Setting a budget is an important part of being financially fit, but many people have trouble sticking to their budget once they get it down on paper. One way to resolve this problem is to use an envelope system. This system works best for people who only pay cash for items instead of operating with credit or debit cards; however, almost anyone can make the envelope system work for them.
How the Envelope System Works
The envelope system involves creating an envelope for each of the different categories of spending that are in your budget and that aren’t fixed or automatic expenses. Essentially, you should create an envelope for expenses other than things like a mortgage, utility, debt payment or savings, all of which should be deducted automatically from your paycheck as soon as it comes in. For instance, assume you want to spend $400 on groceries each month, $300 on entertainment, $100 on dining out and $20 on clothing. You would create an envelope for groceries, entertainment, dining out and clothing.
Once you have an envelope created for all of your expenses each month, you will put the amount of cash you have allocated for that particular type of spending into that particular envelope. If you plan to spend $400 on groceries each month, you would put $400 into your grocery envelope.
Each time you incur an expense in a particular category, you then use that envelope to pay from. This means when you go to the grocery store to pick up your week’s groceries, or a carton of milk or any other item, you would pay cash out of your grocery envelope.
Once the money in that envelope is gone and has been spent, you do not spend any more money on that category until the next month when it is time to refill the envelope. This forces you to remain accountable and to stick to your budget so that you do not have any unexpected overages at the end of the month. It also makes you more aware of how much you are spending, especially when the cash in your envelope starts to get low.
Modifying the System to Use Credit Cards and Debit Cards
Those who use cash may like the envelope system, but if you are using debit or credit cards, you might wonder how it could be of help to you. The answer is that you use the system in pretty much the same manner, but you have to be a bit more disciplined about moving the money over.
The basic premise is that when you charge the money on your credit card or use your debit card, you move the money from the relevant envelope into a different envelope dedicated to paying your credit card. When you charge $20 on your debit card for groceries, remove $20 from your grocery envelope. You can also do this virtually by setting up different sub-accounts on online banking websites.
Of course, using this method requires a lot more discipline and is not the ideal way to use the envelope system as it defeats the purpose of physically handling the cash and seeing the cash decline over the course of the month. Still, for those who simply cannot use cash, a modified envelope system can still be a good way to get control of your finances and ensure you do not overspend.