets, you can try to estimate the market value, or the price youcould sell them for today.

The market value is not the same as what you paid for an asset. For example,if you just bought a new car, you won’t be able to sell it now for what you paidfor it. Similarly, the market value of your stereo system is much lower than whatyou paid for the system, even if it’s practically new. In contrast, you might ownsome assets that have much higher market values than what you paid for them.A first-edition comic book that you paid $1 for 10 years ago may be worth $100today. Also, normally, real estate increases in value over time, so your home prob-ably has a higher market value now than when you purchased it.

For some of your assets, such as your car, there may be a correspondingdebt. If you have outstanding debt on your car, you enter the market value ofyour vehicle on the asset side of your balance sheet and the loan balance on thedebt side. Notice that Danelle has entered $5,000 as the value of her car and$3,000 as the remaining balance on her car loan. If you lease a car, your pay-ment obligations are a debt, but you don’t own the car, so you shouldn’t include

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Figure 2-1

Danelle Washington’s personal balance sheet.

Danelle Washington’s Personal Balance Sheet, December 31, 2004

Assets

Checking accounts $ 500Savings accounts 1,000Money market accountsCash value of life insurance

Total Liquid Assets $ 1,500

Home furnishings 1,200Jewelry/art collectibles 500Clothing/personal assets 3,000Market value of automobiles 5,000

Total Personal Property $ 9,700

Market value of investments(stocks, bonds, mutual funds)

Employer-sponsored retirement planIndividual Retirement Accounts (IRAs)Other retirement savingsCollege savings planOther savings or investments

Total Investment Assets

Market value of homeMarket value of investment real estate

Total Real Property

TOTAL ASSETS $11,200

Debts

Rent or mortgage payment $ 500Utillities and other bills 130Credit card minimum payments 150

Total Current Bills $ 780

Credit card balances1. Master Card 4,2002. JCPenney 1,000

Personal LoansCar loans 3,000Alimony/child support owedTaxes owed (above withholding)

Total Short-Term Debts $ 8,200

Student loans 18,000Home mortgage balanceHome equity loanOther real estate loansOther investment loans and liabilities

Total Long-Term Debt $ 18,000

TOTAL DEBTS $ 26,980

Net Worth � Assets � Debts �$15,780

List the values of your liquidassets (Chapter 5), householdgoods, and automobiles(Chapter 8).

List the market value ofassets, investments, and realproperty (Chapters 8, 11–15).

List your short-term and long-term debts (Chapter 6–8).

Calculate your net worth bysubtracting total debts fromtotal assets.

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it as an asset. You can estimate the market value of your car by using a currentautomotive blue book, available in book form at most bookstores and librariesor online (e.g., www.edmunds.com). In some cases, your car’s value may actuallybe less than what you still owe in car payments.

Although real property, including homes and other real estate, is not veryliquid, it may be your largest investment. Real estate values are determined bythe values of comparable properties in the area, so if you just enter what youpaid for a property on your balance sheet, you will be understating your actualwealth. If you don’t know of a recent sale of a similar property, you can con-sult a real estate professional to help determine the value of your home orother real estate investment. In general, real estate values increase over time,so you need to update this information regularly. Because Danelle is rentingan apartment with some friends from school, she doesn’t own any assets inthis category.

An insurance policy is counted as an asset only if it’s a policy that accumu-lates cash value over time. If you cancel an insurance policy that has a cash sur-render value, the insurer returns that amount of money to you. Because this isan available source of cash, you should count it as an asset. Homeowner’s, auto,and health insurance (discussed in Chapters 8 and 9) don’t accumulate cashvalue, but some types of disability and life insurance policies (discussed in Chapters 9 and 10, respectively) may have cash value. This value is determinedby the contract terms and is generally much smaller than the face value of thepolicy. In some cases, insurance policies also allow you to borrow against thecash value. If you have borrowed from one or more of your policies, you need toinclude the amount owed as a debt on your personal balance sheet. Danelledoesn’t have any cash value insurance.

2.2.3 Calculating Your Net Worth

After you enter all the required information on your personal balance sheet, youcan calculate your net worth by using the following equation:

Net worth � Total assets � Total debts

Notice in Figure 2-1 that Danelle’s net worth is negative $15,780. What doesthis mean? If Danelle sold all her assets and used the money to repay her debts,she would still owe $15,780. In contrast, if your net worth is positive, it repre-sents how much you would have left over after paying everything. Your networth is thus a measure of your wealth.

There is no “magic number” that represents the ideal amount of net worthbecause it depends on an individual’s life cycle stage and personal goals. How-ever, in general, the larger your net worth, the better off you are financially.

What if you have negative net worth like Danelle? If you’re like most stu-dents, you’re in the accumulation phase of your life cycle. You’re developing

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skills and abilities that will lead to greater income and wealth in the future.You may have student loans and car loans but little in the way of financialinvestments. This situation is not overly troubling at such an early stage of life.However, if it continues indefinitely, it will eventually result in insolvency,which is the inability to pay debts as they come due. Insolvency can lead tobankruptcy.

It’s not uncommon for an individual’s net worth to decline due to an unex-pected change in life circumstances, such as an extended illness, the death of aspouse, or a divorce. One of the purposes of developing and evaluating personalfinancial statements is to identify ways to improve your situation so that you canbe better prepared for such problems. As you proceed through the financial plan-ning process, you should keep this in mind and conscientiously attempt toreduce your debt and increase your assets over time.

2.2.4 Preparing a Personal Cash Flow Statement

Your net worth is highly related to your spending and saving behavior. If youconsistently spend more than you earn, you’ll end up financing the extra con-sumption through borrowing. In contrast, if you’re a regular saver, you’ll accu-mulate more assets over time.

On average, Americans spend more than they earn and have very lowsavings rates. Not surprisingly, average household debt continues to riseover time. This problem has been exacerbated over the past few years, asincreasing home values and low mortgage rates have encouraged many home-owners to access home equity lines of credit to pay for vacations and othernon-investment expenses. When this happens, total debt goes up, and networth declines, as you will see when you look at credit in more detail inChapters 5 and 6.

A personal cash flow statement is a financial statement used to evaluatethe relationship between your income and expenditures. Whereas your personalbalance sheet is like a snapshot of your finances at a certain point in time, yourpersonal cash flow statement shows inflows and outflows of cash over a periodof time, often one month or one year.

You use a personal cash flow statement to carefully itemize the amounts ofmoney that come into your household from various sources as well as all themoney that goes out over the same period of time. You can utilize a worksheetsuch to record your cash inflows and outflows; for example, Figure 2-2 showsDanelle Washington’s personal cash flow statement for 2004. A blank worksheetis included in your Personal Financial Planner; an alternative is to use the work-sheets provided with a personal finance software package, such as Microsoft Moneyor Quicken.

