Budgeting Fundamentals
Why budgeting is a necessity and a step-by-step guide to get started.
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TL;DR
- Budgeting is the money management foundation from which you can achieve financial goals
- A proper budget prioritizes savings and necessary fixed expenses
- You can create a budget from a template spreadsheet or by syncing your bank account to a budgeting app
- You should review your budget periodically and update it following a significant change in income or expenses
A budget is a framework for spending money based on your income. Budgeting estimates revenue and expenses over a specified future period of time to help you maximize spending.
Managing a budget does not require intensive labor, advanced math skills, or avoiding buying the things you want. It just means that once you better understand where your money comes from and where it should go, you'll have greater control over your finances.
Benefits of budgeting
Creating a budget is the financial foundation from which all other spending goals can be met.
A written budget can help you visualize sources of income, identify opportunities to save, and plan how to spend money while saving enough to meet your financial goals.
Budgeting brings peace of mind by removing the guesswork from how much you should spend on different expense categories. Once you begin earning money, creating a basic budget should be the first step you take to build wealth.
Types of Budgeting
There are several different methods for creating a personal budget. An overview of popular methods is shown below:
Budgeting Approach |
Strategy |
Pay-Yourself-First |
Set aside a specific amount every time you get paid for fixed expenses and savings |
Envelope Method |
Cash-based approach to categorizing and spending on similar expenses |
50/30/20 |
Spend 50% of your income on necessary expenses, 30% on discretionary expenses, and 20% on savings and debt payments |
Values-Based Budgeting |
The process of right-sizing your budget categories so that they better align with your priorities and values in life |
Zero-Based Budgeting |
Every dollar earned is justified in yours budget |
Each of these approaches shares the goal of bringing visibility to your spending while ensuring you prioritize saving. Therefore, which approach to use is a matter of personal preference.
Regardless of methodology, there are universal steps you can take to build your first budget.
How to budget
Create your first budget in five steps:
- Calculate your income
- Track current expenses
- Determine your savings goal
- Forecast spending
- Monitor and adjust
Calculate your income
Creating a budget begins by calculating your net income or take-home pay after taxes. Most personal budgets are managed on a monthly basis, so if you have a salaried position, your monthly income is equal to your annual income divided by twelve. If your income is variable, divide your anticipated annual income by twelve. For example, if you get paid depending on the number of projects you complete, find your average monthly earnings for the prior year and decide whether to adjust this number up or down depending on your anticipated workload. All sources of income, including those from investments, should be included in this total figure.
When calculating your income ensure taxes are reflected in your net estimate. If you are a company employee, taxes will be withheld from your paycheck throughout the year. If you are self-employed or a contracted worker, estimate the amount of money you expect to pay in taxes and do not include it in your spending plans.
Track current expenses
Next, determine the approximate amount of money you spend monthly on expenses. You can track your expenses by reviewing the last few months of your checking account bank statements. As you review these statements, identify how much you spend across common expense categories, such as:
- Housing
- Utilities
- Groceries
- Transportation
- Health
- Clothing
- Dining out
- Entertainment
- Saving
- Insurance
- Giving
- Saving
When categorizing past expenses, consider which are fixed, variable, necessary, and discretionary.
Fixed expenses are those you pay the same amount for on a regular, typically monthly, basis. Examples include rent, insurance, and entertainment subscriptions. Variable expenses are those which fluctuate every month depending on how much you choose to spend. Examples include clothing and eating at restaurants.
Necessary expenses are those required every month, such as housing, transportation, groceries, and utilities. Discretionary expenses, or wants, include entertainment, giving, and dining out. Some expenses overlap both categories. For example, while you should spend money on your physical health, this doesn’t require buying the most expensive gym membership. You need clothes, but they shouldn’t all be designer.
Understanding approximately how much you currently spend on these categories will inform how you can adjust spending to best fit your lifestyle as you continue earning money.
Determine Your Savings Goal
After reviewing how much you spend every month, determine how much you should save during this same period. This amount of money should go towards medium to long-term savings milestones and other financial goals and should be the maximum amount you are willing to put aside and not use for short-term spending on needs and wants. To find this number, start by evaluating how much money you currently save every month.
Without a budget, the amount of money you save is equal to the amount of money left after your needs and wants are paid for.
Savings = income - needs - wants
If you don’t consistently have money left in your bank account after spending on needs and wants, you aren’t growing your savings. This practice, called living paycheck to paycheck, poses risks as it doesn’t adequately prepare you for unexpected life events or long-term financial growth. Budgeting helps make saving a habit by prioritizing it before spending on needs and wants. In a balanced budget, spending on wants is determined by how much money you have remaining after allocating toward necessary expenses and savings.
