Budgeting is the foundation and road map for your personal finance. A budget is an income and spending plan. The goal of budgeting is to spend less than you earn so that you have enough to meet your savings goals as well. A good budget also anticipates surprises and emergencies that would otherwise destroy your finances.
The foundation of any budget is determining your income, your anticipated spending and your savings goals. To draw up your budget, use a spreadsheet or piece of paper. In one column, list all your sources of income. In the second column, list your expense and savings categories with dollar amounts attached to each category.
Establishing your expected earnings may be easier for some than for others. If you work a steady full-time job with a fixed pay rate, determining your income is as simple as looking at your paystub. For the purpose of budgeting, you simply want to consider your after-tax income.
If your earnings are less stable, establishing your expected income is a little harder. I would recommend underestimating rather than over-estimating. If there is a minimum amount you can count on, it might work well to use this to budget for essentials, and use anything extra on your discretionary purchases or extra savings. Likewise, if you get paid weekly, just consider four weeks worth of pay for your monthly pay. On the occasional month that you receive a fifth paycheck, you have a ‘bonus’ to use as you see fit.
Expenses and Savings
List your expense categories in order of priority and importance, with your ‘needs’ at the top and your ‘wants’ at the bottom. Remember to include savings in this list. Keep in mind that you may want to add savings or expense goals that you have not been saving in the past, such as an emergency fund, retirement savings, car savings or life insurance. Also, don’t forget about the expenses that come up only once or twice a year!
Next to each category, write down your target (maximum) spending for that category. If you have no idea what your target for a category should be, just write down how much you have spent in that category in the past- you can always change it in the next few steps. If you have to make an educated guess, that’s fine. A budget is always subject to change. If, down the road, you realize that you’ve budgeted too little for a category, you can always make adjustments.
Once you have a target for each category, add up all your categories. If your total is less than or equal to your income, great! If your total is more than your income, you need to start trimming categories, starting at the bottom (lowest priorities). This is often the hardest part of budgeting. You may be forced to start cutting out things that you’ve grown used to, such as cable, a gym membership, or even part of your grocery budget (although be realistic- no one expects you to live on $10 a week of food). Once you’ve done some trimming, re-total your categories. If your total is still greater than your income, do some more trimming until your expenses total less than your income (I realize this is much easier said than done).
Sticking to Your Budget with a Method
Now that you have a budget, you need a way to stick to it. There is no single good way to budget. A lot depends on your personal situation. You need to consider whether you are a natural spender or natural saver. You might need a different budget if most of your income is spent on needs versus a lot of disposable income. Perhaps you function better with multiple spreadsheets and accounting tools to guide your every penny, or you might just need a loose budget to guide your broad spending patterns.
Itemized or Zero-Based Budgeting
If your income is fairly tight, or if you really want to feel in control of your money, you may want to consider this budgeting method. Basically this budget divides up your income between different spending and saving categories, assigning a job to every penny you earn.
If you stick strictly to this budget, you don’t allow yourself to spend money from a category anywhere else. For example, money that has been allocated to groceries can only be spent on groceries. No ‘borrowing from Peter to pay Paul’. No using grocery money to pay for your car repair. And definitely no borrowing from grocery money to buy a new TV. Some people prefer to stay flexible, allowing themselves to borrow from certain categories to bail out others.
There are several ways to put this budget in place. Obviously for your wealth building categories, you’ll need to set up investment accounts. Set up automatic contributions to those accounts to correspond with the amounts you’ve budgeted. Do the same with savings accounts for your savings categories- have an automatic transfer scheduled shortly after each paycheck. For your spending categories, you may prefer to keep the money all in a single checking account and keep track of your spending with a spreadsheet or checkbook, or you may prefer to take the money out in cash and separate it out in several envelopes- one envelope per category. I’ve also written a post about using multiple bank accounts to create a ‘hands-off’ barebones budgeting system.
Much like itemized budgeting, proportional budgeting divides your income up among different categories. Again, this is like assigning tasks to all the dollars you earn. Unlike itemized budgeting, however, proportional budgeting divides your income up by percentages. Proportional budgeting tends to work better with broader categories, and is often divided between needs, wants, and savings. A common proportional budget is the 50/30/20 budget, where 50% of your income is put towards needs, 30% towards wants, and 20% towards savings. How you spend that money within those categories is left to your discretion.
The biggest benefit of the proportional budget is that its easy to set up. You don’t need to set specific amounts to 15 different categories. The budget is also auto-balancing. If your income drops, you don’t need to worry about re-balancing your budget- it happens for you, all the while ensuring that you are still socking money in your savings.
In practice, however, this budgeting method runs into some flaws. For one, its hard to automate. With your itemized budget, you can set up automatic contributions to your investment accounts and automatic transfers to your savings accounts. As far as I know, there is no bank that will automatically transfer a specific percentage of each paycheck. This adds hassle of needing to log into your investment accounts and bank accounts on a regular basis just to make a bunch of transfers.
If your income is tight, this budgeting method also puts you at risk of not being able to cover all your needs. Many of your needs are either fixed expenses, or expenses that you can’t quickly trim in a month when your income takes a dip. Try telling your landlord that because your income was 20% lower this month, his rent check is also going to be 20% lower. It won’t work well.
Proportional Budgeting as a Guideline
Perhaps the best way to use proportional budgeting is simply as a guideline for itemized budgeting. For most (but not all) situations, the 50/30/20 ratio is a good balance between needs, wants, and savings. If your budget falls too far out of this ratio, ask yourself if there’s a good reason for that or if you need to re-evaluate.
Of course, everyone’s life circumstances are different. You may be in a situation where your income is tight, and 70 percent of your income has to go to cover your needs, with much less to split between savings and wants. Or you may be anticipating a big life change such as a house purchase or higher education, prompting you to bump your savings to 40 percent. Or you could simply be fortunate enough to have a very large income, allowing you to spend a greater amount on wants. Whatever your situation, make your budget what works for you!
Priority budgeting is probably the easiest budgeting method. There actually isn’t much budgeting involved at all. Priority budgeting arranges your expenses chronologically following your paychecks in order of their priority. When you run out of money, you stop spending.
Assuming that you are making saving (wealth creation) a priority, schedule your investments and saving transfers to happen right after you get paid. Remember to include your emergency fund. Schedule your bills to be paid soon after that. Everything left over can be used for your regular spending. This does require a little financial discipline, since some necessities such as groceries and gas will still come out of your regular spending. If you get paid multiple times per month, you may have to move some bills around so that some get paid after the first paycheck, and some get paid after the second paycheck. If you find yourself consistently running low on spending money, you can either learn to spend less, or you can find regular bills to trim or eliminate.
One big caution! DO NOT use a credit card if you do priority budgeting. Priority budgeting works because there is little guesswork involved and because you feel budget shortfalls immediately and in a very real way (an empty wallet). Spending stops when the cash is gone. The credit card lets you keep on going even after your true ‘purchasing power’ is gone which will send you into credit card debt before you know it. And at 20% interest rates, credit card debt is the quickest wealth destroyer that the financial industry has ever created (other than payday advances).
Enjoy Peace of Mind With a Budget in Place, Watch Your Wealth Grow!
When used correctly, budgeting ensure that your needs are taken care, and your goals are being saved for. This allows you peace of mind for the present while you still plan for the future. To make budgeting even easier, consider automating as much of your budget as possible. This means you spend less time and energy sticking to your budget, while all your goals take care of themselves. With a budget in place, you can now focus on the rest of your life.
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- While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.