Takeaways
- Budgeting improves your chances of meeting long-term financial goals.
- Selecting a budgeting method that matches your personality improves adherence.
- Budgeting helps improve your ability to save, invest, and pay off debt.
- Choose a budget that aligns with both your short and long-term money goals.
- Creating a budget only takes a matter of minutes.
What Is a Budget?
A budget is a financial plan based on your income and expenses that helps you decide how and where to spend your money. It considers all your sources of income and how much money you would like to spend throughout the month. If you create a budget, you will have a financial roadmap with guardrails to help you achieve your goals.
Budgeting is incredibly valuable because it helps you manage your monthly expenses, pay for necessities, pay off debt, buy large-ticket items (e.g., buying your first house), and meet long-term savings goals. Think of your budget as your business plan.
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Why Budgeting Matters
Budgeting is one of the most powerful financial tools, but it gets a bad rap as being difficult and time-consuming. The reality is that anyone can create a budget effectively in minutes, and the financial clarity that mapping out your expenses can bring is worth the time and attention.
Here are four ways that creating a budget can improve your financial life:
- Aligns with Your Financial Goals: Creating financial goals is the cornerstone of any successful financial planning effort, and the power of budgeting is that it coordinates your spending to achieve your financial goals. Making your money work to achieve your goals is one of the capabilities of a well-crafted budget.
- Helps You Pay off Debt: If you are trying to pay off your credit card debt, student loans, car note, or any other type of consumer debt, creating a budget can help you free up more of your monthly cash flow to achieve this goal.
- Meeting Your Savings Goals: No matter where you are with your savings goals, budgeting can help you put more money toward building your emergency fund, slush fund, or investment account.
- Gives You a Rich Life: Money facilitates what you want to do in life. Budgeting can help you lead a fantastic life by giving you more intention with your spending. The more conscious you are about where your money is going, the more you can focus on doing things you love.
How to Create a Budget
Creating a budget is an essential step to sorting our your personal finances. Here are the seven key steps to start your budget:
Step 1. Set Your Financial Goals
The best way to build a budget is to start with the end in mind. By creating financial goals, you will know what goal you need to accomplish first. This could be meeting a specific goal, such as paying off debt or saving for an emergency fund. Or it could simply be to spend less than you earn. Your financial goals may evolve depending on where you are in your financial journey.
Writing down your goals will give you the insight you need during the budgeting process to prioritize your spending to meet your goals. The recalibration of your financial goals with your income and expenses is what the budgeting process is all about.
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Step 2. Revisit Your Past
Now it is time to review your spending history. Have you been spending wildly, or have you been relatively disciplined? Has your spending allowed you to meet your financial goals? Has a lack of tracking your expenses caused you to spend too much?
Taking a spending inventory can help this process. Conducting an inventory means reviewing your transactions over the last couple of months. Use your online checking account or online savings account to pull your recent transactions. Give yourself an honest assessment of your spending patterns.
Ask yourself questions like:
- Did I spend more than I made last month?
- Did I plan for this purchase?
- Was I able to make my minimum debt payments?
- Did I achieve any of my financial goals?
An honest review of your spending patterns will give you clarity and allow you the opportunity to chart out a new course of action for the future.
Step 3. Calculate Your Income
Budgeting with a top-down approach allows you to focus on the two key levers of any budget: income and expenses.
The first step of constructing any budget should begin with summarizing your total income. Your monthly income should include every source of money generated that month. These income streams traditionally include your paycheck, side hustle earnings, or investment income (interest or dividends). But don’t forget other forms of income such as royalties, tips, alimony, disability payments, or social security.
Read More: What Is Discretionary Income?
As a major lever to any budget, increasing your earnings can significantly improve your financial life. However, when you increase your income, you must simultaneously avoid lifestyle creep. Resisting the natural urge to increase your spending in correlation to your earnings can drastically increase your savings potential.
By earning more money, you can spend more, meet your savings goals faster, and pay off debts quickly. Planning how to earn more money is just as important as designing your spending.
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Step 4. Determine Your Expenses
The next step in the budgeting process is to take a full inventory of your spending. This includes thinking about your fixed and variable costs throughout the month.
Fixed costs are monthly costs that do not change over time and are longer-term in nature. Here are some typical fixed costs: mortgage, rent, or insurance.
Variable costs, in contrast, fluctuate based on your consumption patterns. These costs go up and down depending on your level of consumption during the month. Here are some typical variable costs: food, transportation, clothing, or travel and entertainment.
After mapping your monthly variable and fixed costs, factor in expenses such as mandatory debt payments. These could include credit card payments, student loan payments, fluctuating mortgage payments, or other types of consumer debt.
