Creating—and sticking to—a budget is one of the cornerstones of personal finance. But if you’re struggling to find a budgeting system that works for you, you’re not alone. Using a cash envelope system can be a great way to take control of your budget.
Maybe you’ve already tried tracking your expenses in a budgeting app like Mint or Personal Capital. Perhaps you created a complicated, headache-inducing Excel spreadsheet.
Those tools work great for some people. But maybe you keep falling off the budgeting bandwagon, or you can’t figure out why your spending habits sabotage your savings goals.
If that’s the case, then cash envelope budgeting might be a good idea. This article aims to discuss the details about the cash envelope budgeting method. From there, we’ll take a closer look at how you can use cash envelope budgeting to reach your savings goals.
What is the cash envelope system?
The cash envelope system is a budgeting method where you withdraw a specific amount of cash each month for your discretionary spending in various categories (Groceries, Dining, Clothes, Entertainment, etc.) and place it in labeled envelopes.
All of your spending throughout the month for those categories is done using cash only. This means you do not use a credit card or debit card when you run out of cash. Once an envelope is empty, you stop spending for the month in that category.
When it comes to budgeting methods, it doesn’t get much easier than the cash envelope system. Though it’s been popularized in recent years by personal finance guru Dave Ramsey, this technique has actually been helping folks stick to a budget for decades.
And it’s easy to see why. Unlike some other methods, the cash envelope system includes a built-in way to control your spending. Once you use up the available cash in a spending category, you simply have to do without for the rest of the month.
Conversely, this system rewards for spending under your budget. You simply have leftover cash that you can use towards other financial goals. You can start paying down your debt snowball or build up your emergency fund.
This comes in handy when you’re struggling to stay motivated.
How to set up the cash envelope system
Getting started with the cash envelope method of budgeting couldn’t be easier. It comes down to understanding your income, creating your budget categories, and funding the appropriate envelope. That’s it!
1. Calculate your discretionary income.
The first step is to calculate your discretionary income. Discretionary income is the what’s leftover after fixed expenses. Fixed expenses include things such as:
- Phone coverage
- Mandatory debt payments
In other words, fixed expenses are expenses where you can’t really control how much you spend each month. They’re just fixed.
Conversely, discretionary income should cover the variable expenses that you can control each month. The goal is to make sure that you have savings left over each month after your variable expenses have been covered. That’s where your cash envelopes will come in.
Tip: Try to reduce your fixed expenses before starting the cash envelope system. Start by taking a hard look at your expenses to see if there’s anything you can cut completely. Here are some things you could look at more closely:
- Premium cable channels
- Gym memberships
- Cell phone plans
- Subscription services
If you’re paying a lot of money for things or services you never use, then now is the time to make changes. That will go a lot further to put some of that money back in your pocket.
2. Establish your personal budget.
Once you’ve determined your monthly expenses, you’ll want to set up a budget for the rest of your spending. There’s no rule of thumb here, but below are a couple of guidelines.
Start with a savings goal in mind.
To take a line from Stephen Covey, you should have a goal in mind. You probably know more about your budget than you think.
Most people know where their money is going. And they know what they could be saving if they could just maintain some discipline.
So if you can, start with a savings goal in mind. Let’s imagine $200 per month is your starting point. From there, the rest of your discretionary income will be allocated towards the different spending categories in your cash envelope budgeting system.
While it’s good to set aggressive goals, you’ll want them to be realistic ones. You wouldn’t hop off the couch one day and run a marathon without training. Perhaps you’d start with training for a 5K first.
Same principle applies here. Even if you think you can save $500 per month by being aggressive, start small first. And if you succeed, give yourself permission to move quickly as you get used to your system.
Mark a date in the future to review your progress.
Goals are easier to achieve when you take the opportunity to measure progress. If your 1-year goal seems daunting, start with doing a review at the 3-month mark.
That should give you time to get used to managing the cash envelope system. At the same time, you can take a pause to make adjustments.
3. Establish your cash envelope categories.
This is where you set up a budget category for each type of discretionary spending. Each household will have different ways of doing this, but the goal is to make sure that you’ve covered all of your expenses.
If you have no idea where to start, perhaps you should begin by reviewing your credit card statements.
Credit card statement review
Take the last three months’ of credit card statements, and go through each of your purchases, line by line.
No judgment here. Simply establish a budget category for each expense. After you’ve finished your review, you might have 8-12 different categories for all of your spending.
And each household is different. One person might be a foodie, so restaurants show up a lot on their statement. A different couple might be really into cooking their own meals, so grocery shopping dominates their spending.
Maybe you’ll want to combine dining and entertainment into one envelope. Perhaps you’ll add an envelope for gifts. That’s fine, as long as you spend only what’s in your envelopes.
But the point is to get your arms around your spending. That will help you determine your budget categories. Some examples are listed below.
Cash envelope categories
Examples of budget categories include:
- Household Goods
Establish your budget categories & assign a cash budget to each of them.
Decide on a budget for each of your different categories. When you do this, ensure that the total does not exceed your total discretionary income.
If you need help determining how much money to put in each category, check out some of these simple financial rules of thumb. You can also set this system up as monthly budget or a biweekly one, depending on how often you’re paid.
