Budgeting 101: What is a Budget and How to Start Budgeting
Knowing how to create a budget is an important money skill that everyone should have. Creating a budget is pretty straightforward, and anybody can do it. All you need is a bit of effort and a few basic skills that you will learn from this guide. When you learn how to make a budget and understand the importance of sticking to it, you take control of your money rather than letting your money control you.
What is a Budget?
A budget is a plan for spending your money. A budget helps you understand how much money you make and how you spend it. It also ensures that you include your financial goals in your spending. You can make a budget using a spreadsheet, an online tool, or just a pen and a piece of paper.
Do I Need a Budget?
A budget is necessary for people who think to themselves, "I don't know where all the money goes." But budgeting is not only for people who have difficulties with keeping their spending under control. Budgeting is immensely helpful to virtually anyone. The main goals of budgeting are:
- Ensure you don't spend money you don't have and avoid debt.
- Prepare for emergencies and figure out your financial goals and work towards them.
- Identify your bad spending habits and show you potential areas where you can cut unnecessary expenses and put the money to better use.
- Get the big picture of your financial situation and set priorities to maximize your money potential.
Why is Budgeting Important?
Budgeting has numerous benefits and can help people in different financial situations. Firstly, creating a budget helps determine if you are "living within your means", or in other words, what you spend is less than the amount of money you earn, or at least is equal to it. A budget helps you make sure you have enough money every month for all your mandatory living expenses.
A budget helps you figure out your financial goals and make them realities by actively working towards them. Even if you think you don't have money right now for your big life-goals, creating a budget can prove otherwise. In any case, setting financial goals is the first step towards your financial wellness.
Another benefit of budgeting is that it helps you set priorities by revealing whether you have the resources to spend on items you want versus those you need. Planning and monitoring your budget will help you identify unnecessary expenses and indicate when you need to adjust your spending to free up money for the important things, like your financial goals. Seeing the breakdown of your expenses may surprise you. You may find areas where you can cut back without affecting the quality of your life one bit.
Sticking to a budget can help you avoid or reduce credit card debt and increase your net worth. All in all, a budget can put you in a stronger financial position and help you decide where your money should go instead of wondering where it all went.
How to Create a Personal Budget?
The basics of creating a budget are simple - know how much money you have coming in, figure out your monthly expenses, and then create a spending plan to allocate the money in a way that will benefit you the most.
If you are creating a budget for your family, it's essential to involve all family members in the process. Implementing the spending plan will have better success if all members are part of the decision-making and everyone understands the goals and the need for cutbacks.
Remember that budgeting is not just a one-time event. You will need to track your spending over time and update your budget as needed. It won't be perfect in the beginning, and that's alright. It usually takes several months to refine your spending plan. Here is how to make a monthly budget in nine simple steps:
1. Choose a Tool to Help You Manage Your Budget
You will need a tool for tracking your income and expenses to create a budget. You can use pen and paper, a simple or automated spreadsheet, or a budgeting app. You don't need to commit to a tool right away. It is easy to switch between them at any time. You can try various tools over time and see what works better for you.
- Use Money Knack's free online budget planner and calculator. This tool automatically calculates your expenses and provides a clear summary of how your money is allocated.
- If you prefer a physical format, download our printable budget worksheet to see how much money you've spent this month, and then use this information to help you plan next month's budget.
2. Set Your Financial Goals
Your financial goals should be a part of your budget. It's a good idea to come up with a list of goals before creating your budget. Having financial goals in your spending plan is important when you decide how much money to spend and how much to set aside for your goals.
Think about your short-, medium- and long-term financial goals. That may include paying off debt, creating an emergency fund, saving money for retirement, creating an educational fund for your children, saving for a home down payment, or anything else you are striving to achieve. Even if you don't have the money yet to contribute to your goals, adding them to your plan is the first step to making them realities. When your budget indicates that you have some money to allocate - you will know where it should go.
Related: How to Set Your Financial Goals
Most budgeting tools recommend saving a minimum of 20 percent of your income each month, which should be used for building an emergency fund, paying down debt, growing your retirement accounts, and other long-term savings.
3. Decide on Your Budget's Cycle
Most bills follow a monthly schedule and a monthly budget is the most logical choice for most people. But if you prefer to create a weekly or bi-weekly budget or a budget for any other period - it's totally fine. The main goal is to make budgeting work for your situation.
