Budgeting is one key to managing expenses and saving. In the short term, a budget can ensure that you have money on hand to build up an emergency fund, and for special occasions, that might require an occasional splurge. In the long term, a budget can also help you prepare for big financial goals, like buying a house or ensuring a secure retirement.
At first, a budget might seem restrictive, but you may find that having one is actually a relief. Budgets can be a great way to align your values and spending, by helping you to become responsible about your finances and avoid unnecessary debt.
What is a budget?
At its most basic, a budget tracks the money you have coming in—your income—and the money you have going out—your expenses. To avoid going into debt, your income must be greater than your expenses.
Comparing your monthly income to your monthly expenses can help you make important decisions. You may decide that you want to cut back on some types of spending, or realize that you have more to put into savings than you thought. A budget might also inspire you to take a more aggressive approach toward debt repayment. Whatever you decide, creating a budget can help you accomplish your goals.
For the purposes of budgeting, it’s important to distinguish between your gross income and your net income. Your gross income is the total amount that your employer pays you. For example, if you make $20 per hour and work 10 hours per week, your gross income is $200 per week. However, your paycheck will generally be less than that, because before your employer pays you, they take out things like taxes and federal insurance.
The amount you see on your paycheck after these costs have been taken out is known as your net income. When making a budget, you’ll rely on your net income, since that’s the amount you actually receive each month.
Budgeting also involves looking closely at your expenses. There are two types of expenses: fixed and variable. Fixed expenses don’t change month to month, and you have to pay them. They include things like rent, car payments, and insurance.
Variable expenses tend to change each month. They can include necessities like groceries and clothing, which you may spend different amounts on each month, as well as non-essentials like travel and dining out. Variable expenses are also sometimes referred to as discretionary spending. Differentiating between fixed and variable expenses is key to creating a budget.
Creating a budget
Building a budget usually requires these basic steps:
1. Determine your income. If you work for someone else as a full-time employee, you’re likely to have a predictable income, with regular pay periods. If you work irregular hours or rely on a side gig, do your best to estimate how much you take home each month. Be careful not to overestimate, or you could come up short when it’s time to pay your bills.
2. Get a handle on your expenses. Even if you’re afraid that your expenses are out of control, tally them up so you know how much you’re spending each month.
Start by adding up what you usually pay for fixed expenses, such as utilities, insurance payments, transportation, rent or mortgage. Subtract this amount from your net income. What’s left is for your variable expenses such as groceries, travel, or entertainment, and for savings.
3. Track your spending: Keep track of where your money is going and compare it to how much you have set aside for fixed and variable spending. Tally your receipts each week, or look at your bank statement to see where your money goes.
Rather than looking at every expenditure individually, group your spending into categories. Doing so can give you a general idea of your spending patterns, without bogging you down with every little expense. Some banks will actually do this for you on your statement, or through their digital banking services.
4. Set goals: Remember what inspired you to create a budget in the first place. Perhaps you’re working to pay off your credit card debt, or you’re trying to save for a vacation next year. Figure out whether your goals are long-term, short-term, or a combination and determine how much you can set aside to meet them.
5. Start saving: Creating a savings plan may be one of your primary budgeting goals. Yet some people are so focused on paying off debt or planning for a specific event, like a wedding or vacation, that they lose sight of the importance of long-term saving. Try not to let the short-term goals prevent you from saving money for long-term goals, such as retirement. Save regularly, even if you can only afford to put away a small amount.
6. Make changes when necessary: Your budget shouldn’t be written in stone, and it should change as your life changes. If it looks like your income, expenses, and goals just don’t add up, it may be time to pivot and change the way you spend. Look over your variable expenses and figure out what you can cut.
Be realistic. You may not need to cut out all restaurant dining, but you can limit yourself to a certain number of times per month. And if your circumstances change down the road—say you get a raise, or your rent goes up—you may need to pivot again. Keep adjusting your budget to keep pace with your goals and lifestyle.
Types of budgets
Generally, the best method for budgeting is the one that you can stick to. But if you need some guidance on how to structure your spending, here are some different budgeting techniques.
The 50-30-20 budget: This budget is based on the idea that 50 percent of your income should go toward necessities, such as housing, food, and other fixed expenses. Thirty percent is then allocated toward variable costs, such as entertainment and dinners out, and the final 20 percent goes toward savings.
You can tweak the percentages a little, depending on your circumstances. But ideally, you probably want to stay as close as you can to the 50-30-20 breakdown. Doing so helps ensure that you’ll have enough savings to put away in a rainy day fund, while still being able to enjoy yourself and cover basic necessities.
The envelope method: Envelope budgeting requires limiting your spending to cash, and being very strict about how much you spend. Here’s how it works. First, you break your spending into categories, such as entertainment, groceries and gas and make an envelope for each category. Place the amount of money you plan to spend on each category for the whole month in its corresponding envelope.
Then, when you need to buy groceries or gas up your car, you take money from that envelope. When an envelope is empty, you can’t spend any more on that category until the next month. The envelope method requires discipline to keep from dipping into other envelopes, and it could help you consider everything you buy more carefully.
The zero-sum budget: With this type of budget, you make sure to “spend” every dollar you make, so that at the end of each month, your income minus your expenses always equals zero. This type of budgeting requires that you have a specific plan for every dollar you make. For example, if your monthly income is $4,000 and your expenses in a given month total $3,700, zero-sum budgeting requires that you to put that remaining $300 somewhere purposeful so that you’re back to zero.
You may opt to put that extra money into a long-term savings account like an IRA, an emergency fund, or toward paying down debt. But whatever you do, you don’t let it simply sit in your checking account collecting dust.