When should you record cash flows? You prepare a cash flow statement on a“cash basis,” which means you record cash flows when they are received or paid.

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Figure 2-2

Danelle Washington’s Personal Cash Flow Statement, 2004

Cash Inflows

January 1 toDecember 31,

Monthly 2004

Salary/wage income (gross) $792 $9,500Interest/dividend incomeOther income (self employment)Rental income (after expenses)Cash from sale or assetsStudent loans 500 6,000Scholarships 108 1,300Other incomeGifts 17 200

Total Cash Inflows $1,417 $17,000

Cash Outflows

January 1 toDecember 31,

Monthly 2004

Income and payroll taxes $71 $852Groceries 171 2,052Housing

Mortgage or rent 300 3,600Property tax & insuranceMaintenance/repairs

UtilitiesHeating 40 480Electric 25 300Water and sewerCable/phone/satellite 15 180

Car loan payments 113 1,356Car maintenance/gas 80 960Credit card payments 125 1,500Other loan paymentsOther taxesInsurance

LifeHealth 42 504Auto 67 804DisabilityOther insurance

Clothing 25 300Gifts 30 360Other consumables (TV’s, etc.)Child-care expensesSports-related expenses 13 156Health club duesUninsured medical expenses 17 204Education 333 3,996Vacations/travel 25 300Entertainment 84 1,008Alimony/child supportCharitable contributionsRequired pension contributionsMagazine subscriptions/booksOther payments/expenses

Total Cash Outflows $1,576 $18,912

Net Cash Flow � Cash Inflows � Cash Outflows � �$159 �$1,912

Danelle Washington’s personal cash flow statement.

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Thus, if you receive a bill on January 5 but don’t pay it until February 1, yourecord it as an expense in February, not in January. If certain amounts are depositeddirectly to or withdrawn directly from your checking account, such as paycheckdeposits or car payments, you record them when they occur.

Identifying Your Cash Inflows

You should include as cash inflows all amounts of money you receive during theperiod of time in question. You include any income you earn from a job—wages,salaries, tips, and commission. Other sources of income may include

▲ Scholarships.▲ Cash allowances or gifts from your parents or others.▲ Proceeds from the sale of assets.▲ Alimony or child support.▲ Government benefits, such as welfare, unemployment, or Social Security.▲ Investment earnings (i.e., income from dividends and interest).▲ Gambling winnings.

Notice that Danelle records her annual gross income—that is, income beforetaxes and expenses—and records the taxes she paid during the year as cash out-flows. Last year, she earned $9,500 from a part-time job and received a $1,300scholarship and gifts of $200. She also took out a student loan in the amountof $6,000. Her total cash inflows are therefore $17,000 for the year.

Detailing Your Expenditures

Whereas income is generally easy to identify and calculate, expenditures are moredifficult to track accurately. You can probably easily determine the big fixedexpenses—expenses that are a constant dollar amount each period, such as rentand car loan payments. But few people do a good job of keeping track of theirvariable expenses, which vary in amount from period to period, such as gro-cery bills and gas money, even though these can be a big portion of their totalcash outflows.

You can see that on Danelle’s personal cash flow statement, $2,052 for gro-ceries was one of her largest annual expenditures, exceeded only by her rent, at$3,600, and her college expenses, at $3,996.

Small daily expenditures, such as money for parking meters or candy barsfrom vending machines, are especially easy to overlook, but often these expen-ditures can make the difference between achieving your financial goals and notachieving them. Even if you just buy a latté at the coffee shop every weekdayafternoon on the way home from school or work, the seemingly small cost of$3 per day adds up to $780 per year—enough to take a nice vacation or to addto your investment portfolio.

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If you spend money primarily by writing checks and using a debit card, it’sa little easier to track your cash outflows because your bank statement andcheck register are useful sources of information. Alternatively, you can trackyour expenditures on a daily basis in a spending log in which you record allyour cash outflows for a month or longer. Your Personal Financial Plannerincludes a spending log worksheet that you can use for this purpose. At theend of the time period you have chosen, you can then total the amounts enteredin your spending log to put into your personal cash flow statement. You needto do this for at least a month to be sure that you’ve included even the irregular cash outflows.

You should be careful not to alter your normal spending behavior tem-porarily simply because you’re recording everything. Suppose, for example, thatyou never realized how much money you spent on lattés until you began keep-ing your spending log. Even if you plan to reduce your latté spending, you needto incorporate this expense in your log so you can more realistically evaluateyour current finances. If you quit your latté habit during your spending logperiod and decided to allocate the $780 per year to savings, what if you “fell offthe wagon” and returned to your prior spending behavior? At this stage, it’s betterto be brutally honest and record all spending, regardless of whether you plan tomake changes.

Calculating and Evaluating Net Cash Flow

After you enter and total your cash inflows and outflows on the personal cashflow statement, you can calculate your net cash flow. Danelle calculates hers asfollows:

Net cash flow � Total cash inflows � Total cash outflows

� $17,000 � $18,912 � �$1,912

Based on Danelle’s personal cash flow statement, which shows a negative netcash flow, she has been spending more than her income during the past year.How did this happen? Her personal balance sheet gives some clues: Danellehas credit card debt totaling $5,200 and total student loan debt of $18,000.Because the personal balance sheet is cumulative, this amount represents debtshe has accumulated over time, not just in the past year. For example, weknow that she received $6,000 from a student loan this year, which meansshe must already have had $12,000 in student loan debt at the beginning ofthe year.

In addition to taking on more student loan debt, Danelle spent $1,912 morethan she earned last year, so these expenditures must have been made usingcredit cards. The increased debt resulted in a decline in her net worth.

As you can see, Danelle’s income and spending habits have had a big effect onher overall financial picture. We might be tempted to explain Danelle’s financial

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position by pointing to her low income. However, an interesting economic truthis that those who have more tend to spend more. If you’re struggling to makeit on a student’s budget, you likely eat ramen noodles at least once a week andmake do with your current wardrobe. If you’re a movie star earning millions ofdollars each year, you probably have more than one extravagant home, entertainlavishly, and buy only designer clothes. But just because you have high incomedoesn’t mean that your finances are in good shape. Many seemingly well-offpeople have gone bankrupt.

2.3 Using Financial Ratios

Financial ratios provide another important tool for evaluating your financialcondition. You can calculate your financial ratios from the information you’vecollected on your personal financial statements, compare your ratios to recom-mended targets, and track your ratios over time as a measure of your progresstoward achieving your financial goals. In this section, we examine ratios designedto measure three aspects of your finances:

▲ Liquidity.▲ Debt management.▲ Adequacy of savings.

