Tuesday, July 7, 2015

Budgeting 101: Credit cards are not evil - why I never use cash

The misconception that credit cards are evil is particularly bad for those trying to budget and track their spending.  We all know credit card debt on the other hand is very bad as it accumulates interest and can cost dearly if left unchecked.  So how does one strike the balance of benefiting from the financial tracking while avoiding accruing interest?

Paying off the card each month prevents you from being charged interest.  While this concept seems simple in practice, if you are struggling from paycheck to paycheck, this can be difficult.  Lets back up here and dig a little.  If you are living paycheck to paycheck, the chances are you are spending all of the money you earn because you're operating on what is known as a "cash-based" accounting mindset.

This means that you check your bank account (or wallet) often to see how much money you have before you decide to make a purchase.  If you don't have enough money, you don't buy something or you go for the cheaper option, whereas if you have extra money you'll splurge a bit and maybe buy something you don't need.

Even if you aren't living paycheck to paycheck, most of us do this naturally.  It's the most simple learned behavior from interacting with money, like kids with their allowance.  Sure you can save up for something big, but the quantity of money one has directly influences their purchases.

Accrual Accounting

The quickest way to get out of the paycheck to paycheck cycle is to upgrade your cash-based accounting mindset to the more advanced accrual accounting methodology.  This is a discipline that goes hand in hand with budgeting.  If cash-based is like taking the pulse of someone's heartbeat by hand, accrual accounting is using a full body monitoring system.  It takes more work to operating with accrual account, but the benefits are worth it.

Think about your bank account as a lake.  Water flows in (your income) and water flows out (your expenses).  If the rate of water flowing out is faster than flowing in, the lake dries up.  Accrual account is looking at the total spending vs the total income.  What accrual also means is that credit card spending is counted when the expense occurs, not next month when the credit card bill is due.  This lets you take advantage of your cards and earn points and miles as you use them to pay for everything from bills, rent, loans, to even your $3 daily coffee.

The more you use credit cards and keep them paid off, the better off you are for three reasons.  First, you earn all the points, cash back, miles, or whatever benefits you get from using the card.  These add up when all of your expenses are going through your cards. Secondly, all this spending and keeping your cards paid off dramatically increases your credit scores, enabling you to borrow more at better rates when you need to make big purchases.  And lastly, credit card companies automatically post each transaction to your statement, available online or even through the smart phone app.

This is really important because you can then download these expenses and put them in your favorite accounting software or just plan excel and figure out where your money is going.  This lets you make a budget and curb unnecessary spending habits.  It enables you to be honest with yourself and spend more consciously.  That $3/day coffee habit adds up to more than 3 times the cost of a coffee machine every month.

Thinking ahead

So instead of checking daily how much money you have in your account, you can load your budgeting app or spreadsheet and see how far over or under you are for your budget that month.  If you budget in automatic investments or transfers to savings, then you'll be able to save every month.  And if your income is volatile, knowing in advance how much you need to earn to cover your budget and planned expenses is invaluable.  If you regularly are hit with large, one-time expenses, having the accounting records to see a historical trend can help you budget for future expenses.

Using cash thwarts this system unless you manually enter in every transaction, what it was for, amount, paid to whom, classification, etc.  Using credit cards automatically does this for you.  You'll want to use accounting software or a service to import your transactions from all your cards and bank accounts to keep track of this for you automatically.  Writing checks is only slightly better than using cash; it's still less than ideal.  I only write checks if I have to; most bill collectors will let you pay with credit cards, though watch out, some will add a fee for doing so.

Converting to accrual accounting has never been easier with credit cards and automatic accounting software.  Don't say to yourself "well I don't make or spend very much money, I don't need to do this."  You need to start now before you start earning more money, or you'll end up spending even more.  Think about some time ago when you earned less.  You spent less because you had to.  Now you earn more and if you aren't saving, you are spending more.  The only way to get ahead is to not spend all that you earn.  You can only do that if you have visibility to where your money is going.

This is the first step to financial independence.

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