There are several well-known and widely used personal budgeting methods, all of which can be useful and have their advantages in certain situations, as well as flaws. I have personally tried and recommended the majority of them but have found that one of them is undeniably best suited to those who put achieving their financial goals on top of their personal agenda – reverse budgeting.

The content of this post does not constitute financial advice. It is intended for educational purposes only.

what is reverse budgeting?

Perhaps the most intuitive way that one can use to approach budgeting is to start planning for one’s financial needs first. And this is not wrong per se – everyone wants to make sure their expenses are covered, and that you’re not suddenly out of money for food or rent or medicine – things that are usually absolute essentials. Only after this is done, would the average person set aside funds for more fun activities and financial goals. That is also the reason why one of the first steps is generally analyzing, understanding, and classifying expenses.

For instance, you can take a look at the comparison between some of the most popular budgeting methods below. In the example of the Zero-based budget, you must account for all your income and expenses first (fixed and variable), before you determine what is left off and then assign a job to it. Similarly, you would categorize expenses into “needs” and “wants” under the 50/30/20 rules-based approach, before you allocate money to certain financial goals such as savings and investments. Thus, you run the risk of incorrectly applying your fixed allocation percentages if your real needs run higher than expected or if you abuse the “wants” category each month with discretionary spending you did not really need to do. Finally, in an Envelope budget, you would also generally prioritize the main spending envelopes first. For a great overview of these methods, you can refer to Athena Valentine Lent’s book Budgeting.

Unlike these 3 methods, the reverse budgeting method starts with an allocation towards meeting your financial goals first. They have to be covered in any case – which is why this seems unintuitive and risky to some people. And since the priority is your own goals, it is also called the pay-yourself-first budget. This also means you can be much more confident that you will be adequately prepared for financial emergencies and for your future financial needs. This is an important shift – also in your mindset – because it forces you to calibrate and organize your financial goals before anything else, to look at the bigger, longer-term picture before your current short-term situation (and spending).

HOW IT WORKS – STEP-by-step

You can think about this budget like this: your financial goals come first, then your expenses. While the former is a priority and takes center stage, this does not mean the latter is completely ignored. On the contrary, it is still a crucial step – but it is incorporated in a way that aims to prevent you from compromising your goals unless you have no other choice.

Step 1 – The goals
What specifically do you want to achieve financially – and by when? The idea is that you create a map of your financial future – so that you know where you are going and how you want to get there – i.e., for each of those goals, if you had to allocate funds from your pay, how much that would need to be. The goals should be realistic, feasible, and concrete. That means they need to be actionable and clear. You can cover goals over a variety of time horizons.

Some examples include:
– retirement savings
– investing
– debt repayments
– purchases of some assets or property (e.g., a home)
– periodic savings into an account, sinking fund, or emergency fund until reaching a specific amount
– achieving some level of net worth
– going back to school
– planning a big trip or a year off work.

Each goal should be quantifiable – so that you know exactly what amount is required. In that sense, some goals could require that you be familiar with your spending habits first – or that at least you have a plan about how spending should evolve in the future. The monthly amounts required for each goal is what is really important for you – as this will allow you to determine what part of your income is left to cover the regular and irregular expenditure each month. Don’t forget to factor in the time value of money when planning, especially over medium and long time horizons – i.e., some of your contributions will be compounding over time as they earn interest or returns, and they will also be depreciating in real terms (i.e., in terms of what you can buy with that money) due to the effects of inflation. These are all important assumptions to consider in such calculations, as well as other costs/fees and taxes. Timing is also a major factor – as the cumulative effects of compounding and inflation + costs become more significant, the longer the time horizon. For instance, the earlier you start investing, the more likely it is that you will achieve the target amounts faster and that you will end up with a higher amount if the end date of the horizon is the same.

Step 2 – The reality check
You need to understand your spending in any budgeting method, otherwise, you cannot plan anything realistically and whatever goals you have set, will likely turn out to be out of reach. Look into all the fixed and variable spending categories and the corresponding monthly amounts. This is what you need to cover with what is left over after the monthly allocations for your goal you determined in step 1. In all likelihood, there will be a discrepancy between what you need to spend and what you have left over – which might force you to make some difficult decisions.

You will already have noticed that it is more likely the gap you discover to be in your favor (i.e., more left over than your actual spending needs) if you have higher income and/or lower expenses. For example, people working in some sectors might be able to save the required amounts for their financial goals by dedicating just 10-20% of their incomes, leaving them with a significant amount for spending. Others, due to low expenses, might be able to save 40-50% of their monthly income, without any problems meeting their needs. So your starting point (your own spending-to-income relationship) will play a big role in whether this method will be easy for you to adhere to. This is why a potential mismatch that is not in your favor can be resolved by either increasing your income or reducing your spending. These two types of actions need to be a priority to avoid jeopardizing any goals you have set. Only as a last resort, the goals themselves could be adjusted.

It is important to not forget irregular expenses – some buffer for those must always be planned. Ideally, you could factor that in a regular allocation or as part of the emergency fund (as long as that can be replenished afterward). The reason this must be emphasized is that, if you happen to take a hit that derails your progress towards your financial goals, this could impact you permanently and delay or impede their achievement.

Step 3 – The flexibility
Monitor regularly how well you meet your targets for the monthly amounts – and if you are having difficulty or if there are drastic changes in any component, be ready to adjust accordingly. Yes, you will want the contributions you make towards the financial goals to be automated (as this also takes away any temptation to amend them frequently), but you still need to have the flexibility to adjust when necessary. Allocation goals should not make you starve or unable to pay rent.

WHY is it better?

The answer is simple – because in most cases personal financial goals are achieved by building wealth persistently and getting rid of debt. This method just forces you to prioritize exactly that – save and invest, save and invest, every month. Since the goals are always on top, they are visible, they are more likely to be hit consistently. While still retaining flexibility. It all becomes a regular habit and the stress is minimized – this unlocks additional motivation for you to focus on those goals.

There are situations in which this may not be the right budgeting method for you. If you have a tendency to overspend, or if you value your current quality of life and experiences above all else, this will be a hard approach to follow, no matter how well you define your goals. In fact, forcing yourself to follow this process could make you feel more significant discomfort and stress, which is exactly the opposite of its intent. You might also not be able to easily recalibrate spending or find additional income sources to close the gap between steps 1 and 2 – for instance, when your income is relatively low.

However, there is a misconception that this method does not work if you have a lot of debt. It does – it just needs to be prioritized in a clever way. You don’t need to bury all other financial goals until your debt is paid off. Focusing only on eliminating the debt burden can be counterproductive in the long run. There are situations where, if you cover the debt payments as they come due, you can still allocate funds to other goals that actually earn you more money. Debt can magnify your returns if used correctly and productively. You just need to know how and when.

CONCLUSIOn

Reverse budgeting is a great method to plan your financial future and manage your finances – and in many cases, superior to other budgeting methods. It ensures you focus on your financial goals first, which enables you to prioritize building wealth and achieve long-term financial security faster. Based on the process and the requirements, you will be able to decide whether it is the right approach for you.