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There’s no getting around it. Learning how to create a budget is a non-starter in the world of personal finance.
While it drastically differs on whether some of us love or hate budgets, we can all agree on the fact that having one is extremely important in not only maintaining your finances responsibly but also in allowing you to reach your savings and financial goals. Without one, you’re bound to have quite a few headaches.
We work hard for our money. A budget takes that money and designates pieces of it among several categories of expenses. You’re rewarded with a clear picture as to where your money is going and how to make it most beneficial to you.
You’ll learn that creating a budget will keep your spending habits in check, allow you to save more money, pay off that debt that you’ve been dying to pay off forever, and will give you peace of mind.
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Budgets might seem confusing to start but they’re actually pretty simple tools to create. This article will serve as your budgeting 101 guide that will help you uncover how to create a budget step by step.
Determine why you want to create a budget
This won’t look the same for everyone, but you need to discover your motivator: the why, the purpose the drive behind you wanting to have a budget in your life.
If I’m being totally frank, budgets aren’t the easiest to maintain for those first 3 months while you’re getting used to them and building the habits. You’ll need a reason to motivate yourself to keep at it.
Your reason can be anywhere from wanting to hit a savings goal to getting out of debt. Find your why and then start the budgeting process.
Add up your Monthly Expenses
In order to set up a budget that will work for you, you need to have a realistic idea of what your current spending habits are like and also know what types of things you are spending on each month.
Track your spending for 30 days or 1-3 months to get a clearer picture of where your money is going.
Tracking each and every expense might sound overwhelming but there are several options for how to do this in a way that works best for you. You can try your hand at the old-fashioned paper and pen listing, updating an excel spreadsheet, or you can opt to use software that’s set up for this such as Mint, Personal Capital, among many others.
Chances are you’re like a lot of other people where you aren’t fully aware of how much you’re spending on basic expenses throughout the month. If you’re in agreement that you need more insight into what you’re spending your money on, you need to prioritize this analysis as an important step in creating your budget.
Calculate your monthly income
A budget is based on two key components: your income and your expenses. In order to create the most suitable budget for yourself, you need to fully understand both.
Unless you’re Bill Gates who likely has several sources of income at his disposal each month, it’s likely that you have far fewer income sources than you do expenses in the average month. Calculating income is therefore usually the easier side of creating a budget.
Add up all income sources that you receive regularly, or irregularly if you know them. Sources of income include, but aren’t limited to: salary, bonus, profit share, side hustle income, investment income, alimony/child support, and others.
It is definitely possible to have some months where you might have higher income (like an annual bonus) and you should plan for this in your budget. Even if you are designating all of this extra income to savings, you should still have that budgeted!
While many have a set, monthly income that they receive consistently, there are situations where you might not have this same consistency. If you have a variable income, your goal should be to come up with a specific amount of money that you pay yourself each month. Stash away extra money in the months where you receive more so that you can continue to pay yourself this salary in the months where you might make less money than what you need.
Subtract expenses from your income
Once you have an idea of what income and expense items you’re working with every month, you can subtract your expenses from the income total.
Note that you’ll have both non-discretionary spending and discretionary spending. This is a fancy way of saying absolute needs versus spending on wants or nice-to-haves.
Start off by subtracting your non-discretionary (essential) expenses from your income. What are you left with? Hopefully some extra money for those nice-to-have expenses.
Now subtract your non-essential expenses (discretionary spending) from what remains.
Which of the following did you end up with?:
- A positive amount. Great! This means that you have leftover income after tallying up all of your expenses. You can decide to save this money or work to payoff debt with the surplus.
- Zero dollars. You’re breaking even with your monthly budget. You have no surplus to use against saving or debt, and you might want to go back and re-evaluate your non-essential spending to build in more of a cushion.
- A negative number. Ouch. Back to the drawing board. It looks like you’re overspending every month. You’ll want to go back and look through your non-essential spending categories and decrease one or several until these are less than your income.