The individual ratios and their calculations are explained in this section usingDanelle Washington’s financial information from Figures 2-1 and 2-2.

2.3.1 Measuring Liquidity

If you experience a total loss of income, if you’re temporarily disabled or laidoff, you might need to meet your expenses without having your regular income.The liquidity ratio tells you how many months you could pay your monthlyexpenses from your liquid assets. This ratio is calculated as follows:

Liquidity ratio � Liquid assets/Monthly expenses

1. Define net worth, liquid assets, market value, and fixed expenses.

2. List some of your variable expenses.

3. What type of statement helps you track your spending?

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2.3 USING FINANCIAL RATIOS 115

2.3.2 Measuring Debt Usage

Everywhere we turn, it seems there’s someone inviting us to borrow money tobuy something today instead of waiting until we’ve saved enough to pay cash.Small wonder that one of the biggest financial problems U.S. households face isthat they have too much debt.

If your money style is to spend impulsively or if you tend to avoid financialmatters altogether, you may already understand the problems associated withmonthly payments on credit cards. Although debt is not inherently bad, pay-ments made to lenders include interest charges and fees—funds that could bebetter used to build your financial wealth. You can use your personal financialstatements to assess your debt management. Financial institutions such as banksand mortgage companies use a variety of debt ratios when they evaluate you formortgage or car loans. We discuss three ratios in this section:

▲ The debt ratio.▲ The debt payment ratio.▲ The mortgage debt service ratio.

These are the ratios that financial institutions most commonly use in their mort-gage lending process.

The debt ratio measures the percentage of your total assets that you’vefinanced with debt. It is calculated as follows:

Debt ratio � Total debt/Total assets

FOR EXAMPLE

What if Danelle Loses Her Scholarship?Danelle has liquid assets equal to $1,500, the total value of her checking andsavings accounts (refer to Figure 2-1). Her annual expenses, from the cashflow statement in Figure 2-2, are $18,912, and her monthly expenses total$1,576. Thus, Danelle’s liquidity ratio (rounded to one decimal place) is

$1,500/$1,576 � 1.0

This means that Danelle could meet her expenses for only one month with-out her regular income sources. Financial planners often recommend that youhave liquid assets sufficient to cover your expenses for three to six months,so liquidity is a concern for Danelle, particularly at the end of the school year,when she has depleted her student loan and scholarship funds. However, alow liquidity ratio does not necessarily imply that she needs to increase herallocation of funds to liquid assets. She may have other sources of funds thatcan be tapped in an emergency, such as family loans or credit cards.

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As your credit card balances increase, so does your debt ratio because credit cardpurchases are usually for consumer goods that add little—if any—value to yourassets. For example, suppose you use a credit card to pay for dinner and a moviefor you and your significant other. This causes your debts to increase by, say,$50, but your assets don’t increase at all. The end result is that your debt ratiogoes up. However, the debt ratio generally declines as you get older because yourfinancial assets and home equity increase in value.

The debt payment ratio estimates the percentage of your after-tax incomethat goes to paying required monthly minimum debt payments of all types,including mortgage loans, student loans, car loans, and credit card payments.The debt payment ratio is calculated as follows:

Debt payment ratio � Total monthly debt payments/After-tax monthly income

Note that we use after-tax income in the denominator of the equation becausethe purpose is to assess ability to pay. As you can see in Figure 2-2, Danelle’smonthly after-tax income is $1,346 (calculated as monthly gross income of$1,417 less $71 in income and payroll taxes). Her monthly debt payments total$238 per month ($125 for credit cards plus $113 for her car loan). Using thisinformation, we can calculate Danelle’s debt payment ratio as follows:

$238/$1,346 � 0.177, or 17.7 percent

Bank lenders commonly require that total debt payments not exceed 33 percentto 38 percent of gross income, which implies that the debt payment ratio(based on after-tax income) could be even higher. By that measure, Danelle’s17.7 percent debt payment ratio is not very high, but she will have to beginpaying her student loan a few months after graduation, so the ratio is likelyto rise in the near future. In addition, this ratio tends to understate Danelle’sactual financial obligations because it doesn’t include her required monthly rentpayments.

For most individuals, housing costs, either rent or mortgage payments, arethe largest monthly expenditure. The total monthly cost of a mortgage, includ-ing the principal and interest paid to the lender, property taxes paid to the localmunicipality, and homeowner’s insurance, is called the mortgage debt service.Mortgage lenders commonly require that borrowers make a single monthly pay-ment to cover all these expenses. The mortgage debt service ratio, which mea-sures the percentage of your gross income that you pay out in mortgage debtservice alone, is calculated as follows:

Mortgage debt service ratio � (Principal � Interest � Taxes � Insurance)/Gross monthly income

Both the debt payment ratio and the mortgage debt service ratio measureyour ability to pay your financial obligations. In determining your creditworthi-ness, lenders commonly compare these or similar ratios to maximum values. Forexample, a mortgage lender might require that your total debt payments be no

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2.4 DEVELOPING AND IMPLEMENTING A BUDGET 117

more than 35 percent of your gross income or that your total mortgage-relatedexpenses be no more than 25 percent of your gross income.

2.3.3 Measuring Savings

You can assess how well you’re implementing your savings goals by tracking yoursavings ratio over time. The savings ratio measures the percentage of your after-tax income that is being allocated to savings and is calculated as follows:

Savings ratio � Monthly savings/After-tax monthly income

Because the amount you have available for savings is what’s left over fromyour income after you’ve paid all your expenses and taxes, it’s quite possible tohave negative savings. This happens whenever your cash outflows exceedyour cash inflows. In that case, your savings ratio is negative as well. DanelleWashington’s savings ratio is

�$159/$1,346 � �11.8 percent

Because her negative savings ratio implies that, rather than saving, Danelleis accumulating more debt, this financial situation cannot continue for long. Asshe begins to develop her personal financial goals, Danelle will probably wantto include goals related to improving some of the financial ratios described here.Financial advisors commonly recommend that households target at least a10 percent savings ratio and that they attempt to increase this ratio over time.

2.4 Developing and Implementing a Budget

You’ve learned how to organize your finances and evaluate your personal finan-cial situation. Unplanned small cash outflows can interfere with your ability toachieve your financial goals—that is, unless you’ve included them in your finan-cial plan and budget. Your personal balance sheet and a personal cash flowstatement help to evaluate how well you’ve managed your money in the past. Abudget is a plan for future spending and saving that will enable you to achieveyour financial goals. The budgeting process, whereby you plan for future income

1. Define gross income.

2. What financial ratios measure your ability to pay your debt?

3. Where does the information for ratios come from?

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and expenditures and track your actual cash flows over time, is critical to imple-mentation of your financial plan.

