When I was younger and impressionable and first learning about personal finances, I ran across a post by the reddit user WhiskeySauer. He laid out four fundamental categories of spending: mandatory, investments, debt, and fun. This simple model made so much sense, I based my entire personal finance system around it.
He has since made a post detailing his finances over the past nine years which uses these categories:
In my previous post I showcased that cash flow reviews can reveal personal spending habits. The great news is that if you start tracking categories, you can learn even more details! Before we get into those details, let's start with the basics.
Debt takes the form of credit cards carrying a balance, personal loans, car loans, and so on. Note that using a credit card like a debit card, where you pay it off in full every period, does not actually count as debt. Debt is when you are charged interest.
Your first priority should always be to eradicate high-interest debts, especially credit cards. Eliminating all other debts is the second step toward financial freedom. As long as you have debt you are in an emergency, and you should give up everything you can to put towards paying it off.
On the other hand mortgages are an interesting form of debt. They tend to have reasonable interest rates, and not everyone rushes to pay them off. It's up to personal preference how you address mortgages.
If you are risk averse you may treat mortgages as a debt that needs to be crushed for better stability, so that losing your income doesn't lead to foreclosure. Or you may consider mortgage payments as a mandatory expense, much like a rent payment. You can also break the mortgage payment into its two parts, and treat the interest payment as debt and the remaining principal as a mandatory expense.
These are bills that must be paid to live your life. Housing and repairs, commuting for work, groceries, utility bills, insurance, and so on. Failing to pay these bills normally results in an crisis. Therefore your first priority should be to always have enough funds on hand to cover your mandatory expenses.
If you are out of debt, then you'll want to keep a cash runway that's roughly three to six months worth of mandatory expenses. This is subtly different than mainstream advice, as they recommend several months of your total expenses instead of just your mandatory ones. I find that overcautious. You're better off investing those extra funds.
More importantly is that if you have to burn some of your cash runway by dipping into that emergency reserve, you are in an emergency! Stop all discretionary spending, and only do the bare essentials until you are safe again.
It is easier to turn one million dollars into two million than it is to turn one dollar into two dollars. This is because money's power grows faster the more you have of it.
Investments are ways of giving up cash in the present for the prospect of even more cash in the future, and they take countless forms. For personal finances this is usually buying stocks, buying real estate to rent out, or buying tools for your business.
Investments are a powerful tool for gaining financial independence. With enough of them, you will be able to retire and still have a growing surplus of value thanks to the power dynamics of contemporary capitalism.
Investments should be a fourth priority, and come after establishing an emergency fund. This is because of the risk involved with investing. You must be ready to lose some of the money you put into investments, as the future is always uncertain. Investments should also come before discretionary spending.
Fun / Discretionary Expenses
You can control how much money you spend on discretionary expenses. These will be things like dining out, buying new floggers and toys, vacations, recreation, gym and fitness fees, and so on.
The goal is not to cut out all fun spending entirely! Instead you should consciously set your acceptable amount of spending, and try to find cheaper ways to maximise your happiness. The less money you need to spend to be fulfilled, the better. If you keep yourself happy, you'll be more productive overall.
What To Look For With Categories
WhiskeySauer's original post has several great examples of how this categorical view of cash flow reveals areas where you can improve spending. For instance the general rule for housing is "30% of your income." If you're spending more than that, you're bleeding yourself dry. Get a roommate or change location!
If you have debt, you want to see it being consistently paid off every paycheck. There should also be almost no "fun" spending for as long as you are bound in the stocks and chains of debt. You want to see large amounts of money being sent immediately to pay off debt, that way you're never tempted to spend that money on anything else.
If you have no debt then you should invest a reasonable amount of income. Heed the saying "Spend one, save one" and start at 50% of income invested if you're new, or aim for 75% if you like the thrill of chasing financial independence.
Finally, keep tabs on your fun money spending! Make sure you stay within your budget by checking how close you are to it each week – or daily, if you need to. The act of needing to check your budget will make you more mindful, and will ideally cause you to think twice every time you want to spend money. Is a cup of coffee really worth needing to sit down and track that expense later?
How Many Categories?
Too many categories is no different than looking at each and every single expense. Too few and you will only garner vague notions of your spending. I find it reasonable to track around twenty categories, including refuelling costs, other car fees and repairs, groceries, eating out, insurance, and hobbies/entertainment.
This level of detail gives you insight into the minutiae of expenses. Perhaps you drive an 11 MPG truck that costs you hundreds every month, inflating your mandatory expenses. Or perhaps you have a used car that costs little in fuel, but it keeps needing costly repairs that add up over time and drag down your savings rate.
However, tracking more than the simplified four categories takes mental power. In my case I run my finances off of a spreadsheet that does the categorisation for me. If you are a pencil and paper type, it's more reasonable to track something like eight categories.
Tracking your finances is just the first step on the path to freedom. "What you can measure, you can predict. What you can predict, you can control."
Always mind the three goals: make money, invest as much of it as you can, and keep yourself happy. Knowing your finances makes it easier to budget, but you still need to put in the effort. It's the everyday grind, the tiny decisions and habits that add up.
Not every month will go well, but as you gain more experience you'll find that it becomes easier to exercise your control over finances. With enough practise you'll be satisfied as a Mistress/Master/Maestro of your own finances.