“Beware of little expenses; a small leak will sink a great ship.” ~Benjamin Franklin
Creating your first budget can definitely seem overwhelming, but if you’re looking to get ahead financially, it’s a must have. There is no compromising on this one. The most basic rule of building wealth is living a lifestyle in which you earn more than you spend. Sadly, just like calories in that delicious piece of chocolate cake… we often grossly underestimate how much we’re spending (or consuming!) when we’re not keeping track. A budget is an estimation of your income minus your expenses over a given period of time, typically a month for personal finance purposes. Once you understand your monthly budget, you can start optimizing and making conscientious decisions to improve your financial well-being.
Prior to starting a detailed budget, I highly recommend everyone calculate their net worth. This exercise will give you a bird’s eye view of your overall financial picture and allow you to track financial advancement as time progresses.
Ok, let’s get started on that budget!
1) Assemble Your Financial Information
Gather all of your financial information from the past few months – recent pay stubs, bills, credit card statements, bank statements, receipts. Don’t forget about expenses that you only need to pay once or twice a year. Starting jotting everything down in a notebook, a spreadsheet or your favorite budgeting software.
2) Determine Your Monthly Take-Home Pay (Net Income)
Take-home pay, or net income, is the amount that shows up in your bank account each pay day, after deductions (taxes, health insurance, 401k contributions, etc.) are all taken out.
Everyone’s payroll situation is different, so here are a few recommendations on what to use as your net income in your monthly budgeting:
- Weekly Pay: A typical month will encompass 4 paychecks, but every few months, there will be a “bonus” 5th paycheck. I highly recommend budgeting based on a 4 paycheck month and utilizing those “bonus” months as a means of contributing extra to your savings and long-term financial goals.
- Biweekly Pay: A typical month will encompass 2 paychecks, but twice a year, you will receive a “bonus” 3rd paycheck. Budget based on a 2 paycheck month and save those bonus paychecks for additional contributions to your financial goals.
- Hourly Employee with fluctuating hours and/or unpaid sick/vacation days: Review your last 3-4 months worth of take-home pay and calculate the monthly average. Create a budget based on a slightly lower than average month, following the pay frequency recommendations above. If you can’t always count on a full 40 hour week or overtime pay, don’t plan it into your budget. It’s always best to plan conservatively and then be pleasantly surprised if additional income does come to fruition.
- Bonuses, overtime pay and other forms of unexpected income: Bonuses and overtime pay are great, but they are intermittent and variable. Err on the side of caution and don’t plan them into your monthly budget.
If you’re starting a new job and unsure of what your take-home pay will be, ADP has a nice calculator to provide guidance. It allows you to enter your state, gross income, pay frequency, voluntary deductions, etc.
Bottom Line: Create a budget utilizing the “worst case scenario” for income. Planning conservatively gives a lot more wiggle room for dealing with unexpected situations. No bonus this year? Sucks, but your budget can handle it. Company is cutting back on overtime hours? You’re prepared. Car needs a major repair? Good thing you were able to stash away that bonus paycheck in your emergency fund!
3) Know Your Spending Categories
Understand which expenses will fluctuate month-to-month and which are well-defined:
- Fixed Expenses: Expenses that are the exact same amount month-to-month, such as rent/mortgage, insurance, loan payments. These are easy to budget for since the amount due is known in advance.
- Variable Expenses: Expenses that vary month-to-month, typically based on consumption, such as utility bills, groceries and gas. Review variable expenses over the past 2-3 months and calculate the average monthly expense. Some expenses, like heating, vary significantly season to season. If possible, review a year’s worth of utility bills and calculate the monthly average. Be conservative and use a slightly higher than average amount for your monthly budget.
- Periodic Expenses: Expenses which do not occur every month, but still need to be included in your monthly budget. Examples include home repairs, car inspection/registration, travel, gifts, charitable donations and yearly memberships. Follow the same estimation procedure as variable expenses or take a yearly expense and divide by 12 for the monthly equivalent.
Understand the difference between “needs” and “wants” and how much of your spending should be dedicated to each for a comfortable lifestyle with fewer financial worries:
- Necessities: These are expenses that are required to maintain a basic quality of life. Housing, utilities, food, transportation, medical care, etc. While it may be possible to reduce some of these line items, it is impossible to eliminate them completely. Paying for necessary expenditures should be your top priority every month. Target keeping this category at 50% or less of your total spending.
- Savings / Financial Goals: Pay yourself first. After taking care of necessities, allocate at least 20% of your “spending” towards savings, additional retirement contributions, investments and other major financial goals. Remember those bonus paychecks and other variable income? Use that extra income to boost this category above and beyond your baseline plan.
