In my opinion, getting an understanding of your burn rate can be one of the most important data points of your financial picture.
What is a burn rate?
Your burn rate, in the simplest explanation, is how much you spend. Your annual burn rate is the most telling number, but is best determined by starting with your monthly burn rate.
The reason this number is important is because it can tell you a lot about what you can and cannot do with your money, what kind of risks you can take in the future, and it gives you a baseline to track any changes going forward.
Some individuals may avoid tracking their burn rate because they do not want to know the number, or feel bad about how much they are spending - but you cannot live without spending, so there is no need to feel bad! It is important to understand it so you can structure your finances and create realistic goals.
Here are some important factors to consider and benefits of knowing your burn rate:
Knowing how much you spend
Duh… your burn rate tells you how much you spend. This is important because it gives you a gauge of where you currently stand. Once you have this number, DO NOT google if it is a good number. Everybody has a different situation and you shouldn’t be comparing yourself to others, but instead getting a feel for what this number means to you.
My recommendation is to ask yourself how this spending feels to you. What are some of the categories that you spend most of your money on? Is that in line with the type of life you want to live? A great example is eating out - do you love eating out? Or is it just easy? If it’s just easy, consider finding new ways to eat at home like meal prep or weekly meal planning so that you can use that extra money on things that bring greater joy.
Once you know how much you are spending per month, you can start coming up with goals based on your spending and the remaining income available for saving. This is definitely not a one-month project… it will develop overtime, but starting now will refine your understanding of your burn rate sooner rather than later.
Risk capacity is the financial ability to take on risk whereas risk tolerance is the emotional ability to take on risk. In other words, risk capacity is how much risk you CAN take on vs. risk tolerance is how much risk you WANT to take on. I would argue that knowing your burn rate allows you to determine how much risk capacity you have, and having a lower burn rate increases your risk capacity (even if you do not WANT to take on more risk).
I have two examples of this. The first is your emergency fund. Many recommend 3 - 6 months of expenses in an emergency fund, so we will use that for purposes of this blog. A lower burn rate allows you to have a smaller emergency fund, which in turn may allow more savings for investment. Additionally, in the event that you need to use your emergency fund, a lower burn rate allows you to replenish the account quicker (since it takes less savings to refill 3 months of lower spending).
My second example is in the event you want to take an opportunity which results in loss of income. This includes starting a business, taking a break from work, changing careers, etc. Knowing your burn rate gives you an idea of your runway before you have to start covering your expenses again. This also gives you the opportunity to plan for this better, e.g. “I need to get a job in 5 months because that is how many months of expenses I have in cash”. A lower burn rate allows you to have a longer runway, which in turn may allow for more opportunities.
One last advantage of understanding your burn rate is to put a stake in the ground with which you can compare future months / years. This allows you to see if, and why, some of your spending may change in the future.
A great example of this is lifestyle creep, which is the idea of spending more on your lifestyle after getting a raise or increased income. Understanding your burn rate gives you an idea of your current spending in dollar terms as opposed to percentage terms. This is not to say you cannot spend more in the future, but gives you a starting point to recognize if spending has increased, and what has caused the increase (and if that is something intentional).
This also comes with recognizing that life changes like marriage, kids, home purchase, moving to a new city, etc. will likely have an impact on your burn rate. This isn’t to say your spending can’t change, but that it’s important to recognize how and why it is changing.
I have never found value in writing down or tracking every single expense of mine, but I have found a lot of value in reviewing my total expenses every month. It has helped me set goals for my savings and determine what risks I can take with my money and career opportunities.
Understanding your savings rate is important as well, but it comes as a function of your burn rate. You must spend money every month and getting a hold of your burn rate can create opportunities that you may not even know are coming yet.
A great way to start your tracking is through budgeting software like Mint or YNAB (You Need a Budget). I do all my spending on two credit cards so my preferred method is to sum up (on a sticky note) the total of those two cards, plus major bills that get pulled directly from my bank. There is no “best” way to do this, as everybody has their own preferences. Find what works best for you and start learning that burn rate!