When most people think of budgeting, they think of the all-too-familiar monthly budget. All of the popular budgeting tools are set up to track budgets on a monthly basis. And most of our income and expenses are on a monthly cycle. But while a monthly budget is an important part of sound money management, there are some very important reasons to also create an annual budget.
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I first read about creating an annual budget in Kimberly Palmer’s excellent book, Generation Earn. In her book, she cites a study that found college students underestimated their monthly expenses by 40 percent, but overestimated their annual expenses by just 3 percent. The reason the annual estimate was much closer to reality, oddly enough, was due to a lack of confidence. Annual estimates seem to be much harder to make than monthly ones, so we tend to add more to the budget just to be safe.
An annual budget has several distinct advantages over a monthly budget. First, it forces us to factor in periodic expenses. Most folks, for example, pay auto insurance every six months, not monthly. Life insurance is typically paid once a year. And various fees, dues and taxes are often paid just a few times a year.
Second, an annual budget forces us to be more realistic about unexpected expenses. Hopefully our cars do not need service every month, but they likely will need costly repairs once or twice a year. The same is true for our homes. While estimating these future costs can be challenging, an annual budget forces us to make our best estimate of these costs that are sure to come up sooner or later.
Third, an annual budget brings into focus certain seasonal costs. Many families take a vacation during the summer. You may have an annual family reunion to attend. And buying gifts during the holidays can be a very big expense for some. By taking an annual perspective of expenses, we capture our best estimate of these non-monthly costs.
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Fourth, it’s worth spending some time to think even beyond a year when it comes to finances. Most of us probably don’t buy a car every year, but it’s an expense we should budget for long before we buy the car. My 25th wedding anniversary is three years a way, and I’ve started budgeting for the gift I plan to give my wife (she’s earned it!). And then there is the cost of college for our children, and the list goes on.
Finally, preparing an annual budget is a great way to evaluate your financial situation. For example, with mortgage rates at historic lows, you may be planning to buy a home or refinance an existing mortgage. How will those decisions affect your finances this year? You may be considering starting a business, which will likely have a significant impact on your finances. Or there may be other significant life changes that you anticipate over the next several years. Thinking about how these events may affect your money and planning well in advance can go a long way toward better preparing you financially and otherwise.
Preparing an annual budget may seem impossible at first. But as you reflect on the upcoming year, your list of expenses, and your future plans, you’ll find that it’s quite doable. And it will give you a perspective over your finances that a monthly budget simply cannot.