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Step 5. Choose a Type of Budget
The type of budget you choose should align with your personality and financial goals. There are a variety of budgets that mesh with different personality types.
Here are four popular types of budgeting systems to help you live a rich life:
Zero-Based
The idea behind zero-based budgeting is that every dollar of income is matched to an expense. At the end of the month, income minus expenses equals zero.
Zero-based income is particularly useful for people who have a regular monthly income. This allows you to map out where each dollar is going to go in your budget every month and assigns a use to that dollar. Not all money has to go toward expenses. Instead, you can assign money to goals such as paying off debt, savings, or investing,
One of the challenges with zero-based budgeting is that if you are overspending in one area, you must borrow from another area of the budget. This can complicate the budgeting process and makes tracking your spending goals regularly throughout the month essential. Saving up a slush fund to help offset moments of overspending can help.
Because of how important it is to track every expense, a zero-based budget is often used by people who have been budgeting for a while or need serious accountability.
Envelope System
If you like handling cash, the envelope system could be for you. The envelope system follows the same process as the zero-based budgeting system, except that at the beginning of the month, you pull out all your income in cash.
Once you have your cash, you take envelopes and assign them a responsibility for the month. For example, if you assign yourself $300 for the month to go out to eat, you have an envelope titled “Eating Out." Every time you want to go to a restaurant that month, take cash from the “Eating Out” envelope to spend on your meal.
The point of the envelope system is to manage your money. Physically touching and deciding where every dollar is allocated brings a high level of consciousness to where your money is being spent throughout the month.
If you use credit or debit cards, this system is probably not for you. If you don’t like the idea of walking around with a lot of cash, this system is probably not for you, either.
50/30/20 Method
The 50/30/20 budgeting method is a more simplistic view of budgeting. The 50/30/20 budgeting method advocates for breaking down your whole budget into three expense categories:
1) Necessary Expenses - 50%
2) Discretionary Expenses - 30%
3) Debt and Savings - 20%
Much like the zero-based budgeting systems, the 50/30/20 allocates every dollar of income to the three categories. For first-time budgeters, this can be a great option because it is straightforward to follow.
One of the disadvantages of the 50/30/20 budget is that for budgeters with high debt loads – student loan payments, credit card payments, car notes, etc. – dedicating only 20% of your after-tax income to this category might not be enough to cover those expenses. The same is true for heavy savers. For those looking to accelerate their savings, emergency fund, or investing, savings of only 20% might not be enough to reach their financial goals.
Passion Budgeting
Passion budgeting is the process of aligning your spending with the highest impact for happiness, or what brings you passion. In this system of budgeting, you take an inventory of your past spending and categorize your spending into categories including housing, food, transportation, fun, clothing, and others.
The next step is to rank your categories in order of importance to you. For example, if spending money on fun brings passion and joy to your life, then you would rank this category at the top of the list. And if all you use your apartment for is sleeping, then it might end up at the bottom of your list. Once all your categories are ranked, it is time to analyze how to allocate your spending into categories that bring you the most happiness and cut expenses in areas that don’t.
Generating passion in how you earn money is just as important as spending on things that make you happy. Do you love your job? Does it spark passion in your life? A passionate income can help you earn more money and be more sustainable throughout your career. Passion budgeting seeks to maximize fulfillment with your money and life.
Ultimately, the budgeting system you choose needs to help you along your financial journey to meet your personal financial goals.
Step 6. Leverage Technology
Sticking to a budget can be difficult. Over 70% of Americans don’t follow their budget. There are countless distractions throughout the month that can derail a budget. Luckily, there are budgeting apps that can vary in methodology, user-friendliness, scope, and other features.
These budgeting applications can help you track your expenses, categorize your spending, set financial goals, send progress reports, and help you adhere to your budget. Leveraging technology can keep you on the smart money path.
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Step 7. Track Your Progress
Everyone needs to set a financial touchpoint. Whether that is at the end of every month, quarter, or year, revisiting your budget and tracking your progress is an integral part of achieving financial success.
After you have made an honest assessment of your financial performance, adjusting your budgeting system or process based on your success in meeting your financial goals is part of the process.
Budgeting is an essential pillar of personal finance. While not every budgeting system is made for everyone, everyone should be budgeting. Getting your budget right can help you plan, execute your goals, and give you the financial clarity to live a rich life.
Smart Summary
No matter where you are in your financial journey, you can benefit from creating a budget. Whether you adopt the 50/20/30 budget or envelope budget, planning where you are going to spend your money is essential for making smart money moves. Budgeting lets you get a clear picture of your personal finances and lets you calibrate your income and expenses to meet your spending, saving, and investing goals.
