In our current economic climate, there are plenty of factors to make us feel uneasy. Eggs are seemingly on the verge of replacing the gold standard, housing markets are cooling across the country, and record levels of inflation continue to affect Americans in their daily spending.

If you’re concerned about overspending, know that you’re certainly not alone. The best way to safeguard your financial comings and goings is to create a budget, and today, we’re going to take a look at the envelope budgeting method — read on to see if this approach is right for you!

What is the envelope budgeting method? 

Before the dawn of the digital age, people often paid bills by setting aside cash for each of their expenses in spare stationery jackets, a.k.a. envelopes, labeled for each individual budget category. This was the birth of the traditional envelope budgeting system as we know it today.

In this technique, the idea is to break down your monthly living expenses, savings, and debt repayments into categories and set aside the appropriate amount for each bucket — one envelope for the rent, another for the car payment, one for each credit card payment, one for savings goals, etc. 

Once the money is allocated, the goal is to keep it allocated. You don’t want to take money from your rent envelope unless you’re using it to pay the rent!

The pain of paying

One of the reasons this old-fashioined system still works (and works well) is because of the “pain of paying.” Have you ever bought something and felt… okay, let’s face it… bad? Whether we’re talking immediate buyer’s remorse or the angst of paying 25.5% APR on a maxed credit card, this feeling is all too real!

In 1996 while writing his dissertation at Carnegie Mellon University, behavioral economist Ofer Zellermayer coined the term “the pain of paying.” The concept is pretty simple — the more displeasure we feel at the register when we buy something, the less likely we are to buy it (or buy it again). The experience, he explains, doesn’t feel like we’re acquiring something to better our lives, but more like we’re losing money. 

Even more intriguing, Zellermayer discovered that paying with cash was more painful than by card or electronically. Since the concept’s introduction, it’s been used to help individuals curb spending due to the negative reinforcement associated with loss.

So, what does this have to do with the envelope budgeting system? It goes hand-in-hand with the methodology — if you try to take money from one cash envelope to pay for something else, you’re setting yourself up to experience the pain of paying!

Advantages of envelope budgeting

As with any budgeting system, there are definitely advantages. Here’s a look at several benefits that the envelope budgeting system provides:

  • The barrier to overspending is higher, making it more avoidable
  • It’s visually clear how much money is earmarked by the amount of cash in separate envelopes
  • You can combine this budget system with others, like zero-based budgeting or a 50-30-20 budget, just by labeling the envelopes accordingly
  • It’s completely customizable, giving you as much freedom as you want

Disadvantages of envelope budgeting

It’s important to remember that all budgeting methods aren’t created equal. What works for a doctor in Long Island might not be the best approach for a recent grad in Louisiana. When it comes to the envelope budgeting system, here are a few drawbacks:

  • It’s inconvenient (and inadvisable) to be dealing with so much physical money
  • It’s time-consuming to set up your budget manually each month
  • The system doesn’t work well for monthly expenses that are estimated or variable
  • There aren’t any guidelines for how much money should go toward expenses (or even which expenses to include)
  • You probably won’t have enough cash on hand to fill all the envelopes at the start of the month, so you’ll have to figure out which envelopes to fill when
  • There are no prescribed savings or investment goals

How virtual envelopes improved the envelope budgeting system

Why use virtual envelopes instead of tangible ones? For one thing, we strongly urge our readers to avoid keeping large sums of cash in envelopes around the house. It’s a bad idea to keep that much cash on-hand — you don’t want to misplace that rent amount or have your dog chew up your BMW payment. 

Even though the cash envelope system is based on traditional budgeting, you can still apply its concepts and central tenets to the digital age. How, you might ask? It’s simple — you can allocate the money in your checking account to virtual envelopes, which you’ll then use to categorize your monthly spending. 

Although you can set these virtual envelopes up in a spreadsheet, there’s nothing “tying” those envelopes to your bank account — if you spend money, it doesn’t look like you’re taking those funds out of your envelopes. So using a spreadsheet doesn’t trigger the “pain of paying” to help you keep your budget on track.

Instead, you can use a money management app like Simplifi to manage and track your virtual envelopes. With the ability to set spending goals and create categories for each expense, the app makes creating digital envelopes a breeze. You can even set up alerts to notify you as you approach your spending limits and easily see where your money is going.

How to start an envelope system budget

Allocating your money to designated categories can keep you on track to avoid overspending while making sure your bills get paid. Want to give it a try? Here’s how:

1. Figure out your monthly income

Start by determining how much you’re bringing in each month — after taxes. You’ll want to use your net pay because that’s how much you’re going to have for your actual spending. 

If you get weekly or biweekly paychecks, this should be pretty simple — take a look at your bank statement and multiply the amount deposited in your bank account by 4 for weekly or 2 for biweekly. You’ll actually end up with a couple of “extra” paychecks over the course of the year, but that’s a good problem to have.

If your income changes month to month, try to make your best estimate of your income for each of the last 3 months and average them — and remember to stay consistent. If you had an unexpectedly high income for one month, make sure not to base your budget around it!

Once you determine your monthly income, you can start on the next step. 

2. List your monthly expenses to create envelope categories

Everyone’s situation is different, so you’ll need to do some work to figure out where you need to spend your money each month. Remember, if you’re using a budgeting app, it should automatically create these buckets for you, so you’ll just need to go in and make sure everything is in order and add any missing categories.

If you’re creating your digital envelopes manually, you’ll need to track your spending categories in a spreadsheet. Try starting with these:

  • Housing, like your rent or mortgage
  • Car payments, maintenance & insurance
  • Other travel expenses
  • Food and groceries, including take-out
  • Utility bills (electricity, water, gas, internet, cell phone)
  • Health insurance & other medical costs
  • Entertainment & social events
  • Credit card payments
  • Retirement savings & emergency fund

Remember, average expenses can differ from person to person — so start with your monthly income and be sure to cover fixed expenses, like rent or car payments. 

Then, determine the variable expense categories where you want to place your remaining income, like a personal entertainment budget or contributions to an investment or savings account. This is especially useful if you have money left over at the end of the month.

3. Adjust and adapt

Remember, your budget isn’t likely to be perfect right from the jump. It can take a few months to lock in a budget that works for you! And that’s okay — just keep monitoring your expenses and adjust when you need to. 

If your variable bills, like the utility or grocery envelope, start going over (or if you don’t set enough aside on the 1st of the month), you can dip into categories like your entertainment or clothing budget to offset the cost. If you have money left over each month, you can add it to an appropriate envelope, such as your savings.

The idea is just to stay consistent. Once you figure out the rhythm and flow of your budget, you’ll get the nuances of your expenses dialed in and have an easier time setting aside the appropriate amount for each of your digital envelopes next month.

4. Stick to it

There is one universal rule that applies to all budgets — they don’t work if you don’t stick to them! This very much applies to the envelope-based system. If you’re battling overspending and feeling like your money just doesn’t stretch as far as it used to, then sticking to your budget is the best way to make your money work for you. 

By adhering to your budget, creating adjustments when needed, and making a concerted effort to stay on top of your personal finances, you can manifest better spending habits, reduce your overspending, and ultimately, continue the journey to reach your financial goals.