Identify and Set Financial Goals
I think it’d be safe to say that most people who are looking for how to create a budget have the desire to accomplish financial goals that they might have for their money. They want their money to work for them, not against them in achieving those goals.
Everyone has their own version of what it means to be financially savvy or their own definition of financial goals to achieve. There are patterns in the types of financial goals that people aspire towards. The following is a short list of possible financial goals that you can use as a guide in creating your own:
- Retirement savings
- Emergency fund
- Buying a home
- Buying a new car
- Pay off debt
- Save for college
- Save for vacation or other big purchases
Setting financial goals is the backbone of the budget. Without goals, your budget is directionless.
Create SMART Financial Goals
To piggyback off of the last paragraph, you’ll want to make sure that your goals are SMART. I’m sure that by now you’ve heard of this method for creating goals time and time again.
If you need a quick refresher, SMART translates to making sure your goals are Specific, Measurable, Achievable, Relevant, and Time-bound.
Example: Looking to pay off that credit card debt within a year? Let’s say you owe $5,000 with 15% interest. In order to pay this off in 12 months, you’ll need to make a minimum payment towards your debt of $451. You decide: is this achievable (can you afford it monthly) and is this action relevant to the big picture of your financial goals?
Which type of Budget is best?
People might have the same financial goal, but they might go about tracking these goals and their budget in a way that works best for them but might not work best for you. We live in a world filled with options so you decide which method seems like the best fit.
Keeping up with your budget can be accomplished with the following methods:
- The 50/30/20 budget
- The zero-based budget
- The cash envelope system
The 50/30/20 method
This method was made popular by Senator Elizabeth Warren. In this method, 50% of your income is allocated to your needs, such as rent, food, minimum payments among others. 30% is allocated towards your wants such as vacations, clothes, etc. The final 20% is meant to go towards savings and any other financial goals you might have, such as paying off debts.
The Zero-Based Budget
This method is set up in a way that is meant to confirm that you have accounted for each and every dollar that you earn and will spend in an average month. Basically, your income less your expenses will equal zero when you are finished designating every dollar to a specific job that it will play. Some dollars might be assigned to saving while the rest could be assigned to rent or groceries. The point is to make sure every dollar has a home.
The Cash Envelope system
The envelope method is slightly different from the above methods, or could be used as an addition to the above methods. The difference being that this is a cash-based method versus debit or credit card based.
Once you set up a budget, you create physical envelopes for each category and fill that envelope with the designated amount of cash. This cash is your limit for spending on that specific category. This can be a tough method to sustain if you’re not used to carrying cash but it can be a good method for those who struggle with credit cards.
Everyone’s budget will be set up a little different but find a method that gives you the structure and tools you need to create it. A budget isn’t very helpful if you find that you aren’t using it to make decisions or don’t check it often. Choose what makes the most sense.
How to Make a Monthly Budget
Now that you’ve covered the basics of budgeting you need to determine how to create a budget.
You’ll need to determine what tool will be the best to use to set up your budget initially and to keep track of. You can choose the old-fashioned approach of pen and paper, creating an excel spreadsheet or with use of any of the online budgeting software or apps available.
Obviously, my personal favorite in these choices would be to use a software that was created specifically with budgeting in mind. Great examples to check out and compare would be YNAB or Mint.com. Another great software to check out is Pocketguard. Each of these has a unique spin on budgeting or way of tracking but all help you achieve the same goal.
Identify Essential Budget Categories
Now that you’ve determined how to create a budget and keep track of your spending, you’ll need to actually come up with the numbers.
The first step is to determine the budget categories that you need to plan for. As mentioned in the prior paragraph above, it helps to track about 1-3 months worth of expenses to determine your main expenses as well as a range for spending. Use this as your guide to set up categories.
Once you’ve determined your categories, assign a dollar amount to each. This amount is the limit for how much you are allowed to spend on that category.
Remember to always build in a little extra room in case of unexpected expenses or overspending in one or two categories. Keep this safety net amount as a separate line item on your budget. You’re bound to go over in categories and you’ll want to prepared for when you do.