2.4.1 Factors Affecting Household Budgets

Many factors affect each household’s budget and how the household allocatesresources to various categories of expenditures. Family size and makeup, age andeducation of household members, sources and amount of income, and moneyattitudes all have an impact on budget decisions. Figure 2-3 Average House-hold Budget Allocations at Different Ages shows the differences in allocationsacross several categories of expenditures for families in different life-cycle stages.If you’re a full-time student, it’s likely that your allocation of funds to educa-tional expenses is high, but you are not yet allocating funds to savings. Familieswith young children spend more on housing and child care, whereas retireeshave relatively greater health-care expenditures. Even within each category, how-ever, you will find wide variation across households.

0%

Under 25Age 25-35

Age 35-44Age 45-54

Age 55-64Age 65+

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Tob.& Alcohol

Charity

Education

Clothing

Health & Pers.Care

Recr. & Entertainment

Pension & Insur.

Figure 2-3

Average Household Budget Allocations at Different Ages (Source: Consumer Expenditure Survey www.bls.gov)

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2.4 DEVELOPING AND IMPLEMENTING A BUDGET 119

2.4.2 The Budgeting Process

The budgeting process includes four steps: forecasting, implementing, monitor-ing, and evaluating. If you haven’t already organized your financial data, thenyou’ll need to do so before proceeding with the budgeting process.

Forecasting Future Income and Expenditures. Since your budget is a planfor future spending, you’ll need to forecast your future income and expenditures insetting up the budget. Before you begin, you’ll need to answer several questions.

1. What time period will your budget cover? Although an annual budgetcan help with the big picture, most families find it necessary to budgeton a monthly basis to coincide with payment obligations.

2. How will you keep your records? You need to make decisions at theoutset regarding the record-keeping format that you’ll employ. You canuse your personal cash flow statement as a starting point, but you maywant to condense or expand on the categories of income and expensesused in that financial statement to develop a budget system that worksfor you. The process of recording day-to-day expenditures can be tediousbut is absolutely necessary, so make it simple enough to ensure thatyou’ll persist in doing it on a regular basis.

3. How much do you expect your income and expenses to change over time?In preparing your forecasting estimates, the best approach is to make twopasses. In the first pass, go through each income or expense item on yourfinancial statements and estimate its value for the coming year based onpast spending patterns and your reasonable expectations of the future. Atthis stage, don’t add any expenditures for your new financial goals. The netcash flow under this scenario will tell you how much you have available (or how much you will have to cut) to apply to these objectives.

The starting point of your forecast is to estimate changes in your future income.Salary changes will be easy if you already know what your raise will be—asin the case that your employer has announced raises or you have a union-negotiated salary scale. Tips and bonuses are not as easy to estimate, but youshould make a best (conservative) guess and plan to revise this part of yourbudget as you obtain new information.

Next, estimate your expenses. Fixed expenses are, by definition, going to bethe same next year as they are currently. If the principal and interest on yourfixed-rate home mortgage totaled $750 per month last year, it will be $750 permonth next year, unless you refinance. However, your property taxes and home-owners’ insurance payments will probably increase. Variable expenses may bemore difficult to estimate. One approach is to take current variable expenses andincrease them by the expected rate of inflation in your area. For example, if yourhomeowners’ insurance premium was $600 last year and you anticipate

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4 percent inflation, your premium for the coming year can be estimated as $600 � (1.04) = $624. Note that this is the calculation for the future value ofa lump sum for one period at 4 percent interest.

Reconciling Your Budget and Applying Funds to Your Goals. Once you’veestimated all the line items in the first pass, you can calculate your estimated netcash flow—total cash inflows less total cash outflows. If this value is negative,you must determine how you’re going to increase your income or reduce yourexpenditures to reconcile your budget. Reconciling a budget is the process ofadjusting income and spending so that your expenses do not exceed your income.Variable expenses can be changed most easily in the short run but even fixedexpenses can be reduced in the long run. You can increase your income by ask-ing for a raise, changing jobs, or taking a second part-time job. If your net cash

FOR EXAMPLE

Creating a BudgetUsing their current year personal financial statements, Cindy and DaveThompson put together a forecast for the following year to see if Cindy canquit work become a full-time homemaker for their son Kyle and a new baby.They also want to save for their children’s education and their own retire-ment. Using actual current year financial information, they estimate nextyear’s inflows and outflows in the first pass. Figure 2-4 includes notes in theComment column that explain how they arrived at their forecast values foreach line item. For income, they entered Dave’s expected after-tax incomebased on his expected 10% raise. For most variable expenses in the firstpass, Cindy and Dave simply assumed an increase of 4 percent for inflation.

Based on their personal financial statements, Cindy and Dave had approx-imately $9,400 in net personal cash flow last year. The first pass at next year’sbudget shows that, without Cindy’s income, the family will not be able tomeet their expenses without a change in spending behavior, a shortfall ofabout $5,000. In order to meet their financial goals, in the second pass, theycarefully go through their budget and decide on ways to reduce discretionaryspending. They also estimate that they can reduce expenses by refinancingtheir home and paying off their credit card debt while Cindy is still working.By focusing on controlling their discretionary spending, Cindy and Dave findthat they will have sufficient extra cash flow to apply to their other financialobjectives as indicated in grey shading on the worksheet. They will contributeto a college fund for their older son, increase their retirement savings, andbuild an emergency reserve fund with their remaining positive net annual cashflow. They also decide to buy a life insurance policy for Cindy ($12 permonth) and to purchase disability insurance for Dave ($50 per month), sincethe family will now be so dependent on his income.

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Figure 2-4

Cindy and Dave Thompson Budget.

