Budgeting 101: Creating a budget in a nutshell
Financial Planning
Intro (The Warm Up)
Creating and maintaining a budget is a skill that not many people like to talk about or actually follow through with and manage. Interestingly enough though, according to a 2020 survey from Debt.com where they polled 1,000 individuals, they found that 80% of people do actually budget. That number was 68% from their 2019 survey. Finally, 88% of those budgeters said it got them — or kept them — out of debt. It leads us to believe that Americans are becoming wise when it comes to managing finances, eliminating debt and building wealth. Budgeting, whether everyone wants to believe it or not, is an important part of your life if you want to be successful and in balance with your finances.
Defining Income and Expenses
Before you can get your budget off and running, you need to distinguish between the different types of income and expenses you have. Remember, when creating your budget, you take income minus your expenses.
Income
First, let’s talk income. Your net income is the amount of money you take home after taxes. Not all income is the same. You can receive income from a variety of sources.
Fixed Income
Fixed income is the set salary amount of money you earn by the end of the month for your services or work. Fixed income could include business income, fixed monthly salary, fixed investment, or any other fixed or set profit you receive.
Variable Income
Variable income varies and depends on factors revolved around your performance. It includes bonuses, returns from investments, profit from side hustles, interest income, tips, etc. Since you can’t be sure of how much you’ll make in bonus, this will go into the variable income column. Add up all of your sources of income to determine your total net income for the month. This is the first step when creating a budget.
Expenses
Next, it is time to deal with your expenses or what you spend your money on each month. Expenses can be broken down into three types. There are fixed, variable and discretionary expenses.
Fixed Expenses
These are the expenses that need to be paid no matter what. Examples of fixed expenses include a mortgage, rent, insurance, set fees among other expenses. These expense are uncontrollable. If you do not pay them, you can run into legal issues.
Variable Expenses
These are the expenses that you can control. Examples include buying groceries, and shopping for clothes among others. Variable expenses can be reduced which is why they vary per month.
Discretionary Expenses
These are the expenses that are not necessary in your life. Examples may include luxury and holiday shopping. In order to afford these expenses, saving for them well in advance is key.
When creating your budget, breaking down your expenses into the three types will help you manage your budget successfully. You will know what you can and can’t afford each month, and make the appropriate changes in advance of creating your budget.
Why You Need a Budget
It ultimately comes down to spending less than you make. If you can do that, you have successfully lived on a budget. If you spend more than you make, you have essentially created or added to your debt. Living on a budget gives you freedom, going into debt by spending more than you make weighs you down. It creates barriers to your ability to grow your wealth.
Living on a budget gives you full and complete control over your money. Most people living paycheck to paycheck are not living on a budget. Every month is a guessing game. Living on a budget allows you to reach your financial goals much sooner.
Budget Goals
Speaking of goals, let’s talk about some goals around budgeting. We have to rewind a bit and think about before you even start your budget. It is important to think about your long-term money goals. What are you looking to achieve in the next year, 5 years, ten years or even in retirement. These goals will greatly impact the choices you make in your budget.
Goal Examples:
Saving $20,000 for a car in the next 24 months
Saving $10,000 for a European vacation
Fully funding Roth IRAs for you and your spouse ($13,000 annually)
Saving to buy a home
Becoming debt-free in 3 years
Avoid spending money on shoes
Writing out your goals, will help you decide how much you will put in savings as well as the categories you would like to spend your hard-earned money on.
Budgeting Essentials
You’ve set your goals and determined your income for the month. Now it is time to ensure that you have all your budget categories and funds in their proper place. This is the part that is specifically up to the budgeter, but there are a few categories or funds that you want to make sure you include. Creating your plan and categories helps you control spending.
Categories
There are a variety of viewpoints on how to organize your categories. From there you can create your smaller sub-categories. Four broad categories below will help guide you and ensure you include funds that are essential to a proper budget.
1. Money for your Future
Emergency Fund
Do you like security? That is what an emergency fund gives you. Life happens, and it can happen quickly! An emergency fund is money you set aside for life’s emergencies. You have an unexpected health problem, an appliance goes out, your basement springs a leak. How are you going to pay for it? Hopefully, with your emergency fund. Set 3-6 months of expenses into a savings account. Your emergency fund should be located somewhere you can access quickly and you should not touch it unless there is an emergency. Buying the latest Jordan’s is not an emergency!
Retirement Accounts
Pay yourself first. Before you pay any bills or do any shopping, a portion of your earnings should be distributed into your retirement account(s) for your future self.
Time flies so planning for your future is key. You do not want to have to depend on your kids or the government to take care of you in retirement.
