Importance of Budgeting in Financial Planning
” It is not necessary to do extraordinary things to get extraordinary results.“
– Warren Buffett
Budgeting plays a very important role in personal financial planning. Budgeting involves listing down the income and expenses of a household. The idea is to be able to contain the expenses within the income available and determine the possible savings. The process of listing and itemizing the income and expenses gives clarity to an individual’s financial situation.
The income or earnings in the working years are used to meet current expenses first, and a part is saved and invested to create a corpus that will generate income for the retirement years. Adequacy of income to meet current and future needs are again not uniform across individuals and in different stages of life. People with a higher income relative to their expenses have the capacity to save more than others whose income may be just enough to meet their current expenses, leaving very little for savings.
Similarly, young people who just started earning may feel that their income is too small to save and invest. They may think that they can be able to save and invest for their retirement and other financial goals when their income increases in subsequent years. However, leaving savings for later in life when income is high enough may lead to many goals, including retirement, being under-funded. It is important to start early and build the funds required overtime out of savings so that the risk of the accumulated funds being inadequate to meet the goals is reduced.
Budgeting is one way to inculcate the discipline to save for goals. In the early years, when income is tight, a budget is a useful tool to help live within the available income and generate savings for goals. In the later years, even when the income is adequate, a budget helps in increasing savings with a focus on the goals.
There are mandatory expenses, such as taxes and loan repayments that have to be first met out of available income. Then there are essential living expenses related to housing, food, education and transportation that have to be met. These are a category of expenses which cannot be avoided, but the individual can cut back and economize depending upon income available and savings goals. For example, finding housing in a less expensive locality and using public transport are ways to reduce expenses in this category. Discretionary expenses, related to entertainment and recreation, are the last category of expenses. This is the category that can be cut back significantly to generate savings when income is limited.
A budget helps identify wasteful expenditure that can be eliminated or reduced to accommodate saving for goals. It also helps in prioritizing expenses and goals, given the expected income. It helps get a clarity on what financial goals are realistically achievable given the available income and level of savings.
Financial goals such as retirement that cannot be given up or avoided have to be funded first and get a priority claim on available savings. It is important for a budget to be realistic about current income and expenses, and therefore on possible savings. Overestimating income or underestimating expenses are both dangerous for achieving the goals. In both scenarios, savings are likely to be lower than what was expected and will result in goals being under-funded.