THE THOMPSONS BUDGET WORKSHEET-REVISED

Actual First Pass Final

Current Year Next Year Next Year CommentsBudgetDave Cindy

CASH INFLOWS

Dave's After-Tax Income $48,000 52,800 52,800 Raise

Cindy's After-Tax Income $18,000 0 0 Cindy quits work

Interest/Dividend Income 50 51 51

Child Support from Cindy's ex 5,200 5,200 5,200

Total Income $71,250 $58,051 $58,051 13,199 difference

CASH OUTFLOWS

Groceries and Eating Out $10,400 10,800 9,400 Grocery infl + eat out less

Housing

Mortgage Princ & Interest 6% 10,800 10,800 9,600 Refinance at 5%

House repairs/expenses 2,000 2,000 1,000 Delay maintenance

Property taxes and insurance 3,000 3,100 3,100 Inflation

Utilities

Heating 1,200 1,248 1,248 Inflation

Electric 600 624 624 Inflation

Water and Sewer 420 437 437 Inflation

Cable/phone/satellite 600 624 624 Inflation

Car loan payments 2,851 2,851 2,851 4 years to go

Car maintenance/gas 3,180 3,307.2 3,000 Cindy drives less

Credit card payments 1,440 1,440 0 Pay off balance

Insurance

Life 150 156 300 Insure Cindy

Health 1,800 2,300 2,300 Increased Premium

Auto 1,800 1,320 1,320 Increased Premium

Disability 600 For Dave

Clothing 1,000 1,040 700 Reduce spending

Gifts 2,000 2,080 1,000 Careful shopping

Other consumables (TV's etc.) 1,800 1,872 1,500 Reduce spending

Child care expenses 2,700 1,140 1,140

Sports-related expenses 180 204 204

Health club dues 420 420 420

Uninsured medical expenses 540 1,000 1,000 Baby costs

Education/training 600 600 600 Dave's continuing ed

College fund 2,400 For Kyle

Vacations 6,000 6,240 3,000 Reduce spending

Entertainment 2,040 2,124 1,000 Reduce spending

Charitable contributions 1,200 1,248 1,248

Non-employer pension contributions 3,000 3,300 6,300 IRA for Cindy

Magazine subscriptions/books 120 120 120

Other payments/expenses 600 600 600

Total Expenses 61,841 62,995 57635.8

NET PERSONAL CASHFLOW $9,409 ($4,944) $415

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flow in the first pass is positive, you can use the second pass to determine whereyou will apply the extra funds—to increases in your savings or spending consis-tent with your prioritized financial objectives.

After determining your net cash flow, you’ll adjust your budget, in a secondpass, to reflect anticipated changes in spending and saving. Most important, youshould now include in your budget the estimated costs of your new financialgoals. If these costs exceed the extra cash flow that you estimated in the firstpass, your reconciliation will require you to make decisions to reduce yourexpenses, increase your income, or adjust your financial goals to be more real-istic, given your financial constraints.

As you can see from the Example, careful consideration of your family’s pat-tern of expenditures can help you identify ways to reallocate funds to achieveyour financial objectives. Now the challenge will be for the Thompsons to stickto their plan—reducing their credit card debt and their expenditures in certainbudget categories.

1. Describe the steps in the budgeting process.

2. What time period should a budget cover?

S E L F - C H E C K

2.5 Monitoring and Controlling Your Budget

Planning to reduce your expenditures is one thing—implementing the plan maybe more difficult, since old spending habits are sometimes hard to break. Tomake sure that your actions are consistent with your plan, you should regularlyreview your actual spending and make changes to your budget as necessary. Youcan best accomplish this by creating a monthly spending plan and tracking youractual spending to see how much it varies from your projections. If necessary,you can revise your budget as a result of what you learn.

2.5.1 Tracking Budget Variances

There are two main reasons for tracking budget variances:

• To identify small cash leakages as soon as possible so that you canchange your behavior before you have a major budget shortfall.

• To ensure that large irregular cash expenses do not cause financial hard-ship. Income often comes in regular, predictable amounts, whereas someexpenses, such as car and home repairs, tuition bills, or tax payments,may come in chunks and must be budgeted for in advance.

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2.5 MONITORING AND CONTROLLING YOUR BUDGET 123

Household budgets can experience some variance from month to month dueto larger one-time expenditures. Fortunately, in the example, the Thompsons’income was sufficient to cover these expenses, but many households are not solucky and must plan in advance to cover large irregular expenses. You can dealwith this problem in various ways:

• Build a fund for this purpose (over the course of the previous months).If, for example, you pay your health club dues every January, the verynext month you could begin to set aside the money for the followingyear’s dues so that, by the following January, you would have the fundsand it wouldn’t be a big hit to your budget for that month.

• Use emergency funds (and replace them in later months). One of the purposes of such a fund is to help you manage monthly budget fluctuations.

• Obtain a short-term loan (but be sure to include financing costs in yourbudget).

2.5.2 Revising Your Budget

After tracking your budget for several months, you might find that you havebeen too conservative in estimating certain expenses or that you have forgottento make allowances for unexpected expenses, such as car repairs or medical bills.In either case, you need to go back to the original budget and revise it so that,going forward, you’ll be able to meet your expenses.

If the reason you’re exceeding your budget is that you’ve failing to control yourdiscretionary spending in certain areas (most commonly entertainment-related),you should take the time to review your financial goals, evaluate your progress

FOR EXAMPLE

The Thompsons Track Their BudgetCindy and Dave Thompson kept track of their monthly expenses for thefirst three months of the year. The first column of Figure 2-5 on page 124shows their budgeted monthly amount, which the annual amount from theirbudget in Figure 2-4 divided by 12.

The Thompsons had a small budget shortfall in January, but were aheadin February and March. Many household expenses, such as their health clubdues and magazine subscriptions, are paid one time for the whole year. Ifthey occur early in the year, the family budget may be strained for a bit.Their uninsured medical expenses were also larger than budgeted, in partbecause their health plan requires they pay the first $500 of yearly expensesbefore the insurer covers the costs. Fortunately, other expenses were lowerduring those months, so the Thompson’s were able to meet all their expenses.

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toward meeting them, and carefully weigh the benefits and costs of the purchasesthat are interfering with your plan. Research also shows that unexpected events,such as layoff, illness, and divorce, commonly lead to household financial distress.Even though you can’t necessarily anticipate these problems, you can lessen theimpact by maintaining a financial cushion. Some advice for dealing with theseand other common budget problems is offered in Figure 2-6.

Figure 2-5

Cindy and Dave Thompson Budget Variances.

