This is a question I get asked often, especially with the way our inflation rates have increased since the COVID pandemic. An it is often times viewed to be complicated. This is not because the process is but, because of the anxiety folks feel surrounding the “money talk”. Making a budget that works requires you to realize that a budget is is nothing more than a written plan, and plans tend to change with time. Making a budget is unique to the individual or household.
A budget is not meant to be a hard ruled plan.
It is important to remember two points of making a budget that works. The first is that is your plan and can be adjusted as needed. The second is to remember the reason we create a budget is to give you and your family an idea of where your money is going. Once you have this information you can begin the next process in setting up money goals or milestones.
As you learn, your budget will adjust. Eventually you will develop a budget that is pretty close to accurate. So breath, allow room in your budget for change.
What are the first steps in creating a budget that works?
The steps in creating a budget are easy enough.
- Set Clear Goals
- Set Realistic Savings Goals
- Gather Your Financial Information
- Record your income, detailing how much money you earn
- Document your expenses, encompassing all your expenditures
- Separate your expenses into two categories: fixed (non changing) and variable (changing) expenses
- Prioritize Essential Expenses
- Choose a Budgeting Method
- Begin your plan
- Monitor and Adjust Regularly
- Emergency Funds and Advice
Set Clear Goals
Setting clear goals can be difficult when we have so many we want to accomplish! Or at least that is often the problem that I have.
When trying to set your goals, you have to first decide what your goal is. Whether you aim to pay off debt, save for a down payment on a house, or build an emergency fund, clearly defined goals will provide direction and motivation for your budgeting journey.
What is it you want to do? Once you decide that, you need to answer two more questions. How much is this going to cost? When do you want it by?
Example:
We will say our Goal cost is equivalent to $5,000. We want to have this money saved by this time next year. Just take the cost divided by the months. In this case we have $5,000 divided by 12 which is $416.67. We would need to save $416.67 a month to reach our goal.
Set Realistic Savings Goals
If this amount is too much, try extending the time frame. If you cant, well, it is time to figure out how to bring in extra income. Don’t give up on your goals just because it is hard. You should make them attainable. If you are only making $30,000 a year, and want to buy a $100,000 vehicle. Well, you most likely wont do this in a three year time period.
…maybe work on building assets to help obtain this goal later down the road. This would mean your new goal, is to build an asset.
Saving money is a crucial pillar of financial stability and it is how you build your net-worth. Determine how much you want to save each month towards short-term goals and long-term goals. Short term goals are within three year time lines. Long term goals are time periods past three years.
Gather Your Financial Information
When creating a budget we want to be as accurate as possible. You can do this, by gathering up your information about your income, expenses, debts, and assets. This is simple enough, collect your pay stubs, bank statements, credit card statements and any other relevant financial statements you think you need to capture a complete picture of your financial information.
Calculate Your Income
Start by looking at all your pay stubs and records of income. This includes salaries, wages, bonuses, freelance or side hustle income. If you have investment income include that as well. You want to write down the total amount earned NET (after taxes) or if you are a computer person enter the information into whatever software you are using.
Put down the source and the total amount. Than add all sources together.
Track Your Expenses
You are going to do a similar thing for your expenses. This is just as critical as determining your income if not more so. Be sure to print off a transaction record (a statement) of your spending accounts like credit cards, debit cards and even payment apps like Venmo or Paypal. I know this seems like a pain…but it is the only way to get the best picture of your spending. An we only want to do this once, so you don’t want to miss any expenses.
Now the difference between calculating our expenses versus our income is that we must have two categories of expenses. These two categories are Fixed (unchanging) and variable expenses (changing). Fixed expenses are known as bills, because they are reoccurring.
Bills include expenses like mortgage, water, gas, electric, car payments, car insurance and etc. These are known as fixed expenses because the amount you pay does not fluctuate more than $5 a month.
Variable expenses are typically calculated into broad categories such as shopping, food, entertainment and etc. This is were you need to make some decisions. If you are using a budgeting system, the decision will be made for you. If you want to make your own system you need to decide is all grocery shopping and personal shopping (clothing, jewelry, household goods, and etc) going to be in one category? Whatever decision you make ensure you remember and that all parties involved in the budget are aware of your budgeting rules. Personally, I believe in keeping it simple.
For example, in our budget we will use the following expense categories.
Example: For our food category, any going out to eat or stopping for coffee with donuts will go here. Shopping is when I go to anywhere other than Walmart and Grocery stores. I realize that you can do shopping at Walmart, but my Wife typically does most of our clothing shopping at TJ Max so a majority of the time the money spent at Walmart will be groceries. As a rule, all Walmart purchases will be listed as Groceries.