Debt Payoff
No one likes debt. Especially consumer debt, so having a fund specifically meant to knock it out is important. If you do not currently have debt, then no need to worry about creating this fund. Just make sure you stay out of it. Just so you know, this does not include your mortgage if you have one. That’s a separate category.
2. Money for your Essentials / Needs
Next, think about what is essential or a must to be paid throughout the month. These are the things that you need to live your life. Getting your nails done or shopping for clothes does not belong here.
The categories that do belong here are things like mortgage, rent, transportation, food, and utilities. These items are often called the four walls of your budget. Keep these categories broad, or break them down if needed. For example, Utilities could be broken down into water, sewer, electric, gas and trash.
Protect your four walls.
3. Money for your Life Goals
The third broad category for your budget includes funds for your life goals. This includes money you are saving besides your retirement account. Maybe you have some mid-level goals like saving for a home, home remodel, a business or college.
It is up to you, but having separate accounts for these savings may help you organize your life and budget for these categories of savings.
4. Money for Leisure / Entertainment / Fun
Finally, it is time to create categories for your non-essentials or really anything else. These funds are for things you choose to splurge on. For example, you may have a shopping fund, eating out fund, traveling fund, entertainment fund, hobby fund or whatever else you like to do. Have fun with this category, but these funds should be budgeted for last.
4 Budgeting Methods
Budgeting can be done through a variety of ways. There is not one budgeting method that trumps all. Each method has its pros and cons and is preferred by varying individuals.
1. Envelope System
The envelope system has been around for years. This budgeting method is best for individuals who tend to overspend and need discipline in maintaining a budget. Using cash is essential to this method because it involves writing your budget categories on envelopes and stuffing those envelopes with the specific allotted amount. You cannot go over the specific amount that is in each envelope.
2. Budgeting Apps
Smartphone apps are a growing trend in regards to creating and maintaining a budget. Because most people carry a mobile device everywhere they go, it is easier to track your expenses. One major benefit to using budgeting apps is that some apps link to your financial / bank accounts to alert you or automatically update your expenses.
Some apps are free and some cost money for extra features. The most popular apps are Mint, You Need a Budget and Every Dollar.
3. Spreadsheets (Excel or Google Sheets)
The use of spreadsheets to keep a budget have proven to be a great tool that you can use on laptops, desktops or even mobile devices. The customization is a huge reason why people like using spreadsheets to budget. There are formulas you can use to quickly and efficiently add figures and get updated balances.
4. Paper / Pencil / Printed Budget Tracker
This is the more traditional method of tracking your income and expenses within a budget. The paper / pencil method of budgeting can be tiring and take a little extra work. It is often suggested to buy a specific notebook or printed budget tracker to ease the amount of writing you do each month. Depending on how specific you get, you may use this method daily or at the end of each week so that you do not get overwhelmed.
The Simple Budget – 50/30/20 Budget Rule
If you’re feeling incredibly overwhelmed right now, then starting here might be for you. The 50/30/20 Budget simplifies budgeting and could be a good place to start.
50% Needs
It states that half (50%) of your budget should consist of needs. This includes items like:
Food
Rent
Mortgage
School Tuition
Utilities
Transportation
Insurance
30% Wants
It states that 30% of your budget should consist of wants. This includes items like:
Shopping
Dining
Personal Care
Hobbies
Subscriptions
20% Financial Goals / Savings
It states that 20% of your budget should consist of financial goals or other savings. This includes items like:
Emergency Fund
Savings
Debt Repayment
Retirement (401k, IRA, pension, etc)
Budget Consistency
It’s one thing to create a budget, but sticking to it is another. There are a variety of barriers to being consistent. For example, you may forget to track and record your income and expenses.
However, there are solutions to being inconsistent with your budgeting. First, do not do it alone. This will typically be a spouse, but could be someone else. Now, you only want one person in control of the budget, but having accountability is important. Checking in, and planned budget meetings are key.
Making sure everyone in your family is aware and on the same page is also important. If you are working together toward one common goal, you will be able to save and limit your expenses.
Finally, keep your credit card use to a minimum. Using credit cards are so easy these days, but you can get much more careless and free with your spending if you just swipe for everything. If you do use a credit card, limit how many you have or use one card for specific purchases.
Conclusion (The Cool Down)
Maintaining a budget may not appear to be important on the surface, but it can be the overwhelming factor in whether or not you are successful financially or not.
Start small and simple, test different methods out and ask questions to other successful budgeters until you master it. When your expenses are less than your income, you know you are doing it right!
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