Wants = income - needs - savings
Doing so ensures you have enough money to reach longer-term goals and improves the likelihood of maintaining a positive net worth.
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This is how you look trying to save when you don’t budget for it
Treat savings like a bill and pay yourself first, even if it’s not much. You’ll be surprised at how consistently saving even a seemingly insignificant amount of money adds up over time.
Forecast Spending
Once you know how much you earn, spend, and save, use these inputs to determine how you want to spend money during the months ahead.
Start by identifying the amount of money you are comfortable saving every month. If you have never saved before or spend more than 50% of your income on necessary expenses, consider starting small and building towards 20%. If you are already accustomed to saving money, target 20% (or more).
Next, forecast the approximate amount of money you anticipate spending toward other expense categories. Focus on the percentage of your income you reasonably expect to spend on necessary expenses. The 50/30/20 methodology suggests about 50% of your income should go towards necessary expenses, but make adjustments for what’s realistic for you.
Many have proposed guidelines for how much money should be allocated toward different spending categories. For example, Dave Ramsey, an American personal finance personality, published the following recommendations below:
Unlike the 50/30/20 methodology, Dave Ramsey recommends spending 10% of your net income on savings and 10% on charitable giving
Only after you determine how much you plan to save and spend on necessary expenses should you calculate how much money you expect to have left for discretionary spending on wants.
Wants = income - needs - savings
By prioritizing how much you plan to save and spend on necessary expenses first, you will determine how much remaining money you should spend on everything else. So long as you have already allocated enough money towards savings and necessary expenses, this difference can be spent guilt-free.
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Whatever forecast you create for your first budget should be realistic in the short term. If you feel confined by a new budget or it doesn’t reflect your spending reality, don’t be afraid to make adjustments.
Monitor and Adjust Results
After creating your budget, review it against your bank statements during the first several months of use and consider the following questions: Were you able to consistently save the same amount each month? Did you adequately forecast spending for necessary expenses? Could you afford wants based on your estimates? If you answered no to any of these questions, adjust your spending on savings and needs until you have a budget you can comfortably maintain.
With a working budget in place, review it at least once a year to see how your spending habits change. Additionally, you should reevaluate your budget whenever you have a significant change in income or expenses.
Budgeting in Practice
A number of online resources can be used as a starting point for creating your own budget. For example, Redditor yeahThatRules created a free spreadsheet template that can be downloaded and populated using the abovementioned process. The spreadsheet requires Microsoft Excel and can be downloaded on the /personalfinancesubreddit.
Yeahthatrule’s spreadsheet follows the pay-yourself-first methodology in that it prioritizes spending on necessary expenses and savings before discretionary spending. The spreadsheet is pre-populated with sample data. To customize the budget for your needs, enter numbers in the blue cells to change the calculated results shown in the gray cells. Step-by-step instructions for editing the template to fit your needs are below.
Calculate your income
Start by entering your approximate net income on the Income tab of the spreadsheet. The template references tax brackets from 2020 to estimate take-home earnings. This calculation is for educational purposes only; verify your actual net income by cross-referencing your paychecks against current state and federal income tax rates. If necessary, consult with a tax advisor to assess your situation.
To estimate your net income within the spreadsheet, change inputs in the blue cells to arrive at an estimated paycheck that most closely reflects your financial reality.
Track current expenses
Once you have a baseline estimate of your anticipated monthly income, use the Expenses tab to determine how much money you should allocate toward necessary regular and irregular expenses. The spreadsheet defines regular expenses as those paid every month, while irregular are those paid at least once throughout the year. For regular expenses that are variable, like utilities, the author budgets the six-month average plus an additional 25%.
Determine savings goal
Next, use the Long-Term Savings tab to anticipate how much of your net income should be allocated toward savings.
The spreadsheet includes the option to categorize long-term savings by investment; however, you don’t need to know how to invest this money to start saving. Long-term savings are generally reserved for milestone expenses, retirement, and other long-term financial goals.
The author of the spreadsheet chose to use their savings to invest in index funds, an investment vehicle explored in greater detail in Grow
Forecast spending
Lastly, the Bank Accounts tab shows how much money should be left over for discretionary spending after necessary expenses and savings are subtracted from your anticipated net income.
The author of the spreadsheet purposefully does not categorize discretionary expenses because they don’t find it necessary after budgeting for fixed expenses and savings. Instead, they believe that once money reserved for discretionary expenses is spent, you should wait until your next paycheck before spending more on wants. Although you can use funds reserved for savings and regular expenses, doing so is a bad habit as it detracts from longer-term savings goals.
Although this template is flexible, you may find it difficult to use for your financial situation. If it is, consider searching online for a different budget template or using an app that creates a budget for you.
Opportunities to Automate