- Discretionary Spending: These are “wants” – expenses that enhance your lifestyle – and the lowest priority spending category. If you need to trim your budget, these are the line items to focus on. Entertainment, restaurants, vacations… are all luxuries that can be reduced or eliminated if necessary. Target keeping this category at 30% or less of your total spending.
4) Categorize and Calculate Your Monthly Expenses
Using the guidance above, capture all of your monthly expenses, including periodic expenses. The budget categories below are a reference to help you get started, but your budget should be personalized to reflect your individual situation. I recommend organizing your budget into the 3 overarching spending types listed above and calculating the subtotals for Necessities, Discretionary Spending and Savings/Financial Goals.
- Debt / Loans: Student Loans, Car Loans, Medical Debt, Other Debt
- Insurance: Health Insurance, Homeowners/Rental Insurance, Car Insurance, Life Insurance
- Housing: Mortgage/Rent, Property Taxes, Home Maintenance
- Utilities: Heating, Electricity, Water / Sewer, Trash Service, Home Phone, Cell Phone, Internet
- Transportation: Gas, Tolls, Public Transportation, Taxis, Vehicle Maintenance
- Child Care: Daycare, Diapers, Formula, Children Activities, Babysitters
- Pet Care: Pet Food, Pet Supplies, Veterinarian Visits, Medicine
- Medical: Doctor visits, Medical Devices, Prescriptions, Dental, Vision
- Education: Tuition, books, fees
- Food: Groceries, Restaurants
- Personal Care: Clothing, Shoes, Haircuts, Makeup, Personal Items
- Entertainment/Hobbies: Cable TV, Media subscriptions, Theaters, Sporting Gear, Fun Activities
- Miscellaneous: Household items and supplies, gifts, charitable giving
- Savings/Financial Goals: Emergency Fund, Paying Off Debt, Additional Retirement, Investing, Major Purchase (home improvement, vehicle, etc)
Tip: It can be overwhelming trying to capture every. little. spending. category. For low expenditure areas, consider lumping multiple items into a broader category. For instance, we have minimal expenditures on pet care, household supplies, personal care items, medical and gifts. I categorize all of those items as “Miscellaneous Household Expenses” and call it is a day. I keep household repairs/maintenance, hobbies and vacations as separate line items because we spend an appreciable amount in those particular areas.
Here is an example monthly budget, created in Google Sheets, to automatically calculate income and expense totals, spending category subtotals and their percentage of total income:
5) Evaluate Your Budget and Conduct a SWOT Analysis
What are some spending areas that you struggle with? Is your spending in line, but your income needs to increase? Do you have an emergency fund? Could you be saving more? All excellent questions. Time to dig in and identify areas where your budget is excelling and where there is room for improvement.
Applying a SWOT analysis to your personal financial situation is a great way to strategically identify:
Strengths ← Ways to leverage strengths for additional financial gain?
Weaknesses ← Areas to focus on improving
Opportunities ← How can we tip these opportunities in our favor?
Threats ← Be aware of risks and mitigate as much as possible
By identifying how these attributes pertain to a particular financial situation (in this case, budgets), we can leverage strengths and opportunities, while mitigating weaknesses and threats as we come up with a plan to meet our financial goals. For an example budget and SWOT analysis, check out The Saverdink’s Monthly Budget.
6) Make a Plan for Financial Success
You know your income. You know your estimated expenses. You evaluated budgetary strengths and weaknesses. Now it’s time to make a plan and start on the path to greater financial stability and growth!
What are your short-term and long-term financial goals? Contributing more to retirement? Staying ahead of monthly bills and eliminating short-term financial worries? Saving up for a new car? You now know what you used to spend based on the above budgeting exercise. Now it’s time to define what you want to spend and work towards savings goals that are most important to you.
- Define spending priorities and set targets for each budget category. Set up a budgeting plan that allows you to live within your means and promotes long-term financial growth.
- Identify ways to earn additional income
- Identify ways to save money on existing expenses
- Be proactive in your savings approach. Set up automatic transactions to transfer money to savings/investments, particularly savings for periodic expenses.
7) Track Your Expenses and Revise Your Budget as Necessary
Great job making it this far! Going forward, track monthly expenses and see which areas of your budget you’re able to stick to and which may need revision to be more realistic. As long as your expenses are less than your income, you’re on the right track. Life events may dictate a budget overhaul, but it’s much more manageable when you already have a solid structure in place.
Automate budgetary tracking as much as you can. One of my favorite online tools is Personal Capital, a free tool that allows you to link various financial accounts to track net worth, income, expenses and investments. It’s a one-stop shop for viewing your entire financial picture. For budgeting, it allows you to categorize transactions and auto-tallies your income or expenses for a given period (“this year”, “past month”, custom dates, etc). You can select a particular category for more details on % of your total budget expended, individual transactions and average spent each week/month.
Explore a little. See what works best for you and continue to take control of your financial well-being!