ACTUAL

Budgeted Monthly January Variance February Variance March Variance

CASH INFLOWS $ 4,837 $ 4,837 $ –– $ 4,837 $ –– $ 4,837 $ —

CASH OUTFLOWS

Groceries and Eating Out $ 783 $ 900 $ (117) $ 800 $ (17) $ 750 $ 33

Housing

Mortgage Princ & Interest 800 800 0 800 0 800 0

House repairs/expenses 83 0 83 0 83 300 (217)

Property taxes and insurance 258 258 0 258 0 258 0

Utilities

Heating 104 150 (46) 170 (66) 130 (26)

Electric 52 45 7 50 2 35 17

Water and Sewer 36 36 0 36 0 36 0

Cable/phone/satellite 52 52 0 52 0 52 0

Car loan payments 238 238 0 238 0 238 0

Car maintenance/gas 250 190 60 230 20 200 50

Credit card payments 0 0 0 0 0 0 0

Insurance

Life 25 25 0 25 0 25 0

Health 192 192 0 192 0 192 0

Auto 110 110 0 110 0 110 0

Disability 50 50 0 50 0 50 0

Clothing 58 0 58 75 (17) 50 8

Gifts 83 50 33 0 83 0 83

Other consumables (TV's etc.) 125 0 125 0 125 0 125

Child care expenses 95 75 20 75 20 75 20

Sports-related expenses 17 50 (33) 0 17 0 17

Health club dues 35 400 (365) 0 35 0 35

Uninsured medical expenses 83 200 (117) 30 53 30 53

Education/training 50 0 50 250 (200) 0 50

College fund 200 200 0 200 0 200 0

Vacations 250 0 250 0 250 0 250

Entertainment 83 120 (37) 60 23 100 (17)

Charitable contributions 104 104 0 104 0 104 0

Non-employer pension contributions 525 525 0 525 0 525 0

Magazine subscriptions/books 10 0 10 30 (20) 30 (20)

Other payments/expenses 50 65 (15) 45 5 35 15

Total Cash Outflows 4768 $ 4,835 $ (32) $ 4,405 $ 398 $ 4,325 $ 478

NET PERSONAL CASHFLOW $ 69 $ 2 $ 432 $ 512

Cumulative Variance $ (32) $ 367 $ 845

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2.5 MONITORING AND CONTROLLING YOUR BUDGET 125

Figure 2-6

Solutions for Common Budget Mistakes

COMMON BUDGET MISTAKES

1. Having Too Little Emergency Cash. Manyfamilies live paycheck-to-paycheck. A layoff, carbreakdown, or unexpected bill can lead tofinancial crisis.

2. Supersizing Your House. Before the housingcrisis, people were encouraged to buy the largesthouse they could afford and borrow as much aspossible on the assumption that income wouldrise, making it gradually easier to pay the fixedmortgage payment. Expensive houses come withincreased costs for maintenance, taxes, andinsurance. Too much debt and you won’t beable to survive a break in employment.

3. Buying Stuff You Don’t Need. Everyone isguilty of doing this at times. But when moneyis tight, many don’t know how to stop.

4. Being Too Generous. Whether it’s charity,gift-giving, or lavish birthday parties for yourkids, it makes no sense to be generous withmoney you can’t afford to give away.

5. Getting Used to Living on 2 Incomes.Onceyou get used to living on two incomes, it’smuch more difficult to go back to one in theevent of illness, childbirth, or layoff.

6. Overusing Credit Cards. If you’re notpayingyour bill in full each month, then youlikely have not fully accounted for theseexpenditures in your budget. You overall financialposition will decline with increased debt.

7. Underinsuring. Even though health insurancecan be a large monthly expense if youremployer doesn’t cover all the premiums, it’s amistake to be uninsured. Twenty percent ofbankruptcies are triggered by medical bills.

8. Delaying Education Saving. Preschool,private K-12, and college costs are all increasingfasterthan inflation. The longer you wait tostartsaving for these expenditures, the moreyou’ll need to put in each month.

9. Underestimating the Cost of Divorce. Twohouseholds are more expensive than one, so a divorce usually has negative financialconsequences for one or both ex-spouses.

BUDGET ADVICE

Budget for an emergency fund using automatictransfer from your paycheck to a liquid savingsaccount. Deposit any windfalls or refunds into thisaccount.

Downsize. Even though lenders may allow you toborrow more, keep your housing expendituresunder 25 percent of your pretax income. Currentlending rules have tightened up, so it is moredifficult to get into trouble.

Having a budget will help, but if you have aserious spending problem, you can try leavingcredit cards at home, requiring another familymember to sign off on all purchases above a dollarlimit, sticking to a “need” list.

Budget for these expenditures and avoid makingimpulse purchases or donations. Consider ways togive your time and talents instead of money. Createan account to save for next year’s donations and gifts.Spend only from that account the following year.When the money’s gone, no more gifts.

Even if you are a double income family, you should tryto live on only one, saving and investing the remainderand using it for extras like vacations. This will increaseyour financial flexibility to deal with the unexpected.

Always keep track of total expenditures, includingthose that were on credit. Try to pay the balance infull each month. If it’s already too much, make a planfor paying it off over as short a period of time aspossible and don’t use your cards for new purchases.

Budget to be able to afford at least a catastrophichealth plan (with a large deductible). Look into dealswith organizations such as the AARP or AAA.

Set up a savings plan as soon as a child is bornandinclude it in your budget. Never borrow to pay forelementary or secondary education. Consider lessexpensive options for college, including communitycolleges and in-state universities. Make your childpay for a share of the costs.

A prenuptual agreement can reduce the risk of acostly court battle. Go to counseling beforesplitting. If divorce is inevitable, close jointaccounts and refinance mortgages to avoid gettingtangled in your ex-spouse’s bankruptcy.

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1. What are the reasons for tracking budget variances?

2. What is the danger of not having an emergency fund?

3. If you pay for an expense with a credit card, should it be includedin your budget?

S E L F - C H E C K

2.6 Money Attitudes and Household Budgeting

Our consideration of budgeting would be incomplete without some discussion ofthe relationship between budgeting and money attitudes. Individual differencesin money attitudes and spending behavior are a major cause of conflict in rela-tionships, not only for families who are struggling to meet a minimum standardof living, but also in affluent households.

2.6.1 Spousal Differences

If you are a saver and your spouse is a spender, you are bound to have prob-lems developing and sticking to a household budget. It is very important to havea frank discussion about money with your partner, preferably before you marryor move in together. In general, you can avoid future problems by setting groundrules at the beginning that are agreeable to both of you. These should not beestablished without careful consideration of the consequences. Some issues thatyou should resolve up front include the following:

• Who will manage the finances in the household, pay regular bills,and make investment decisions? These tasks could be split up, man-aged jointly, or all by one person.

• Will each person retain individual control over some of the money?Although the simplest arrangement for a family is to pool everything,many families do not do this. Indeed, most experts agree that each person should have control over some discretionary funds.

• Which household discretionary expenditures require jointagreement? Some families only jointly decide on very large purchasessuch as new furniture or cars, and others set a dollar limit on discre-tionary purchases. For example, you might decide that if something costsmore than $100, you can’t buy it without consulting one another.

• What are your individual attitudes about spending and borrowing? Ifone person hates to be in debt and the other would rather finance ahigher lifestyle with credit cards, conflict is inevitable unless you haveresolved these issues before intermingling your finances.

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2.6 MONEY ATTITUDES AND HOUSEHOLD BUDGETING 127

• What are your individual attitudes about planning and saving for thefuture? If you and your spouse have vastly different financial goals, thenyou may disagree about how to allocate net cash flow.