Begin adding up what you spent in each category.
Prioritize Essential Expenses
Great! By now you have determined how much money your household earns and you have a pretty good idea on what you spend. I bet you were shocked…just a little, huh? Now that we know this we want to prioritize what expenses are essential to our basic needs. I suggest highlighting or marking the expense you believe are NEEDS. Typically this is housing costs like utilities, rent and groceries. Got them identified? We will come back to this to this.
Calculating all the money spent
This part of making a budget is easy enough. You want to add everything together into a final expense total and a income total.
Once you get your total income and total expense together. You want to subtract your expenses from your income. The resulting number is what you have left over.
If the resulting number is negative, it indicates that you’re spending more than you earn. If this is the case, DO NOT panic. It just means this month you overspent, remember we haven’t made our budget yet. All we have done is seen what we have spent in the past.
If you have money left over, like in our example picture. Congratulations! You have managed to save a little dough. You can roll this over into our budget that works. This extra money is called discretionary spending.
Identify Discretionary Spending Categories
Discretionary spending actually includes all non-essential expenses like dining out (Food in our example), entertainment, travel, shopping. Basically everything we did not mark or highlight as essential. These expenses add enjoyment to your life, they should be carefully watched to avoid overspending. Set limits for each discretionary category based on your discretionary income. To figure this out, add up your essential expenses and subtract this number from your total income. The answer is your left over money to do one of three things
- Save for a goal
- Build Assets
- Spend on life enjoyment (shopping, dining out, entertainment)
Create a Budget that Works
You have finished all of the foundational work to creating a budget that works. It is now time to build it. My method is a combination of zero-based budgeting, automation and I try to keep my bills, and discretionary spending within the ratios of the 50/30/20 rule.
Begin by listing out all of your bills and essential variable expenses with how much they cost every month. Make a total of all of these and try to keep it under 50% of your net income. I personally have a flex rule of 5%. Again, budgets are living plans that will fluctuate month to month. If your bills and essential variable expenses go over 55%, you want to start trying to increase your income or decrease your expenses.
This is one reason I shop for home insurance and car insurance every year.
Than list out your Savings Goals, because these should be essential to you before your added joy. Now add how much you need to save each month next to this. The total amount you are trying to save should be no more than 20% of your income. If your employer has a retirement plan, this amount does not include what you are putting into this fund.
You should be putting at least enough to get your employers full match.
Finally we get to our discretionary spending. This is all the variable expenses that bring added enjoyment to your life. Some of these will be fixed, such as Hulu or Netflix. List these out and total them up. They should not be more than 30% of your income. By the time you are done calculating these expenses as well as your savings goals and essential expenses you should have no money left to spend. A great way to achieve this is to read our upcoming article, Automating our Budget that Works.
Monitor and Adjust Regularly
Budgeting is not a one-time activity but an ongoing process that does require regular monitoring and adjustment. As we have said before, it is a living plan. Do not be afraid to adjust your budget from month to month based on your need. It is important to review your budget frequently to track your progress, identify areas of overspending or under spending. You may have a month where you feel little to no enjoyment and when you look back you realize you barely touched your entertainment or dining budget. Just be sure to stay within your financial limits. Be flexible and willing to adapt to fit your needs and goals. It will all change over time. The trick is paying attention to what did change.
Build an Emergency Fund
I wanted to put this close to last because it is important. An emergency fund serves as your safety net to cover any unexpected expenses or income disruptions. Aim to build a fund equivalent to 3 to 6 months worth of essential and non-essential living expenses. This fund should be a priority in that it is one of your first goals.
If you are one of those that tends to spend money you see or have a spouse that does this. Open an account at a different bank than the one you use. Preferably at one with a great interest rate. Set your deposits up to pull from your pay check if your employer allows. This will keep the balance out of site and out of mind.
Seek Professional Advice if Needed
If you find all of this too difficult or overwhelming, don’t hesitate to seek professional advice from a financial advisor or certified financial planner. A professional can help you develop a customized budgeting strategy, optimize your automation, and help you make informed decisions to achieve your goals.
In closing, creating a budget that works is a foundational step towards stability and growth. By following these steps and embracing these budgeting practices, you will be better prepared going forward. Of course by all means, do your due diligence and research further if you think you need to. Just remember, a key to any successful plan is to stay disciplined, and to actually commit to your goal.
