Wednesday, March 7, 2007

The Envelope System - What is it?

This is a three-part series on the financial tool called the envelope system. In the series I will cover what the envelope system is (this post), how to set one up and, as a real world example, how I have leverage it in my finances.

When I was a kid anytime I earned money whether it was for my dad, or my mom would try to extol her financial vitures and disciplines upon me - one of which was the envelope system.

The envelope system is a quite simple yet powerful method of money management that requires you to budget out most of your expenses/savings goals by category assign it an envelope and then set aside requisite money to fund each envelope. Once the money in a particular category is spent you should fight with every fiber of your being not to "borrow" from another envelope. Doing so will mess up the balances of your other envelopes and potentially result in insufficient funds when it comes time to pay certain bills.

In the most dramatic of circumstances TMac is slaving away all day cleaning pizza pans and gets paid $200 dollars at the end of the week. Mom drives him to the back to cash his paycheck and he asks for $10's and $20's in return. When he gets home, he goes up to his bedroom and pulls out his binder with different envelopes attached to it. On the envelope is written the item he is saving for and the amount he is supposed to contribute (either a % of net pay or a fixed amount). He then allocates the approiate amount into each envelope. Typically when the amount in the envelope got to be large enough he would open a savings account specifically for that envelope and once there was a couple hundred dollars stashed away he would deposit it into the bank (The bank tellers would always look at him funny when a 14 year old kid would walk into the bank with four passbook savings accounts and gangster rolls of cash to be deposited, but I digress).

Some of the main benefits of the envelope system are:

  • Information - At any time you can simply look into your envelope and see exactly how much money you have and how far you go to meet your goals.
  • Automation - Once the system is set up and you have decided on the contribution amounts for each envelope, there is no longer a decision to be made each time you have money to be paid. The fixed amount that you need to pay certain bills and expenses gets correctly allocated.
  • Irregular expenses can be easily planned for - Any irregular amount payment can be easily planned for by simply annualizing the payment then dividing by the amount of times per year that you get paid the resulting number is the amount you put in the envelope each time you get paid.
Check back tomorrow when I discuss how to implement the envelope system in your own finances.

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Very interesting series you got going on here. Though I should say, there are some people out there that aren't as big on carrying cash (me for example) I personally loathe retailers who only accept cash. Whenever I have only cash on me, I always 1. spend it all too quickly or 2. lose it. More 2 than 1. I have a similar idea to your envelope method. I'll have to share it one day soon.



Ok Juan, I have a solution to that issue of carrying cash. The answer will be outlined in part three of the series because I grappled with the same issue! The system wouldn't work for me if I couldn't use plastic.