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When making a budget, the idea is to make sure your expenses don't exceed your income. 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 some things to think about and steps to follow when making a budget so you can make sure it best fits your lifestyle and financial goals.
Why Is Budgeting Important?
A budget is a foundational piece of a financial plan. If you're serious about reaching your financial goals, making a budget and sticking to it can help you achieve them. Here are some of the benefits of making and following a budget:
- Live within your means: If you haven't been budgeting up to this point, you may often wonder at the end of the month where all your money went. It's even possible that you're running a deficit and taking on credit card debt to cover the difference. A budget can help you live within your means when you use it to set clear boundaries for your spending.
- Pay off debt: Making a budget is about taking control of your finances. If you're working to get out of debt, decide how to allocate your spending to prioritize paying more toward debt payments. For example, if you notice that you spend a lot on entertainment, you can set a budget to only allow yourself to spend up to a certain amount on that category. Then use the savings to pay down debt.
- Save money: Long-term savings goals are also an important part of a personal budget. Think about setting aside money each month to save for retirement, a vacation or a home down payment. In the short term, make sure to save enough for an emergency fund. A budget can give you better control over how you spend your money, allowing you to cut back on spending and save more.
- Reach financial goals: You likely have financial goals you're working toward. But if you don't have a budget, it can be tough to know where to focus your efforts and make meaningful progress. A budget can help you decide how much money to allocate for each goal to keep yourself accountable.
While these are general benefits of budgeting, take a moment to think about why you want to budget. Whether it's due to a short-term need, long-term goals or simply to understand where your money goes, knowing your reasons for budgeting can motivate you to keep up with it.
How to Start Budgeting
Whether you've tried budgeting before or you're completely new to the concept, here's how to get started:
1. Determine your income.
This first step is easy if your pay doesn't change much from month to month. If it does, maybe because your hours fluctuate or your employment situation is irregular, determining your income can get a little complicated.
If your income stays the same each month, simply take a look at your last paycheck. If you get paid monthly, that's your number. If you're paid every two weeks, multiply your net pay by two.
If your pay isn't regular, consider taking the past three to six months and averaging what you earned during that time. If you know you'll earn at least a certain amount each month, use that as a baseline, then make adjustments each month for the income that goes above baseline.
Whatever you do, focus on your take-home pay instead of your gross income because it's the amount you have the most control over.
2. Calculate your expenses.
Take 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.
Create as many or as few categories as you like, based on how thorough you want to be. For example, you can group recurring monthly charges together or break them out into things 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 set goals for each one 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 the right balance that will keep you motivated and effective.
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 spend your money going forward. This is where you'll focus on why you want to budget.
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. The same goes for saving or any other financial goal.
Note, however, that unrealistic goals will only work against you and make it harder to follow your budget. 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. Also, 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 spending is time consuming, but your budget is worthless if you don't. If you simply set goals for how you want to spend your money but don't keep track of how you spend it, it's possible nothing will change.
Keeping track of spending can be tough, especially if you tend to make several purchases a day. Unclear bank statements, multiple credit card accounts and purchases made in cash 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 your financial accounts and import your income and transactions from all of your accounts into one place. From there, you can categorize each purchase to see what you've spent compared with what you've budgeted for the month.
To avoid spending too much time tracking your spending, consider setting aside time once a week to work through all of your expenses for that period. If you do it more often than that, it can feel overwhelming. But if you do it less frequently, it'll be easier to lose track.
In addition 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.
Remember, there's no single budgeting approach that's right for everyone. Learn about each one and pick the plan that may best suit your needs and preferences.
Which Budgeting Plan Is Right For You?
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 to pay those expenses.
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.
This budgeting plan can be worth considering if you want to avoid credit cards and you generally prefer using cash. But not all bills can be paid in cash, which complicates the process, and if one of your envelopes goes missing, you have no recourse if it doesn't turn up.
With a 50-30-20 budget, it's all about simplicity. Instead of creating several categories for each type of expense you incur, you simply 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 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.
If your necessities take up a good deal more than 50% of your budget, this budget plan may get you to start thinking about how to reduce that obligation, if possible. Reducing necessities may require significant life changes, such as moving or changing your transportation method, but it will leave you with more money for other categories.
It's your budget, so you choose how to allocate your funds based on your particular situation. That kind of flexibility makes this method worth considering for newbies. But keep in mind that the simpler your approach, the harder it can be to break down different categories where you can reasonably cut back to focus on things that are more important to you.
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.
For example, if your fixed monthly expenses total $2,000 and you get two paychecks a month, you'll deposit $1,000 of each paycheck into the account dedicated to fixed costs and the rest in the second account.
Tracking the first account is simple because your fixed costs likely won't vary much from month to month. If you add your savings and extra debt payments to the fixed account, you're then free to spend the money in the discretionary account however you see fit.
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. If, however, you use credit cards, it's possible to extend beyond the available balance in your discretionary spending account, putting you in debt.
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 in that what you budget for each category is set, but you can take money from other categories if you end up overspending.
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, and having more information at your fingertips allows you to make better decisions about how to manage your money.
Just be sure to keep at least a small emergency fund in case something comes up and 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 is usually the hard part. Here are some tips for sticking to 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. But it's also important in the long run as you make adjustments to your plan, your income changes, your lifestyle improves and more.
- 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. This safety net can help prevent your budget from being destroyed by something outside of your control. 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, so they don't throw you off.
- Use credit cards responsibly: You don't have to use credit cards if you don't want to. But if you do, 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.
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
- 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. But as your overall financial situation improves, it's not uncommon to 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. 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.