If you visit personal finance websites (see our top 50 favorite personal finance sites) chances are you’ve come across the term “envelope system.” This is a popular way to help people who want to reduce their debt or simply get a handle on their spending. In its purest form, you take your paycheck, cash it, and divide your cash into envelopes according to budget categories. For example you would have an envelope for bills, food, eating out, gas, and so on.  When spending in any of your envelope categories, you turn to the envelope and draw out the cash you need to cover your expenses. If you find your envelope empty before your next pay period, you then would not be able to spend any more in that budget category and you would NOT borrow money from any of the other envelopes. What this system does is force you to stay within your budget by category and hence stay within your overall budget. It makes you think about spending because you actually handing over hard earned cash so in theory you should think twice about your spending.

Of course, it’s hard to pay bills in cash without having to visit the payment offices of your gas, water, sewer, electric companies, and sometimes these aren’t even local to where  you live. They also may not accept cash payments in the mail, and besides, it certainly isn’t wise to mail a lot of cash in an envelope. Thus, it’s highly likely that the majority of people who rely on the envelope system pay their bills online through an ACH transfer out of a bank account, or with a debit card or credit card account number. They only use the envelope system for food, eating out, and other purchases that you would make at a cash register in a store.

Here’s the biggest problem we see with the cash envelope system. It’s risky to carry a lot of cash. If you cash your paycheck at a check cashing service, you will pay a check cashing fee (versus paying no fee for direct deposit to a bank account or prepaid card account).  You might get robbed walking away from a check cashing place or at any point on the way home. Your cash stash might get stolen by anyone who discovers it in your home.

Finally, some personal finance gurus argue that using cash actually makes you spend more. If you have three twenties in your pocket, a $5 ice cream cone is in easy reach as a spontaneous purchase, but you may resist that cone if you thought about putting it on a credit card or prepaid card, just because it’s a small purchase put on plastic, and some merchants frown on that due to the swipe fees they pay.

Virtual Envelope System

Now imagine that you are using some budgeting software. Today there are many to choose from, or you can even set one up yourself in a simple spreadsheet. You set your budget categories in your electronic budget system. Your starting point might be historical spending going back a year or six months. It’s easy nowadays to download your transaction history from your checking accounts, credit card accounts, and/or debit card accounts. Then import that transaction history into your spreadsheet or budget software. Budget software can even show you your spending categories in a nice pie chart view, or  a table that may help you recognize patterns such as overspending immediately after payday.

Next, like the real envelope system, you divide your savings balance among your different categories. Then—and here’s the harder part with this digital system—you have to have the discipline to not go over your spending limit in each budget category or “virtual envelope.” How do you do this? By checking your budget spreadsheet each time you go out the door, so you know where you are for that category. Say, your “monthly MP3 budget” is $10 and you see that you’ve spent $10 last night downloading ten songs on iTunes, then you can’t buy any more MP3s until next month.

How debit cards make this easy is that you rely on them for all your spending. Avoid your credit cards (because you are likely trying to pay them down). Then, when you download your transaction history, all of that data will flow into your various spending categories automatically.

With a debit card you might lose it or get robbed but your money can remain safe. You have eliminated the risk of carrying cash. You will hopefully think twice about using your plastic for small spontaneous purchases.

With either system, you should soon learn the fine art of budgeting and be on your way to financial well being.