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Making a budget and sticking to it is one of the best ways to understand where your money goes every month—and what changes you could make to help you reach your financial goals. When making a budget, the ultimate goal is to avoid spending more than you earn. That sounds simple enough, but actual budgeting can get complicated fast. There are several approaches to making a budget, and the right way to do it depends on your priorities, preferences and goals.
Here are steps you can take when making a budget to ensure that it fits your lifestyle and financial goals.
1. Determine Your Income
This first step is easy if your pay doesn't change much from month to month. If you get paid monthly, that's your number. If you're paid every other week, multiply your net pay by two.
Depending on your pay schedule, there may be some months where your paydays line up so you earn an extra check within the same month. That said, it's still a good idea to budget for the norm, whether that's two or four paychecks a month, then make adjustments during months when you receive an extra one.
If your wages tend to fluctuate, consider taking the past three to six months and averaging what you earned during that time. Focus on your take-home pay instead of your gross income because that's the amount that actually winds up in your bank account.
2. Calculate Your Monthly Expenses
Once you understand your income, you'll want to similarly run the numbers for your expenses. Start by taking a look at your bank and credit card statements over the past three to six months to get an idea of what you typically spend each month.
Then break down those expenses into categories such as necessities vs discretionary spending. Create as many or as few categories as you like. For example, you can group recurring monthly charges together or split them out into groups like rent, utilities and insurance.
With discretionary spending, it may be better to break down your categories more fully. For example, eating out and entertainment don't always go together, so you may want to calculate each amount individually.
The more comprehensive your expense categories are, the easier it will be to understand where your money is going and how to manage it better. At the same time, it can also get more complicated and challenging to keep track of each category. Find a good balance you can stick to that will keep you motivated and effective.
Monthly expenses can vary drastically from month to month, which complicates things. To better stay on track, it's important to plan ahead for big or annual expenses as much as you can, including for things like car registration renewal, tax bills and home maintenance.
3. Set Realistic Goals
Once you know how you've been spending your money, take some time to set goals on how you want to manage your money going forward.
For example, if you're hoping to pay down your debt faster, set a goal for how much you'll put toward debt each month, then set goals to cut spending in certain categories to make sure it happens.
It's crucial with this step to be realistic with your goals. There's nothing wrong with being ambitious about your budget, but if you fail hard in the first month or two, you may lose interest.
Set goals that require you to stretch a little, but keep in mind that it can take time to develop the habits you want to have. It's easy to underestimate certain expenses, even if you have past data to back up your assumptions, so make adjustments as you get used to the process.
4. Track Your Spending
Tracking your income and setting goals for how you want to spend your money is one thing, but it won't do much good if you don't keep track of your spending.
Keeping track of spending can be tough, especially if you tend to make several purchases a day. Using multiple credit cards, making purchases in cash and throwing away receipts can even further complicate the process.
Consider using budgeting software such as Mint or You Need a Budget to aid in the process. These programs link up with your financial accounts and can import your income and transactions into one place. From there, you can categorize each purchase to see how what you've spent compares with what you've budgeted for the month. Based on what you see, you'll be better equipped to adjust your behavior accordingly.
In addition to the added accountability, tracking your spending can help you test your assumptions and goals and give you an idea of how to adjust them in future months.
5. Pick a Budgeting Plan
Now that you have the basics down, it's time to start thinking about whether you want to use a specific budgeting plan beyond what's already been discussed.
Here are four common budgeting methods to consider. As you read about each, think about how it resonates with your money management style and pick the one you think will be most effective for you.
With this classic approach, you allocate your money for each spending category, then put that amount of cash in an envelope with the name of the category.
When you've spent all your cash from a particular envelope, you're out of money for that given category for the rest of the month—unless you shift money from another envelope. Just keep in mind that not all bills can be paid in cash, so account for that.
The 50/30/20 budget is all about simplicity. Instead of creating several categories for each type of expense you incur, you allocate 50% of your take-home pay to necessities, such as housing, utilities and car payments; 30% to discretionary spending; and 20% to your financial priorities, including savings and and paying down debt.
Keep in mind, though, that you don't have to be married to the 50/30/20 template. If, for example, you're young or generally need to spend more resources focusing on financial goals, you may choose to put 30% toward those areas and 20% toward discretionary spending.
The Two-Account Plan
With the two-account plan, you add up your fixed monthly expenses and divide that amount by the number of paychecks you receive each month. Deposit that fixed-expense amount into one bank account when you get paid, and the remainder goes into a second account for your discretionary spending.
This approach is best if you only use cash and your debit card for purchases because you'll always know what your effective balance is. But this looser approach to tracking expenses could make it harder to manage your budget as effectively as you'd like.
Zero-Based Budgeting Plan
With a zero-based budget, the idea is to assign every dollar to something, essentially making your expenses equal your take-home pay. This approach is similar to the envelope system, but it doesn't require you to use cash for everything.
The zero-based budgeting method requires you to be detail-oriented, and there is less room for error, so it may be best used after you've been budgeting for a while. This level of detail gives you an incredible view of where your money is going, but be sure to keep at least a small emergency fund in case your costs go up or you're hit with a large expense.
How to Stick to Your Budget
Creating a budget may be the easiest part of budgeting. Keeping track of and limiting your expenses month after month so you can stick to your budget is usually the hard part. Here are some tips for staying with a budget:
- Be realistic. As mentioned before, setting realistic goals is crucial because it helps you avoid falling short. This is especially important when you're starting out and need all the motivation you can get.
- Plan ahead. It's almost a guarantee that life won't go as you planned, so it's important to keep emergency savings just in case. Also, keep in mind that some recurring charges don't happen every month. If you have any expenses that occur quarterly or annually—think car expenses and holiday shopping—make sure to plan for those.
- Use credit cards responsibly. You don't have to use credit cards if you don't want to. If you do, though, it's critical that you use your credit cards responsibly. This includes tracking your expenses so you stay within your budget. Keep your balances low and pay them off in full each month to avoid late payments and an accumulation of debt.
How Creating a Budget Can Help Your Credit
As you work to create and maintain a budget, you may start to see some improvements with your credit score. Budgeting can have a positive impact on your credit history for a few reasons:
- It can help you pay down existing debt more quickly.
- It can help you avoid high balances and keep your credit utilization low.
- It can help ensure you always have enough cash to make your debt payments on time.
- It can allow you to save more money and avoid unnecessary debt.
Because every financial situation is different, there's no way to definitively say how budgeting will help improve your credit. As your overall financial situation improves, it's possible you'll see a better credit history evolve.
Above All Things, Remember Your Goals
Making a budget can be an important step in the right direction for you. It'll show you where your money is going and where you may have room to spend less so you can save for a car, a home or whatever your financial goals are. But budgeting for the sake of budgeting isn't fun. As you work with your budget each month, remind yourself of the reasons why you're doing it. Also, evaluate your progress periodically to make sure you're on track to meeting your goals.
As you gain more control over your personal finances, it's also a good idea to keep track of your credit. Create an Experian account for free access to your Experian credit report and FICO® Score☉ based on Experian data. A robust credit history and high credit scores can open doors that can make the financial future you dream about a reality.