Creating a budget is one of the most common financial management tools. A budget is a plan for how you will spend your money. The ultimate goal of any budget is to avoid spending more than you earn. This may seem simple, but it can be hard to keep track of your spending without having a system in place. That’s where a budget comes in. Although it may seem restricting to create and adhere to a budget, it can actually lead to financial freedom.
Creating a budget can be overwhelming at first, especially if you have never examined your finances or spending. To help you get started, here are some steps that you can take.
Calculate Your Take Home Pay
To begin creating a budget, you should first figure out how much your take home pay is. This is the amount that you earn, minus taxes, Social Security, and 401(k). If you’re a full time worker who has submitted a W-2 form, and has your taxes and investment contributions withheld, then your paycheck will correspond with your take home pay. But if you’re a contract or freelance worker, you’ll have to calculate how much your earnings are, and subtract your taxes and investments.
Remember to account for your primary source of income, as well as any extra sources of income such as side jobs or additional part time jobs. Your final take home pay is called your net income. This is the number that you will use to create your budget. This should be a monthly number, since most budgets are done monthly. If you have your annual income, simply divide it by twelve. If you get paid weekly, multiply it by four and a third, or 4.33.
Track Your Spending
To track your spending, first list all of your fixed, regular expenses. These are usually regular monthly or yearly bills such as your mortgage or rent, utilities, car payments, student loan payments, and child care costs. These expenses should be pretty consistent from month to month.
Next, list your variable expenses. These may change each month, and include both necessities and non-necessities. Things like gas, groceries, and medicine are necessities, while things like entertainment, leisure travel and dining out are non-necessities. However, what’s considered a necessity may vary from person to person. For example, a certain amount of clothing is a necessity, but at some point it becomes discretionary spending. Think about what you personally consider to be essential for you to live a normal life.
To help you determine how much you typically spend on variable expenses (necessities and non-necessities), you can look through a few months of credit card and bank statements. Try dividing charges into a few categories, like food, entertainment, and medical, and take the average of each category from several months. You could also keep track of each purchase manually or with an app. After analyzing, you may find areas where you could potentially cut back on spending by switching products or services, purchasing less or less frequently, or forgoing the purchase altogether.
Determine Your Financial Goals
Before actually making a budget, it is important to determine your financial goals. These should include short-term goals and long-term goals. Short-term goals should be achievable within the next one to five years. They may include things like paying off a particular smaller loan, earning a certain amount of money in your salary, or upgrading to a larger apartment.
Long-term goals may take several years to achieve, but they are still important to identify and work towards. Long-term goals could include saving for retirement, becoming entirely debt-free, or saving for your child’s education. You can change your short-term and long-term goals at any time. In fact, it is good practice to revisit your goals often, to make sure that they are still important to you and that your financial habits are in alignment with your goals. Identifying your financial goals can help you in making and updating your budget, so that you know what your priorities are.
Create The Budget
There are a few ways to actually make a budget. Two popular budget rules include the 50/30/20 rule and the 70/20/10 rule. Both of these allocate the majority of your money towards needs or necessities, and then split the remaining among savings, debt, and other expenses.
Budgeting With the 50/30/20 Rule
The 50/30/20 rule allows up to 50% of your income for needs, 30% of your income for wants, and 20% of your income to savings and debt repayment. You first take 50% of your after-tax income for needs, and then the remaining is split between wants and savings. This budget rule is simple but still allows you to save and/or pay off debt while not having to deprive yourself.
Needs include things like housing, utilities, insurance, child care, and groceries. If your needs make up more than 50% of your after-tax income, you should take some money from the “wants” portion of your budget.
Wants are similar to non-necessities, and include restaurants, travel, entertainment, and other non-necessities. Allocating money for “wants” is important so that you do not feel overly constricted by your budget. After all, a budget is useless if you do not actually stick with it.
The remaining 20% of your after-tax income should be used to save for the future, to save for the unexpected, and to pay off debt. How much goes towards debt versus savings will vary on what kind of debt you have, how much you have, what the terms are, and what your short and long term financial goals are.
Budgeting With the 70/20/10 Rule
Another popular budget rule is the 70/20/10 rule. With this budget rule, you allocate 70% of your income to monthly expenses, 20% to savings and investing, and 10% to debt repayment or donation. Just like the 50/30/20 rule, these amounts are based on your after-tax income.
Monthly expenses include things like housing, utilities, insurance, child care, and groceries, but also include restaurants, entertainment, travel, and student loans.
The 20% for savings should include an emergency fund, retirement, and investing.
The remaining 10% will go toward paying down debt and/or donations. While the minimum bill payments are covered under the 70% bucket, any additional payments to pay off debt faster will be under this category.
Adjust As Needed
After you make your budget, you should look over it to make sure that it is realistic and in alignment with your goals and priorities. In addition, any good budget involves re-examining from time to time. Set a reminder to yourself to re-examine your budget quarterly or yearly. This will help to actually stay within your budget and will also provide you with frequent opportunities to adjust your budget as needed.
Creating a budget is useless if you do not stick to it. That’s why it is so important to make a realistic and accurate budget. By taking the time to calculate your take home pay, track your spending, determine your financial goals, and adjust as needed, you will be much more likely to have a budget that accurately represents your money, spending, goals and priorities.