Budgeting

When learning about managing your finances, many experts will recommend you begin with a budget. A budget is a tool that tracks income and expenses, and it allow you to set goals and make plans for the future. Developing a budget for a specific project, for a special event, or to help you with your monthly spending are all examples of using a budget to help you manage your financial situation.

Your Personal Budget

A personal budget is a financial planning tool. Every person should have a personal (or household) budget to keep their spending under control. An effective budget will give you a clear picture of your expected income, a complete look on where you spend your money, and help you set (and achieve) realistic savings goals.

To build your personal budget, you will need to gather your financial records, spend time to categorize and analyze your current spending, balance this against how much money you expect to earn, think of other expenses that you might be facing in the future, and put everything together to fit in with a long-term financial plan.

Gathering Your Financial Records

Your financial records include things like your receipts from the last few months of spending, your credit card and bank statements, your recent pay stubs, and your rent/cell phone contracts. When you are building your budget for the first time, gather as much information on your past spending in one place as you can.

Your goal when gathering your financial records is to have a completely clear picture of how you already spend your money. The biggest challenge of building a good budget is making sure it is realistic. Having the records of how you already spend your money in front of you is the best way to plan moving forward.

Categorizing and Analyzing Your Spending

Next, take a look at just your spending from the last month. Your goal is to separate all of your spending between Needs and Wants, then by Fixed and Variable.

Needs and Wants

Your “Needs” are the things you need to survive. This would be things like your rent, utility bills, groceries, medical bills, and taxes.

Your “Wants” are things that you chose to spend money on, but in theory could have been cut. Eating out, holiday gifts for friends and family, TV/streaming subscriptions, and new clothes might be in this category.

Once you have taken all your spending and put it in these two “buckets”, you will need to divide it again into “Fixed” and “Variable” expenses.

Fixed and Variable

Your “Fixed” expenses are recurring every month, which you can reliably plan for. This would be thinks like your rent, or a subscription fee for a video streaming service.

Your “Variable” expenses change from month to month. This might be how much you spend on fashion, how much you go out to eat, or how much you spend on gas for your car.

Putting It All Together

Once you finish, put everything into a spreadsheet or a piece of paper in 4 boxes – “Fixed Needs”, “Fixed Wants”, “Variable Needs”, and “Variable Wants”. Every penny you spent last month should be listed in these boxes.

Once you finish one month, do the same thing for the month before. What you want to see is an “average” of what you’re spending in each category. The more months you can look at, the better!

Balance Against What You Earn

Once you have taken an honest look on how you spend your money, you can start to balance against how much you earn.

If you earn all your money from one single full-time job, this part is easy – just look at your most recent pay stubs. But if you have a part-time job or some side hustles, estimating your income each month gets a bit harder.

The more months back you can look, the better. You should take an average of what you have been earning – do not assume you will always make as much as you did last month, or your “best” month. Remember: be honest with yourself. You would much rather have extra income left over than always expecting more income than you actually get.

Now you can see how much you are already spending against how much you are already earning. If you already earn more than you are spending, great! But regardless of what you already see, there is still more planning to do.

Looking Ahead

Before setting your savings goals, take a few extra minutes to look ahead. There are several strategies to avoid Spending Shocks, but most come down to spending a few minutes for planning. Think about what holidays are coming up, and how much you plan on spending on gifts. If you visit the dentist twice a year, include that in your “Variable Needs”, so you have the extra cash set aside BEFORE the visit.

Again, building a budget is all about being honest with yourself. Pretending expenses are smaller than they really are, or do not exist, is the fastest way to break your budget. Being able to effectively “plan ahead” for your variable expenses is one of the cornerstones of success.

Setting Your Savings Goal

Now that you have an honest look at how much money flows in and how much flows out, you can set a realistic savings goal for every month.

Your savings goal will come from two concepts – Pay Yourself First, and your Emergency Fund.

Pay Yourself First

“Pay Yourself First” means that you are making your savings goals your #1 priority and is consistently proven as the most effective way to hit your long-term goals. A “Pay Yourself First” strategy means that before you pay any bills or address any other expenses, you set aside your savings so it is absolutely “taken care of”.

With a “Pay Yourself First” strategy, it means you would rather hit your savings goals and be occasionally late on other payments than wait until the end of the month and only save what is “left over”. This means that your savings goal sits at the very top of your “Fixed Needs” every month, and always gets done.

If you are using a “Pay Yourself First” savings strategy, you only look at your income to set your savings goal. A good savings goal should be at least 10% of your expected income every month. With this in mind, you might need to immediately look to find ways to adjust your other expenses to make sure you can always hit your target.

What you do with your savings is up to you – investing can help your savings grow but has risks, while keeping it in a savings account is safe but might not be the fastest way to build wealth.

Your Emergency Fund

Your Emergency Fund is extra savings you have set aside in case of “emergencies” – big, unexpected expenses that might completely break your budget. If you are just starting an emergency fund, your first target should be to save up enough cash for 1 month of expenses, and hit that goal by the end of a year. Your long-term target is to save up to cover 6 months of expenses within the next 5 years.

Your Emergency Fund is not part of your regular savings – if your emergency fund is “low” (meaning less than 1 month’s expenses if you are just starting out), you should aim to double your monthly savings – this means taking a big hit from your “Variable Wants” spending. If you ever need to dip into your Emergency Fund to cover unexpected expenses, you will need to cut back again in the months afterwards to replenish.

Unlike your regular savings, your Emergency Fund should not be invested. It should be set aside in a savings account, available for immediate withdraw in case of emergencies.

Basic Budgeting Strategies

We have a whole other lesson focusing just on budgeting strategies, but when you build your first budget keep these tips in mind:

  • Be honest with yourself. If you are not honest with how you are spending money now, you will never be able to effectively control your spending in the future.
  • If you need to make budget cuts, focus on “Fixed” expenses. If you can shave money off your rent or recurring monthly subscriptions, it will have a much bigger long-term impact on your savings goals than if you skip going to the restaurant once or twice next month.
  • Use automatic transfers for your savings to move money from your checking account to your savings account, either every time you make a deposit or at a fixed time each month. If you do not need to “remember” to set aside your savings, it makes it much easier to hit your savings goals.
  • Spend a few minutes each month doing a “Status check”. Just checking your bank balance might not be enough – doing a quick look at your bank balance, credit card balance, and any bills that you have not yet paid will give you a good feel for how much you can safely spend without breaking your budget.
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About Kevin Smith

Kevin is the content manager for Personal Finance Lab and is from Chicago, Illinois. He has a Master's Degree in Economics from Concordia University in Montreal, Canada. In addition to an economics background, he has also built training manuals to prepare finance companies for licensing requirements in mortgage loan origination and insurance sales.