4. Figure Out Your Income
If you decide to create a monthly budget, start with calculating your monthly income. Make a list of all of your income sources. Your list may include your salary, freelance gigs, income from investments, child support, social security, disability, and any other income you may have.
If your income is irregular, examine your earnings over the past several months to identify patterns or averages. This method may not yield an exact figure for each month, but it will provide a reasonable estimate for your budget. Or figure out and use the lowest monthly income. This more conservative approach ensures you can cover essential expenses during leaner months and save the surplus earnings from more lucrative periods for emergencies or future expenses.
Regardless of your income type, include only the take-home money - the net income after tax deductions, benefits, and other contributions. Once you have all amounts, add them up.
5. Identify Your Expenses
Aggregate all your monthly expenses. You can start by recording everything you spend money on in a month and looking at your bills or bank statements. In short, you need to figure out all ways your money leave your pocket. When you have the list of all expenses, you will need to categorize them.
6. Break Down Your Expenses Into Categories
After identifying your expenses, categorize them into two groups: essential and discretionary. Evaluate whether each expense is a genuine need or merely a want. Place all necessities under "essential expenses" and all wants under "discretionary expenses".
Essential expenses encompass the mandatory living costs necessary for your day-to-day life. Essential expenses include rent or mortgage payments, transportation costs, minimum credit card payments, medical expenses, insurance premiums, and household bills.
If some bills are due every few months, divide the amount owed by the number of months the bill spans. For example, if your car insurance is $600 every six months, divide this amount by six to determine your monthly expense for this bill.
Discretionary expenses are things that you want versus those you need. Discretionary expenses are cool new gadgets, dining out, movies, shows, vacations, and manicures. You are in total control of these expenses and should examine them to ensure they stay under control and don't take away from your essential expenses and goals.
Essential expenses aren't just recurring bills. Many regular monthly charges can fall under discretionary spending. For instance, a monthly subscription to a streaming service, unlike a monthly electricity bill, should be classified as a discretionary expense. Be careful not to confuse recurring discretionary expenses with essential ones.
7. Include Your Goals
If you regularly contribute towards your financial goals, you can add them under your essential expenses. Alternatively, you can create a separate category for your financial goals. Creating a dedicated category may work better if you can't contribute toward your goals regularly. How you label your goals is up to you - the key is to ensure you include them in your budget. However, it may be unwise to put your goals under discretionary expenses.
8. Get the Full Picture
Now, it's time to get the full picture of your cash flow. Add up the expenses from all categories, and then subtract that number from your monthly income.
If you get a positive number - that means you're earning more money than you're spending. You have a surplus and live within your means. But it doesn't mean you don't need budgeting. You can create a spending plan that will further benefit your situation and will help reach your financial goals faster. You can allocate the extra money to retirement savings or make an extra payment on your mortgage or student loans. A spending plan will reveal the money leaks you may want to address to have even larger amounts of extra money that you can use in better ways.
If you come up with a number close to zero, it may seem like you have just enough money, but there is no margin for life's surprises. If you get hit by unforeseen events for which you aren't prepared, you could be left scrambling to cover your costs, especially if you don't already have an emergency fund. In this case, consider adjusting your budget and finding ways to lower your monthly expenses to create a buffer in your spending plan.
If you get a negative number, you are living beyond your means. You may want to figure out ways to cut down your spending on things you don't absolutely need as soon as possible. A monthly budget is a great tool for prioritizing your needs over your wants. Of course, for many people it's not going to be a sole solution, and if your situation requires, you may need to find an extra source of income.
9. Refine Your Budget and Make It Work for You
Now, when you understand your cash flow and have a good idea of where your money goes, you can put your budget to work. Use this information as a template to help you plan next month's budget. Make adjustments to your spending by identifying the areas where you have overspent and where you may be able to prune back.
Start with the discretionary category and eliminate any wasteful spending. Wasteful spending refers to money used on items and services that do not provide significant value, such as unnecessary consumer goods, entertainment, or convenience purchases.
Once you've removed discretionary expenses that offer little value or could be better spent elsewhere, the next step is to evaluate whether you can reduce the essential expenses.
For example, while having a cell phone service is essential, an "everything unlimited" plan may fall under the "wants" category. Consider exploring more cost-effective plans that still meet your needs. If your existing plan is already budget-friendly but still strains your finances, you might consider switching to a mobile virtual network operator (MVNO).
If you've been with your car insurance company for a while, it's worth comparing rates with several other insurers. You might find more appealing options, even if your current coverage was the cheapest when you first signed up.
