How to Create Your First Budget

Woman reviewing her budget using digital tablet on bed
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Creating a budget is an essential first step toward taking control of your money. Many people discover that they’re spending far more than they realized, while a lucky few pat themselves on the back for saving more than they knew.

Once you make a budget, you’ll see the areas in which you can cut costs. You’ll also learn how much you can save each month toward your future goals, and you’ll understand how to divide those savings among your short-, mid-, and long-term plans. Here are the steps in creating your first budget,

Imagine Your Financial Future

Sometimes it's hard to remember why you wanted to budget until you think about all of the things you can do once you have enough money saved up. With money in the bank and control over your spending, you'll have cash on hand for emergencies, money for your next vacation, extra funds if you happen to find out about a great sale, and the chance at a well-funded retirement.

Have a clear vision for what financial freedom would mean for you. This will help you stick to your budget when it's difficult.

Try Budgeting Tools

There are many programs and apps you can use to make the budgeting process easier. Quicken is perhaps the best-known budgeting software program, but relative newcomers such as Mint, Mvelopes, and You Need a Budget (YNAB) have many fans as well. Rates for each of these services vary considerably, so compare the features and costs to decide which is best for you. If you're comfortable in Excel, you can also create your own spreadsheet, relying on bank and credit card statements to fill in amounts and categories of income and expenditures.

Consider Budget Types

Zero-based and 50-30-20 are two common methods of budgeting. In a zero-based budget, all inflows and outflows for a specific period are accounted for in some manner, so there is zero money left over. That doesn't mean you blow every dollar you earn every month; it means you know exactly where every dollar has gone, be it a retirement savings account, a credit card payment, or a checking account.

A 50-30-20 budget assumes you spend 50% of your monthly income on necessities, such as housing, utilities, groceries, and transportation; 30% on discretionary items, such as premium cable, concert tickets, and restaurant meals; and 20% for savings and debt payments. This kind of budget was popularized by U.S. Senator Elizabeth Warren and her daughter, Amelia Warren Tyagi, in their 2005 book "All Your Worth: The Ultimate Lifetime Money Plan."

If you choose this type of budget, your goal will be to keep what you spend on your needs and wants within their assigned percentages so you will have the remaining 20% to put into an individual retirement account (IRA) or make more than the minimum payment on a credit card, for instance.

Many first-time budgeters may find that the zero-based budget requires meticulous attention to detail, while the 50-30-20 method is easier to carry out.

Determine Your Monthly Income

If your only income comes from a steady job, calculating your monthly income is as simple as looking at your latest paychecks. Calculate your monthly take-home pay after taxes and other deductions. If you're self-employed, add your net earnings from the past year, subtract estimated taxes and divide by 12. For greater accuracy, add your earnings from the past three years and divide by 36.

Add irregular or passive income, such as bonuses, commissions, dividends, rental income, and royalties. If you receive this quarterly or annually, average it to get a monthly estimate. This will help you design a consistent budget that doesn't fluctuate every month.

Add Up Monthly Expenses

When you're trying to get a handle on your monthly expenses, you may find it helpful to break them down into two categories.

Necessary Expenses

Necessary expenses are the bills you must pay each month, including: 

  • Rent or mortgage and utilities
  • Auto and home insurance
  • Health care costs
  • Minimum loan repayments, such as student loans and credit cards
  • Groceries, gasoline, and other semi-fixed expenses

Divide the annual bill by 12 for any necessary expenses paid annually, such as property taxes or vehicle registration fees. That will give you the cost per month.

Discretionary Expenses

List your discretionary expenses such as restaurants, entertainment, vacations, electronics, and gifts. You can review the past year of your credit and debit card statements to calculate your discretionary spending. Add everything up and divide by 12 to find a monthly average.

Total Monthly Expenses

Add up all of the monthly amounts and compare your total expenses to your income. If you spend more than you earn, you’ll need to make some changes. If you earn more than you spend, you’re off to a great start.

Cut Expenses

If you spend more than you earn, your discretionary costs should be the first and easiest to cut. Pack a lunch instead of eating out. Stream a movie at home instead of going to the theater. Drop one of your subscriptions.

Fixed costs are harder to cut, but you can save hundreds by doing so. Ask for a re-assessment of your home value if you think property taxes might be too high. Shop around for lower rates for your different insurance policies. Stock up on non-perishable items when they're on sale at the grocery store, and choose perishables according to what's being offered at a special discount that week.

Decide on Savings Priorities

Once your income is higher than your expenses, decide which goals are most important to you. Your savings priorities should fall into three categories: 

  • Short-term: a vacation, a fund for car repairs
  • Mid-term: a wedding, a college fund for your kids
  • Long-term: retirement

Divide your savings into different accounts dedicated to each goal.

If you don't have enough available to save for every type of goal, start with your long-term goals such as eliminating debt and saving for retirement, then make sure you have an emergency fund to cover at least a few months' expenses.

Create a Savings Plan

Now you should figure out how much to put away toward those goals each month. A good rule of thumb is to save 15% of your income for retirement, so if you've adopted a 50-30-20 budget, that leaves you with 5% of your income to set aside for extra debt payments and your short-term and mid-term savings priorities.

Set actual dollar amounts and time frames (for example, $1,000 and six months for the car repair fund), keep track of your progress, and figure out whether you need to drop a goal or downscale it. For instance, maybe you can take a nice long weekend at a beautiful, nearby resort instead of a 10-day vacation in France.

Comparing Spending to Your Budget

Each month, compare your actual income and expenses to the budgeted amounts. You’ll see the areas in which you have shortfalls and the areas in which you have more than expected. Evaluate and adjust until you are able to consistently meet your budget and work steadily toward your goals.