Some of the text here is from DR's forums:
Q. What is a zero-balanced budget?
A. The idea of a zero-balance budget is that you make a
home for every dollar, every month. This has to reflect reality - it's not
some pie-in-the-sky perfect budget that you'd like to be able to stick to.
It has to be realistic. You know how much money is coming in each month
(you do, don't you? You need to.), so you start from that number. There
are some great budget forms on Dave's site. Using the categories on that
budget form, figure out your numbers. It'll have places for everything you
need to spend money on, from saving and gifting to groceries and shaving
cream. Adjust there until you have a home for every dollar you're
receiving - in other words, the difference between what you are getting
and what you have allocated is...drum roll please....zero.
Q. What is the envelope system?
A. On Dave's budget form you'll see some categories with
asterisks next to them. These are items you should be paying for IN CASH.
Not all of us use every category that Dave recommends for the envelopes,
and that's ok. But here's how it works. Take the grocery envelope, for
example. You've budgeted $xx.xx per week. Take that amount of money and
stick it in an envelope and write "GROCERIES" on the outside. When you go
to the grocery store, pay for it with cash from that envelope. Don't buy
anything else with that money, and don't buy groceries with any other
money. When the envelope is empty (here's the key to this plan) stop
spending till it's time to put more money in it. You can do this weekly,
monthly...whatever works out for you. Most of us do it by pay period.
Q. What happens when I run out of money in groceries and
still have a week 'til the next budget cycle?
A. Try to figure out why you don't have enough money. Did
you overspend on unneeded items? Did something unexpected come up? Did you
buy the $30 bag of dog food at Sam's and not have enough because of that?
It may be that you need to increase your grocery budget and after playing
with it for a month or two you will figure out what it actually needs to
be. My pre-Dave budgets were for $400 for groceries for two adults and two
kids (one is a teenager) for a month and no restaurant. We could never
stick to that. It's now $600/month plus $75-100/month for restaurant and
that is working OK. It'd be nice to have more restaurant but that's the
point of this whole thing - deny now to pay for past mistakes and reap
vast rewards later.
If you really need to get a gallon of milk, look at the
budget and see if there is a category which hasn't been used up yet and
get some money from that one - and don't forget to lower the amount you
can spend in the category you borrowed from.
Q. What has this meant for my family?
A. In the past we (I) had tried a rough budget that we
could never stick to. I didn't have enough budgeted for basic household
expenses and it never changed from month to month to account for monthly
differences - it was an ideal that we could never live up to. My wife
wasn't in on this stuff though, she let me pay the bills and juggled as
needed and be the Quicken guru. She doesn't like messing with Quicken and
I would get frustrated with trying to do it all and go blow money we
didn't really have, especially at Sam's club - we just had to have that
new DVD set.
Back in May of 2004 I got The Total Money Makeover from
the library (I'm always getting some financial type book and reading it).
It was sitting around because I hadn't gotten to reading it yet and DW
(dear wife) picked it up and started reading it. After we both read it and
started getting on board with what was in it we attempted our first real
budget in June. We didn't have enough time to get it together and June was
a half-assed month but it was much better than previous months. We had
agreed to make up a budget that we would both follow (VERY IMPORTANT!),
had a rough draft of the budget (we hadn't figured out that you put your
actual expenses for that month not a dream month in it), and started
setting up the envelopes for cash categories. For July we were really
starting to get the hang of how the budget should work, increased a few
household/food categories since we wanted to not go over budget. DW's
income is variable since she can work 10-15 hours per week and it doesn't
matter to her boss. We set her income at the 10 hour/week level in the
budget and the amount over that goes towards credit cards/debt snowball.
Other benefits include:
Q. How does the debt snowball really work?
A. We had 20+ credit cards (duplicates, both our names,
really around 10 accounts) with balances on 5 of them. We closed all the
accounts that had a zero balance and one of the cards had a small enough
balance that we paid it off in one month after getting the $1000 EF done.
Don't close the non-zero accounts because that can cause interest rates to
go up and look bad on your credit report.
Here's how it works though:
Arrange all your debts in order from smallest to largest.
