Image courtesy of Pixabay
Did anyone else look at the calculator upside down to see if it spelled something? No, just me?
When it comes to budgeting, there are many different systems out there. I've seen the envelope system, spreadsheets to track expected versus actual expenses, incremental and activity-based methods, and dozens of others. While I use my own combination of various methods I've seen, there is one concept that has protected my wife and my accounts as we travel down the road to financial independence. And it's not even a new concept, but it's been a lifesaver on more than one occasion. It's the concept of overage.
The Power of Overage
As I've mentioned before, we use Mint.com for all of our expense tracking and a (complicated) spreadsheet for projecting out income and expenses over time. At its core, the sheet does a calculation of Income - Expenses = ? If this number is positive, we gained money during the month. If it is negative, we lost money. The problem with this calculation is it makes it difficult to plan for larger expenses. Let's say I plan to purchase a new (okay, new to me) car in a year and a half. Each month I might show a positive gain to my accounts. But how will I know I have enough money in my account to pay for that sleek (quit judging - beauty is in the eye of the beholder) used vehicle?
The simple answer is "when you have enough in your account to cover the cost." But what about all those other expenses during the month, many of which I have on auto-payment from my account. Considering the high cost of account overdraft fees, this is a detail I cannot afford to miss. Enter the idea of overage.
Overage can be called "fluff," "safety stock," or "insurance." We set up our spreadsheets to always look for a certain amount in our checking - in our case, $5,000. Any more feels like we are not using our funds effectively. Any less and we are at risk for several expenses hitting and overdrawing the account.
The calculation changes to Income - Expenses - 5000 = ? Now if this number is 0, we still have $5,000 in the account. If we make a mistake in planning, the overage keeps us in the green. We may be "negative" according to the formula, but it is easy to adjust spending in the following months to bring us back to even.
Another advantage of this method is having a built-in emergency fund. After addressing immediate bills, the emergency fund is the next most-important item. Estimates range for this fund between 3-6 months of living expenses. While our $5,000 overage does not fully make up these expenses, it puts us ahead of where we would be otherwise.
So you see, the idea of an overage amount helps maintain our accounts safely. How do you manage your finances from month to month? Do you think overage is a valuable concept? Let me know in the comments!