• What are your attitudes toward gift giving? Families differ in theirgift-giving traditions, and this can be a cause for conflict. If your futurewife’s family always gives extravagant gifts for Christmas and birthdaysand you think it’s a waste of money, this will be a cause for conflictevery year if you don’t deal with it up front.

FOR EXAMPLE

What if one spouse makes more money than the other?Robert and Jamie are newlyweds in their 20s. Both are employed, althoughRobert’s monthly take-home pay is substantially more than Jamie’s. Robertmakes $3,000 per month and Jamie makes $1,500 per month. When theysit down to pay their bills together for the first time, Robert suggests thatthey split the regular bills (rent, utilities, phone, and groceries expenses)equally. Although Jamie makes enough to pay her half, she knows she’ll havetrouble covering her other monthly out-of-pocket expenses.

Splitting the bills sounds fair on face, but it’s not the best choice whentwo partners have very different incomes. If Jamie doesn’t have enough tocover her other expenses, she’ll need to ask Robert for money on a regularbasis, which will put her in an uncomfortable position. Robert’s ability to payfor extras like CDs, sporting goods, and other personal items might make herfeel resentful, which will not be good for other aspects of their relationship.Jamie should suggest that she and Robert first develop a budget. Once it isclear that Jamie cannot pay half of the household expenses and still manageher other expenses on her income, they can consider other alternatives. Otherways to split the expenses include:

• Each spouse pays a percentage of the household bills based on theirpercentage of the total income. For example, if the regular householdbills were $3,000 per month, Jamie could pay one-third and Robertcould pay two-thirds.

• Combine all household income into a joint account and pay all house-hold expenses from the joint account.

• Decide on how much each person contributes to the householdexpenses based on their additional budgetary needs. For example, ifJamie spends a lot more on gas because of a longer commute, thiswould be factored into the amount she has to contribute toward theother household expenses.

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• Who pays for the debt that precedes the marriage? Even if you buyinto the “yours, mine, and ours” philosophy of marriage, if one partnerbrings a lot of debt to the marriage, it may not be fair to expect theother to pay for it. In numerous cases, a starry-eyed newlywed has paidoff her or his new spouse’s debts only to have the spouse leave the mar-riage shortly thereafter—with no debt. Having a plan for resolving pastfinancial difficulties will reduce this problem.

• Who pays expenses associated with children from previous marriages?Although you may receive child support from another parent, additionalcosts for children living in your home are inevitable. Depending on thecircumstances of the divorce, the parents may be tempted to compete forthe child’s affections by spending money on him or her. Whether the newstepparent should have any obligation to contribute to the child’s upkeep isan individual decision but one that should be resolved prior to the mar-riage (and should never be discussed in front of the child). In discussingthis issue, don’t forget about college funding costs.

• Should you have a prenuptial agreement? With the prevalence of divorce,individuals who bring substantial assets to a marriage may want to considera prenuptial agreement, which is a written contract in advance of the mar-riage that specifies how the assets will be distributed in the event of adivorce. It is also possible to make a postnuptial agreement at a later dateto accomplish the same end. Although it may seem very unromantic toanticipate divorce when you aren’t even married yet, the process ofdiscussing the prenuptial may actually force you to talk about your moneyattitudes and important financial issues in advance of the marriage.

2.6.2 Using Money Psychology in Budgeting

Establishing a budget and sticking to it isn’t as easy as it sounds. To help your-self achieve your financial goals, you may want to try some of the following bud-geting tricks from behavioral psychology.

1. Avoid pain. Experimental psychologists have long known that peopletend to avoid activities or decisions which cause pain or regret. Unfortu-nately, many personal finance tasks are associated with negativefeelings—paying bills and filing taxes, for example. Even saving is painfulsince it often requires you to reduce your spending on “fun” stuff. Toapply this behavioral principle to your savings plan, make a plan to savefrom future salary increases. For example, when you get a $200 permonth raise, arrange to have it automatically deposited to your savingsaccount. If you’ve never had the money to spend in the first place, youwon’t feel the “pain” of having to cut back on spending.

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2.6 MONEY ATTITUDES AND HOUSEHOLD BUDGETING 129

2. Reward yourself for successes. Just as individuals try to avoid pain,they also like to repeat activities that cause them to feel good. To applythis to your personal finances, you should develop a way to savor yourbudgeting successes. Perhaps you could tape a chart to the refrigeratorthat shows the growth in your savings account. Or, if you prefer moreovert rewards for your hard work, plan to have a special dinner out withyour spouse whenever you reach a personal financial milestone. But don’tforget to include the cost of the “reward” in your budget!

3. Pay yourself first. The principle of paying yourself first, which wasintroduced in Chapter 1, is based on the well-known psychological bias“out of sight, out of mind.” When you don’t have a regular reminder ofsomething, your mind tends to get “fooled” into thinking it isn’t there.This behavioral principle is easily applied to your personal finances. Ifyou have amounts withdrawn automatically from your paycheck andapplied to your personal financial objectives at the beginning of a payperiod—debt repayment or retirement contributions, for example—youare more inclined to spend as if you had less to start with.

4. Use mental accounting. “Mental accounting” is a term used by psychol-ogists to describe a process by which people consider money differently,depending on where it comes from and where it goes to. For example,many people look at end-of-year bonuses or tax refunds as funds that areoutside their regular budget and can therefore be spent more frivolously.Although this example shows how mental accounting might not alwaysbe beneficial from a financial planning perspective, since all your incomeshould be included in your budget, this psychology principle can some-times be helpful in budgeting. For example, if you’re having troublesticking to a budget, you could make the budget more concrete by cash-ing your paycheck each pay period and putting the cash into individualenvelopes that correspond to your budget categories. When an envelopeis empty, then you can’t spend any more in that category until the nextpay period.

1. What money issues should engaged couples resolve before gettingmarried?

2. What does “pay yourself first” mean?

3. What is a prenuptial agreement and when might you need one?

S E L F - C H E C K

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SUMMARYIt’s important that you develop a system for organizing and maintaining your finan-cial records. You can use a personal balance sheet to figure out your net worth,which is the total value of your assets minus the total value of your debts. You cansummarize your current inflows and outflows of cash by using a personal cash flowstatement. This financial statement helps you calculate net cash flow. Personal finan-cial ratios can help you evaluate your current financial position, based on your per-sonal balance sheet and cash flow statements. By comparing your ratios over time,you can track your progress toward achieving your financial goals.

KEY TERMSAssets Everything you own, including liquid assets,

real and personal property, and investments.

Budget A plan for future spending and saving.