Include medical bills, student loans, paycheck loans, family loans, auto
loans, boat/rv/other loans, credit cards, and mortgage/second mortgages.
If the loan amount for a single debt is greater than your annual household
income move it out of the snowball to step 6. Also put the primary
mortgage in step 6. Figure out from your zero-balance budget what you have
left after your main living expenses (food, utilities, mortgage, etc.)
Find the minimum payment for each debt and pay that for all except the
debt with the smallest balance irregardless of interest rate. On the
smallest debt pay all the other snowball amount, hopefully carving big
chunks of it each money and rapidly paying it off. If you find that you
don't have enough to pay minimum payments on all your debts look at your
other expenses again and try to cut those more, if you still can't carve
out enough from those get a second or third job or sell some stuff to get
your income up and get rid of those debts. Things to sell would be ATVs,
boats, motorcycles, classic cars, 3rd TV, things like that. Cut your cable
service to a bare minimum or off entirely, get rid of the cell phone for
your 4 year old, etc.
Here's a simple example of the snowball in action:
That's $995 in minimum payments and you find that you have $1200 to go towards the snowball. Pay minimum on all but the Medical bill, which you pay $225 on. The next month you pay another $225 on it and it's gone. Month 3 you pay $244 (minimum payments on the other things have dropped a little by now plus adding the $50 from on CC1 with a balance of $576 and it's paid for by month 5. Now CC2 gets $298/month and will be paid off in month 12. This continues until month 27 with the last payment on the car. To speed things up you could sell things (garage sale), sell the expensive car and by a $2000 bondo buggy, and/or get a part-time job or two to increase income. Selling the car (assuming you are $1500 upside-down on it and buying a $2000 replacement) will cut the snowball time from 27 months to just over 15 months. A year difference!
Q. Why not order the debts in the snowball with the
highest interest rate to be paid off first?
A. With the time period that most people spend on the debt
snowball ordering the debts by interest rate will make less than one month
difference. The psychological difference of being able to pay off some of
those smaller debts and get them out of the way far outweighs the small
monetary savings of the other method. This motivation can help keep people
on track with the snowball.
Q. What are sinking funds?
A. When setting up a zero-balance budget there are
typically categories that you use to save for future known expenditures.
For example, you know that you'll need new tires in 4 months and they'll
cost $400 for the set. Set aside $100 from each months budget into a
special envelope or savings account. Save for furniture, upcoming
dentist/doctor bills, trips, car repairs, anything that doesn't fit into
the monthly budget that you know is coming up basically.
Q. Why pay off the house early? I'll loose my tax
advantage then.
A. Imagine that you have a 15-year fixed rate
mortgage for $100,000 at 6% interest. Your monthly payment would be
$844/month with $5885 being paid in interest the first year. If you are
able to exceed your standard deduction by that amount you would then save
about $1950 in taxes that year; (on the best year, this savings
decreases each year). Sounds great right?
What if you didn't have that house payment though? You
would have an extra $844/month but have to pay $1950 more in taxes, or
$163/month. So basically if you pay off the house early your net increase
per month will be $680 or almost $8,200 per year! That's a nice vacation.
You also have the comfort of knowing that if you get laid off or something
extraordinary occurs that your house cannot be taken - you OWN it!
Q. How do I eliminate car payments forever? I like having
nice new cars every few years.
A. Dave has a general guideline that the total value of
your vehicles should not exceed 1/2 of your annual household income. If
your family makes $60k/year then your cars shouldn't be worth more that
$30k (present value). Cars ALWAYS go down in value and you shouldn't have
large amounts of your net worth tied up in assets that are going down in
value. How can you get rich that way? That being said, check this out:
Assumptions: Household income of $60,000, two cars needed, current car payments are $480 on one-year old $25k car and $400 on four-year old $21k car. Values are $20k and $6k respectively. Loans are for five years.
What you want: Replacement every 4 years on each car. New car costs $25,000. Old car can be sold for $5,000. This keeps car value at $30,000.
What to do:
If you cut back vehicle expectations you can really cut back on the monthly amount that this takes and the length of time it takes to get into the final cycle.
A better example would be: Replacement every 5 years on each car. Cars are two year old used cars worth $17k (same car as before, just two years old instead of new).