The Wall Street Journal chats with Steve Smith about Students and Finances

Here’s something to consider adding to your college student’s list of back-to-school supplies: a stack of envelopes.No, not for sending you snail mail. Rather, for learning how to become financially independent.
True financial independence requires living within your means. And that requires learning how to manage your day-to-day cash flow.

The vast majority of investors practice what Steve Smith, chief executive officer of online budgeting-system developer Finicity™, calls “account balance spending.” That is, they make their routine spending decisions based on the overall balance in their primary account, typically a checking account.

This works pretty well until you have an “emergency,” such as the car breaking down or a long-forgotten insurance payment coming due. Mr. Smith says 20% of our annual spending falls in the category of periodic spending—things like vacations, holiday gifts and those dreaded car repairs.

If you are spending all your cash flow on recurring expenses, such as food and clothing, and not leaving any margin for periodic ones, such as car repairs, you will be forced into the world of “fire hose management,” says Mr. Smith, wherein you pull out the credit card and get the car fixed—because you need it to get to school or work, right?—potentially setting off a cascade of interest charges, late fees and overdraft fees, not to mention a fair amount of stress.

What if, instead, you set aside separate pools of money in advance—OK, maybe not in actual envelopes, but in virtual ones—for all your expenses, the monthly kind (home mortgage) and the periodic (holiday gifts)?

This might be a daunting task for those with complex financial lives. But for a college student it’s relatively easy, and a nice way to build basic money skills and lay the foundation for a lifetime of healthy spending habits.

“If you can get your child to start thinking in terms of envelope balances rather than account balances before they go off to school, you have done them a huge service,” says Mr. Smith, who has four children, including one entering college this year.

Begin by helping your child identify all of his or her school costs (tuition, room and board, books) and living expenses (car insurance, gas, parking). Don’t forget discretionary items like restaurant tabs and concert tickets. For the annual expenses, divide by 12.

Then take your child’s income from all sources—including part-time or summer jobs, scholarships, loans and, of course, the Bank of Mom and Dad—and allocate it among the various envelopes.

Finicity’s helps automate the process by connecting with your existing bank account or accounts, tracking your deposit and spending transactions, and assigning them to various categories, or “envelopes;” the free version handles up to four online accounts and provides for a maximum of 25 envelopes, plenty for someone going off to school.

You also can do a rudimentary version of this through Internet banks such as ING Direct and even traditional banks such as J.P. Morgan Chase, which give you the ability to set up and manage multiple subaccounts online.

Scrutinize each expense, especially the discretionary ones. Sometimes the hardest thing for students to learn is how to say no to spending, especially when all their friends seem to be saying yes.

What you’re trying to do is right-size their month-to-month expenses and build a cushion to absorb the periodic ones.

With that in mind, don’t forget to include an envelope for longer-term savings, such as for a spring-break vacation or a new car.

“The best way to curb your spending is by setting a financial goal worth saving for,” says Bob Stammers, director of investor education at the Chartered Financial Analyst Institute.

Envelope-balance spending is hard-core. If the dining-out envelope runs dry before the month is over, your student will be forced to make a choice: Steal from another envelope (bad choice) or forgo dining out until next month (good choice).

A word about credit cards: Some advisers feel college students should not have credit cards to fall back on. Others feel credit cards, used responsibly (i.e. paid on time and in full), are helpful in building a student’s credit history.

San Diego financial adviser Deborah Fox had her son get a few credit cards when he was in college. He graduated last spring with a credit score of 760, which enabled him to finance the purchase of his first car with an interest rate of 2%.

Of course, Ms. Fox also had her son earn $3,000 to $4,000 per year to cover the bills—”not to be mean,” she says, “but for him to learn how to live within his means.”

It’s a lesson well worth learning, but one not likely to be found between the covers of those pricey college textbooks.