Debt payment ratio A financial ratio that measures the percent-age of disposable income required to makedebt payments.

Debt ratio Total debt divided by total assets.

Debts Everything you owe to others, including unpaidbills, credit card balances, car loans, studentloans, and mortgages. Also known as liabilities.

Fixed expenses Expenses that are a constant dollar amounteach period.

Gross income Income before taxes and expenses.

Insolvency The inability to pay debts as they come due.

Liquid assets Cash and near-cash assets that can be easilyconverted to cash without loss of value.

Liquidity ratio A financial ratio that measures the ability topay household expenses out of liquid assetsin the absence of regular income.

Market value The price that something can be sold for today.

Mortgage debt service The total dollar amount of monthly mortgageprincipal, interest, property taxes, and home-owner’s insurance.

Mortgage debt service ratio The ratio of mortgage debt service to grossincome.

Net worth The amount of wealth you would have leftafter paying all your outstanding debts.

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SUMMARY QUESTIONS 131

Personal balance sheet A statement that details the value of whatyou own and what you owe to others toarrive at an estimate of your net worth.

Personal cash flow statement A summary of income and expenditures overa period of time.

Personal financial statement A statement that summarizes your financialinformation.

Prenuptial agreement A written contract in advance of a marriagethat specifies how the assets will be distrib-uted in the event of a divorce.

Reconciling a budget Adjusting income, expenses, and saving sothat you don’t spend more than you earn.

Savings ratio A financial ratio that measures the percent-age of after-tax income going to savings.

Variable expenses Expenses that vary in amount from period toperiod.

ASSESS YOUR UNDERSTANDINGGo to www.wiley.com/college/bajtelsmit to assess your knowledge of money man-agement strategies and skills.Measure your learning by comparing pre-test and post-test results.

Summary Questions

1. Because most IRS audits occur within three years of when a return isfiled, it is recommended that tax records be kept no more than fiveyears. True or false?

2. When saving documents, it is recommended that you keep utility bills:(a) only until the next bill arrives.(b) six months.(c) one year.(d) three years.

3. A personal balance sheet shows assets and debts at a single point intime, and a personal cash flow statement reflects cash inflows and outflows that occur over a period of time. True or false?

4. Which of the following formulas is used to calculate personal net worth?(a) Total assets � Total debts(b) Total assets � Total debts

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(c) Total debts � Total assets(d) Liabilities � Unpaid bills

5. Which of the following would be the best definition of insolvency?(a) having more liabilities than assets(b) the inability to borrow any more funds(c) having no savings(d) the inability to pay bills on time

6. If you borrow money to buy a new car, which of the following items onthe balance sheet are affected?(a) assets only(b) debts only(c) assets and debts(d) unable to determine

7. The savings ratio is negative if cash outflows exceed cash inflows. Trueor false?

8. If you have an insurance policy that has a cash surrender value:(a) this represents an asset for you.(b) this represents a debt for you.(c) you enter no value on the balance sheet unless the policy is surrendered.(d) the premiums still due are subtracted from the surrender value to

arrive at market value.9. You have estimated your total assets to be $10,000, your liquid assets to

be $2,000, and your total debts to be $11,000. Your net worth is$2,000. True or false?

10. Don has assets of $5,000, of which $1,800 are in checking and savingsaccounts. His annual expenses are $15,000. Don’s liquidity ratio is:(a) 0.333.(b) 3.00.(c) 0.12.(d) 1.44.

Applying This Chapter

1. Identify the purpose for saving each of the following documents, if any,and how long you should save it:(a) Visa bill(b) apartment rent receipt(c) bank checking account statement(d) tax return

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APPLYING THIS CHAPTER 133

2. Identify whether each of the following is an asset, a debt, or neither:(a) credit card balance(b) weekly employment earnings(c) car(d) rent paid to landlord(e) checking account

3. Use the following personal balance sheet to calculate the net worth:Assets Liabilities

Bank accounts $3,000 Current bills $1,500

Car $5,000 Student loan $10,000

Personal assets $2,000 Car loan $3,000

4. Using the personal balance sheet from Question 3, calculate total liquidassets.

5. Using the personal balance sheet from Question 3, what is the debt ratio?6. Using the personal balance sheet from Question 3, and assuming that

monthly expenses total $1,200, calculate the liquidity ratio.7. The Sandell family reports the following financial information:

Checking and savings account $ 3,000

Monthly after-tax income $ 2,500

Total monthly expenses $ 2,000

Monthly savings $ 500

Total debt $10,000

Total assets $40,000

Calculate the Sandells’ liquidity ratio.8. Calculate the Sandells’ debt ratio.9. Calculate the Sandells’ savings ratio.

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YOU TRY IT

Can You Afford a New Car?Suppose you have your eye on a new car, and yourmonthly after-tax income is $2,000. Your monthly ex-penses are as follows:

▲ Car insurance: $100▲ Rent: 900▲ Groceries: 300▲ Entertainment: 200▲ Utilities: 200▲ Credit card payment: 100▲ Other: 100

What is your net cash flow? Can you afford that newcar? Why or why not?

What’s Wrong with This Picture?Melody and Charles Verona have been married for lessthan one year and currently live in a one-bedroomapartment. They would like a bigger place to live and,with two incomes, they think they could afford to makemortgage payments on a small home or condominium.Unfortunately, they don’t have enough money for adown payment yet, so they want to begin saving forthis purpose. Over the past few months, Melody hasbeen dismayed to find that they always seem to be a lit-tle short on cash at the end of the month. She decidesto sit down with Charles to look more carefully at theirspending habits and begin making a plan that will en-able them to buy a house. The Veronas have collectedthe following financial information in preparation forevaluating their current finances and determining howmuch to save:

Cash Inflows Gross Income After-Tax Income

Melody $22,000 $18,000Charles 28,000 22,400

Cash Outflows Monthly

Groceries $400Eating out 200Rent 950Credit card payments 200Telephone 50Utilities 150Car loan payments 360Car expenses and fuel 160Clothing 100Entertainment 150Health club membership 60Travel and vacations 100

Assuming that these cash flows are accurate and com-plete, what is the Veronas’ net monthly cash flow? If theVeronas allocate their net cash flow to savings eachmonth and they can earn 4 percent after taxes, howmuch will they have in the account after two years?What is a possible explanation for why the Veronas arehaving cash flow problems each month? What wouldyou suggest they do to identify the reasons for thisproblem?

Net WorthConstruct a personal balance sheet by itemizing yourassets and debts. You can use the blank forms in thePersonal Financial Planner to do this. If you aren’t sureof an item’s value, estimate as best as you can. What isyour net worth as of today?

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