By comparing options, you can discover more affordable alternatives for almost any expense, ensuring your budget stays manageable.
10. Create a Buffer in Your Budget
Besides including your goals, it's a good idea to create one more category called "sinking funds" or "unusual". This category will be for any unusual and sporadic expenses that don't fall into the categories with regular monthly expenses. Examples of "sinking funds" could include holiday, wedding, or birthday gifts, school supplies, new car tires, veterinary bills, vacations, and so forth.
For example, let's say you want to save for holiday shopping. First, think about how much you typically spend during the holiday season. Then divide that amount by 12 to get a monthly amount you should set aside each month to prepare for your holiday spending.
That way when something comes up, you will be able to cover it without taking away the money you have already put somewhere else. Keep track of expenses that frequently end up in this category and if they turn out to be not that unusual or unexpected, move them into one of the categories with planned expenses.
Tip: You can transfer all unspent funds from the "Sinking Funds/Unusual" category to your emergency fund or allocate them toward your goals in the next budgeting cycle.
11. Practice Budgeting to Zero
Zero-based budgeting is a technique that involves allocating every dollar you earn to specific categories until there's nothing left. The strategy is to assign every dollar of your income to all expense categories until you are left with zero dollars. By making a plan for every dollar you get, you know exactly how much to spend and where to spend it.
This approach can help discourage frivolous spending and push you to save more. It makes you aware that any impulsive purchases will need to be offset by cuts from other categories, which may be more crucial for achieving your goals.
How to Create a Zero-Based Budget
Creating a zero-based budget follows the same process outlined in this guide but includes an extra step. Begin by subtracting all essential expenses from your income, but hold off on including discretionary spending, goal-related expenses, and unusual costs in the calculation. The amount you get is the excess money that you can spend or save.
Now when you know that your necessary expenses are taken care of, you can allocate the rest of the money for your financial goals, unusual expenses, and the things you have listed in the discretionary spending category. You can assign the left-over money to these three categories to make sure that every dollar has a job and is being used how you want it.
Once all income has been allocated, you've successfully created a zero-based budget. Use this budget next month as a guide to determine your spending allowance for each category.
You've probably heard the adage to "pay yourself first". It means that you should prioritize your financial well-being before you do any other spending.
Evaluate Your Budget Periodically
It is unlikely that you will spend your money exactly how you planned. And that is alright. Your life will be changing and your financial plan will have to change, too. Evaluate and adjust your budget periodically to ensure it's right for the current situation and that your financial goals are still on track.
1. Don't confuse frivolities and luxuries with necessities. Eating is a necessity, eating at a restaurant is a luxury. Categorizing your expenses will help with cutting back on spending. If you need to find areas where you can cut unnecessary expenses - discretionary expenses should be examined and trimmed first.
2. Don't underestimate your expenses. It's better to overestimate your expenses and then underspend and end up with extra money.
3. Don't overestimate your income. It's better to end up with cash leftovers rather than fall short.
4. Try to avoid lifestyle creep. Just because your income increases, doesn't mean your discretionary spending need to increase as well. Instead of finding new ways to spend money, consider saving more for your financial goals and paying off debt.
5. Avoid debt as much as you can. If you carry a balance on your credit cards, you may want to make paying it off a priority. Paying ever-accruing credit card interest is one of the least useful ways to spend your money.
6. Watch the small expenses that can add up and become big monthly expenditures. The daily cup of coffee and soda at a vending machine might shock you when you see how much you spend on them over some time. Consider bringing your lunch rather than eating out every day and drinking coffee from the office coffee machine.
7. Prepare for unexpected circumstances by adding a well-funded emergency fund as one of your financial goals. Budgeting will help you set aside money for building a source of ready cash in case of unplanned expenses.
Related: Find more budgeting tips in Budgeting Tips That Actually Work in Real Life
All these steps look like a lot of tedious work, and indeed, this may be a bit time-consuming, but it's not as bad as it may look at first glance and the results will be worthwhile.
Many people see budgeting as just putting restrictions on themselves. A budget may feel restrictive because it suggest a lifestyle change, or at minimum, a rearrangement. But a budget is not about depriving yourself. A budget merely shows that you have a finite amount of money and if you spend a portion of it on something you want - you may not have enough for something you need. You are in total control of your money and you are responsible for setting priorities. Budget is You setting up a plan for Your goals so that Your financial independence can become a reality.