Make sure that your budget reflects the zero-based method or the 50/30/20 method. This will determine where your money goes as well as whether or not you will account for 100% of every dollar you earn.
Pay Yourself First every Month
If you’re using the 50/30/20 method, you’ll likely be aware that you should be using at least 20% of your income for savings or other financial goals you might have. No matter what method you choose for a budget, it’s important to pay yourself first. Find a way to incorporate either saving more money or paying off debt into your budget.
If you’re saving up for something specific (i.e. a new car, down payment on a house, college, etc.) what you still need to save will be dependent on how much you already have saved, how long you have left to save, and other various factors.
It might be challenging to lock down a perfect amount to save every month but an easy method to find an amount is to take the total amount you want to save and divide this by how long you have to save it.
For debt, use an online debt calculator to input the amount of debt, interest percentage as well as either the amount you’d like to pay each month or the number of months that you’d like to pay off that debt. This will give you a monthly payment amount that you need to hit in order to pay off your debt in the time frame that you have setup.
As a side note, you should be intentional about putting money towards debt in the same way that you are with putting money into savings. If you only make the minimum monthly payments on your debts, you’ll likely be paying off that same debt for decades due to interest.
Avoid common budgeting mistakes
Budgeting might seem like hard work. Or, more truthfully, following a budget might seem like hard work. It involves intentional effort. Just know that mistakes happen and we all have them occasionally. What’s important is getting back on track after a mistake.
The best case scenario is to try and avoid the mistake entirely. Knowing what could cause a budgeting mistake can help you prevent them. Here are common budgeting mistakes you should look out for and plan actions to take to avoid.
- Unrealistic. Many people become overambitious and create budgets that are so far from realistic that they’ll never be able to follow them. If you know that you won’t be able to stick to a certain budget, don’t use that budget. If you don’t budget for fun or entertainment costs, it just won’t work and you’ll burn out fast.
- Forgetting about tax. Always use the post tax and other deductions amount of income when budgeting. Don’t make the mistake of using gross numbers and inflating your income.
- Irregular expenses. We often forget that there are atypical expenses throughout the year that we don’t pay every month. Items could include Christmas, birthday gifts, annual subscriptions. Make sure you factor these expenses into your budget.
Read more: Common budgeting mistakes you need to avoid
Find accountability to maintain a personal budget
I recommend having an accountability partner. If you tell somebody that you are doing something, you now have the added pressure of knowing that somebody else is holding you accountable for following through.
If I’m responsible for holding myself accountable, I’m far more likely to fail and let things slide here and there. This same accountability is what helps other drastic decisions like going on a diet or a new exercise routine succeed.
Automate. Automation is sometimes your best friend. You can use this option to not only pay your bills timely but also to save money each month. You are far more likely to follow through with a financial plan if it’s automated. With automation, there’s less room for backsliding.
Make sure that you are tracking your spending consistently. Monitor how you are doing in relation to your budget. Are you staying on track? Are you overspending?
Monthly Budget review – Adjust and Monitor your Budget
At the end of each month, before setting up the next month’s budget, review how successful you were with staying on budget.
Did you overspend? In what areas? Do you need to make any adjustments to your budget for these particular areas? Are there areas where you need to start making significant cuts in order to save more or pay off more debt?
Every month doesn’t look like the last so it’s crucial to review and plan for the month that is ahead. Think about it: when has any month of spending been the same? It’s unrealistic so make sure you are planning for the realities of the upcoming month.
Budgeting may seem overwhelming or daunting at first. It might even be hard to stick with for the first three months when you start. But, like anything, it becomes a habit when done consistently. It gets easier once you’ve done it and are used to it. After the first initial months, you’ll know how to better adjust your budget going forward.
Now you have all of the steps and necessary action items to create a budget. Time to create one! Start living within your means and achieving your financial goals. You’ll be happier and feel a whole lot less stress knowing that your money is working for you and not against you.
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What was your experience when first creating a budget? If you’ve been at it for awhile, what helpful tips would you give to others?