Some categories, such as groceries and gas, aren’t exactly optional. But you do have some discretion when it comes to how much you spend in each category—by purchasing store brand products, carpooling to work, etc.
Recommended Reading: How To Make A Budget That Works: The TMPF Guide
4. Create separate envelopes for each spending category.
This one is self-explanatory. If having snazzy, decorated envelopes makes you more likely to stick with the program—then go crazy! They even sell cash envelope wallets on Amazon.
If you’re more comfortable using use plain white envelopes with the envelope category name written on the front, then do that instead.
Tip: Color-code your cash envelopes in some way that resonates with you. That way, you can tell at a glance which one to grab money from when you’re rushing out the door.
You don’t want to confuse the grocery money with your home improvement funds.
5. Put the money in each envelope.
Reading an article about your spending limits seems real enough. But if you set aside $500 for groceries, it feels a little more real when you actually put $500 in the grocery envelope.
Even more, it feels real the first time you find yourself a little short and have to finish the rest of the month (or survive until payday) on what’s left in your grocery budget. But your cash envelope system only works when you start putting the cash into your envelopes and start working the system.
6. Save or pay down debt with leftover money.
Hopefully, you won’t spend every last dollar every single month. So what to do with what’s leftover?
If you have debt, your first priority should be to pay that down. And if you’re debt-free, you can ramp up your emergency savings or start investing.
One of my favorite things about envelope budgeting is that it makes spending tangible in a way that using credit cards just can’t.
Need to know if you can afford to order takeout? It’s as easy as peeking inside your “Dining” envelope. You’re reminded of the impact of your spending every time you grab an envelope and see what’s left.
7. Do your review and make adjustments.
While you’re going to review your leftover cash at the end of the month (or pay period), you should take some time at the 3-6 month mark to do a full review.
From there, you’ll want to see:
- Do I have the right categories in place?
- Do I need to add more money to a certain cash envelope?
- Do I consistently have extra cash leftover in another envelope?
- Is this cash management system helping me make progress towards my financial goals?
Even if you’re not making all of your goals, you’re probably better off than when you started. And if that’s the case, perhaps making your goals a bit more modest will help you stick with the plan. Because that’s the hardest part.
8. Stick with it
The cash envelope system is simple, but it all falls apart if you’re not consistent. Use cash every time.
For the first few months, you’ll be working out the kinks. Which envelope do you use for your yoga classes? How do you keep your change separate when spending in multiple categories?
As long as you’re consistent (and using only the cash in your envelopes!) you can set your own rules.
Tip: Remove your credit card and debit cards from your wallet entirely, if it helps you avoid the temptation to overspend.
Let’s look at some challenges you might run into and how to avoid them.
How to avoid potential pitfalls
While the cash envelope system has proven itself, it takes work. After all, if it were easy, then everyone would be an expert.
But even if you have a great plan, those plans can go awry. Here are some of the biggest obstacles to your success and how to avoid them.
Always remember that the cash in your envelope is a spending limit, not a spending requirement. There’s nothing saying that you have to spend it all each month. So don’t buy unnecessary things just because you still have some cash left at the end of the month.
Of course, being able to reward yourself for good spending behavior might be a good way to stick with the plan. Just be mindful.
For example, instead of blowing $200 on a celebration dinner, give yourself $50 to buy a nice steak and a bottle of wine enjoy at home.
The cash envelope system works best when you have already set aside an emergency fund for unforeseen expenses. These unforeseen expenses should include things like new tires, emergency plumbing, or a trip to the emergency vet. They should not be used just because you spent too much cash from your cash envelope.
Having at least $1,000 set aside in your bank account can prevent this kind of expense from turning into a huge budgeting roadblock. For the long-term, your emergency fund should have 3-6 months of living expenses to cover significant issues, like losing your job.
What if you’re trying to budget with a spouse or other family members? While that does make things a bit trickier, it’s totally doable. You just need to agree on the ground rules, and communicate, communicate, communicate.
Some families choose to divide the budget per person. This would allocate the most money in a specific spending category to the person who does the bulk of the spending in that category. Other couples do fine with everyone working from the same envelope. Again, the trick is the find what works for you and stick with it.
What if circumstances conspire to throw your monthly budget into a tailspin? You’ll need to decide together how to address it.
Will you dip into your resiliency fund? Or borrow money from another envelope?
Better yet, your partner might have some ideas on ways to address the need cheaply. After all, two heads are better than one.
If you hate the thought of adding ATM visits to your list of errands, try to make it a little less painful with some preplanning.
For example, does your grocery store have an ATM that you can withdraw from without fees? Or could you combine your ATM visit with your weekly fill-up at the gas station?
So, which envelope should you pull from when you go to Target and buy food, clothes, and a new book? Depending on which categories you use, that one transaction could hit on three different envelopes. It could fall under the grocery envelope, clothing envelope, or be considered entertainment.
When possible, I pull the cash from whichever category I expect to represent the bulk of my spending. From there, I would move money between envelopes when I get home. Just find a process that works for you and make sure you do it consistently.
What about digital cash envelopes?
There are lots of digital applications, such as Qube Money. These digital program create a cashless envelope system that replicates the cash envelope system.
Lots of people find these cashless envelope methods to be quite useful. But for some folks, there’s just no substitute for physical cash in a paper envelope.
The best recommendation is to try (and stick) with a system that works for you.