Creating a budget can seem like a scary and tedious task that you should avoid at all costs. However, setting up and maintaining a budget might be vital to achieving your financial goals. Luckily, the process isn’t as hard as you might think. Find out more in this beginner’s guide to budgeting.
Income and Expenses
The first step toward creating a budget is to analyze your cash flow, i.e., looking at what you bring in as income versus what you spend as expenses.
Without a clear picture of your income and expenses, you are operating in the dark. That can lead to embarrassing (and costly) mistakes such as ‘overgrazing’ (is that even a word, proofreader?) your checking account or maxing out a credit card.
Personal Finance Software and Apps
To avoid such mishaps and get on the road to financial enlightenment, you must start by tracking every transaction you make. You can do this with desktop software like Quicken, websites such as Mint.com, or even with a simple Excel spreadsheet.
Categories are Key
Every time you deposit or spend money, record the date, where the money came from or went to, the amount of the transaction, and the category.
Categorizing your transactions is somewhat of an art form. Categories that are too broad won’t give you useful information.
For example, consider a group called “Household,” where you put all transactions related to your home. At the end of the month, you won’t be able to tell what you spent on rent versus utilities versus repairs. That is where subcategories shine.
Creating a Budget – Pro
With subcategories, you can get as granular as you like and still have the transactions roll up into their parent categories.
Under “Household,” you could have a subcategory for “Utilities,” which then has subcategories of its own for “Electric” and “Gas.” Now you can see what you spent on each utility, look at the “Utilities” parent to see what you spent for all utilities, or look at the “Household” parent to see all of your household expenditures.
Feel free to set up your categories in a way that makes sense to you and gives you some insight into your spending patterns.
One budgeter decided to set up a group called “Dining Out” to track restaurant expenses but went on to set up subcategories for each type of meal: breakfast, lunch, dinner, and snacks. These allowed him to follow his overall restaurant spending but also zero in on where he was spending the most money. In this particular case, tracking the breakfast category showed that his morning coffee habit added up to a significant amount pretty quickly.
Once you’ve tracked and categorized your transactions for a month or two, you are ready to go ahead.
The next step is to look at your overall cash flow: is it positive or negative?
If you are spending more money than you are bringing in, you are on a path to financial trouble.
The only options, in this case, are to find ways to generate more income or find ways to cut your spending.
That is where your categories will come in handy. You can efficiently analyze a couple of months of data and see exactly where your money is going.
Chances are, you will be surprised at how much some of these categories total.
Reducing spending in these bloated areas can help turn your cash flow positive.
Discretionary spending should be the first target for your budget cuts; with a few small lifestyle changes, you can cut “fun money” categories like restaurant expenses significantly.
Fixed expenses are usually harder to trim, but don’t assume it’s impossible. Call each of your vendors — utility companies, cable providers, etc. — and tell them your bill is too high, and you’d like to lower it.
You’ll be surprised at how much you can save just by asking; switching plans or getting a promotional offer applied to your account can save you hundreds of dollars for the minimal effort.
The last step is to create your budget for the next month.
First, look at the data you collected and make a list of all of your “must pay” expenses: rent, utilities, groceries, etc. Make sure you don’t forget about infrequent expenses.
For example, you might only pay your auto insurance once every six months; you should add this to your list so you can add funds every month toward the expense. If your auto insurance costs $600 every six months, you want to set aside $100 every month, so when the bill comes due, you will have the money to pay it sitting in your account.
You should also add some categories for your financial goals, such as savings, retirement planning, vacation fund, or new house fund.
Add your discretionary spending groups to the list last.
Once you have these categories listed, add up all the income you expect to receive during the month — this is your available pool of money for the month.
Next, you should allocate these funds across your list of categories.
Every dollar of income coming into the budget must be given a “job” by being assigned to a group.
You can picture each of your categories as an envelope containing cash for that expense. Some people do use physical containers to help them to budget, but in today’s cashless society, it is much easier to use a spreadsheet or program to track your “envelopes” instead.
As you go through this process, you will find you have to make some decisions. If you have $500 left after allocating money for all of your bills, do you want to put that into savings or the clothing category so you can buy a new jacket? That is the essence of budgeting — making informed decisions on what to do with every dollar you earn.
As you proceed through the month, continue recording transactions against the balances you gave each category. If you allocated $100 to the restaurant category and you go out and spend $40, you’ve just spent money out of the restaurant “envelope, ” and you have $60 remaining. If you have an excess balance in one category, you can allocate it to another one (such as taking the remaining $40 in the restaurant category and re-allocating it to savings).
Likewise, if you run negative in a category, you must offset it with money from another. Remember, the key here is to use only the money you have coming in each month. If you consistently run categories into negative territory, your budget will not be sustainable.
The best-case scenario is when you end the month with balances left over in some categories. In this case, you can roll the funds over to the next month’s budget and re-allocate it as desired. As you proceed month to month and collect more data, you can adjust your categories and budget amounts. That will help your budget become more accurate over time.
Creating a Budget
Creating a budget requires a bit of time and effort to set up, but once you get used to using one it will become second nature, and you will never look back. Forming strong financial habits at a young age will put you on a path to a debt free, financially independent life.