Have you ever wanted to buy something but wondered in the back of your mind if you can really afford it? It could be something small, like a fancy cup of coffee, or it could be a big-ticket item like a car or a once-in-a-lifetime vacation. Whatever the case, the little voice in your head has spoken—and it’s up to you to decide whether or not to pay attention to it.
When you find yourself in this situation, having a budget can help you figure out whether your purchase fits in with your long-term personal and financial goals. It may seem strange to think a small transaction today could have an effect on whether or not you can buy a nice car, live in a big house or retire young. But the first step toward long-term financial success is getting a grip on your everyday spending decisions. A budget could be a good tool for the job.
The first step in building a budget involves taking an honest look at the money you earn. Your total income establishes the upper limit of what you can reasonably expect to spend, though you probably don’t want to spend that much.
Next, you’ll need to decide on your short-term and long-term priorities. You’ll use that information to set spending limits that will help put you on track toward your financial goals. It may sound like a lot of steps, but each one builds logically on the last, and no single step is actually all that difficult.
Healthy spending habits boil down to one simple concept: spend less than you earn. For most of us, however, living according to this principle is far easier said than done. Expensive surprises like home and auto repairs come out of nowhere. And there’s seemingly no end to those less-than-essential travel and shopping opportunities that seem like a great idea at the time, but add up to a big drain on your finances.
Let’s take a look at the steps of creating a budget.
Where are your sources of income?
First, take a look at your monthly income. If you have a full-time or part-time job, this means examining your periodic paychecks. Be sure to look at the actual amount of money that goes into your account after taxes, since that’s the actual amount that will make up your budget. If you don’t receive a regular paycheck, you can make a reasonable estimate of your monthly income by dividing your expected annual income by 12 and subtracting taxes.
In addition to paychecks, include any other sources of income, such as bonuses, child support, occasional part-time employment, and investment income. Once you have a monthly income total, it’s time to look at your monthly expenses.
What have you been spending and where?
To monitor your expenses, decide on a time frame that will allow you to gather detailed information. More than six months of data would be helpful as it will give you a more complete picture of your spending, but one or two months might be an easier starting point. The important thing is to be as thorough and accurate as you can. Go through your bank and credit or debit card statements and make a list of every expense you can identify. This information will serve as the basis for your budget and give you a clearer picture of your current spending habits.
As you go through your expenses, categorize them as fixed or variable. A fixed expense is something that you pay each month that remains the same, such as a rent or mortgage payment. A variable expense changes from month-to-month, such as entertainment expenses or eating out.
Remember to include any payments you’re making to reduce pre-existing debt, including loans and outstanding credit card balances. Finally, treat any form of saving or investing that you may do as an expense in your budget. Even though you don’t pay that money to somebody else, it still comes out of your monthly income. So, you still need to account for those funds in your monthly budget.
Balance your budget
Once you’ve figured out how much you earn and how much you spend, it’s time to compare those two numbers. If you discover that you’re spending more money than you earn, you’ll need to look for places to trim your expenses right away. Your ultimate goal will be to keep the total amount of your expenses (including debt payments and money you add to your savings account) lower than or to your income.
In practice, this will mean adjusting the amount of variable spending you do from month to month, making sure your income covers expenses you cannot easily cut. Don’t worry, you can always adjust your budget as things change in your life.
Why are you budgeting?
Before you turn your income and expense numbers into a full-blown budget, think about your long-term financial goals. These goals will directly inform the type of budget you choose, and can include:
- Saving for retirement
- Paying off existing debt
- Saving for treats – a big vacation, a new car, etc.
- Cutting back on wasteful everyday spending
Pick a system that works for you
Once you have your goals in mind, it’s time to take a look at your current spending and figure out what adjustments you can make to help you reach them. Budgets can be as simple and low-tech as a handwritten note you can pin to the wall above your desk or as automated and sophisticated as software packages and apps that link your bank account, investment and credit card accounts in real time and allow syncing via your smartphone.
Whether you opt for old-school pen and paper, a spreadsheet or budget-focused software, you’ll need to look at every category of spending you have and find a budgeting system that fits your priorities. Various frameworks exist that can help you decide how to allocate funds for different types of expenses. Here are some common options:
- The envelope method: To make budgeting less of an abstract exercise, some people find it easier to use real cash. One common system involves writing the names of your expense categories on a series of envelopes, and then inserting the amount of cash you expect to spend on those categories into each envelope. Physically removing the money from each envelope can make it easier to see where your money is going, and how much you have left over.
- Zero-sum budgeting: If you want strict control over every dollar that flows through your household, zero-sum budgeting may be for you. With this system, you assign a purpose to each dollar of income you earn every month, including money you plan to save. You can track things on your own with a spreadsheet or use a budget app to earmark your funds for specific needs. Zero-sum budgeting can be especially helpful if you’re trying to be disciplined about paying down debt, or building savings.
- 50-30-20, or other percentage-based budgeting: For a bit more flexibility, consider a budget that treats your expense categories as percentages of your total income, rather than as a fixed dollar amount. For example, with the 50-30-20 budget, you might devote 50% for essential expenses, 30% for optional expenses and 20% for savings. These types of budgets can be especially helpful for maintaining control over your spending as your income and expenses change over time.
Ultimately, the best budget—like the best diet and exercise plan—is the one that’s easiest for you to follow and stick to. As much as having a budget can help you chart a path toward your financial goals, you’ll still need the discipline to monitor your budget and make appropriate decisions about spending.
Exercising discipline can help minimize the anxiety that comes with those decisions. The next time you feel unsure about whether you can afford that fancy coffee—or a nice new car—your budget will help you give a firm, confident answer.