Although only around one-third of Americans use a household budget, there are substantial benefits to laying out a spending plan. Making and following a budget can help increase your financial security and build wealth.
Whether you’re budgeting for the first time or updating your existing spending plan, it's essential to account for your income sources and your expenses. Every month, you probably spend in these categories:
- Fixed expenses
- Variable expenses
- Discretionary expenses
Let’s look at each of these different expenses.
Fixed expenses are necessary ongoing costs that don't change in amount or frequency. They might arrive monthly, twice a year, or once a year. For example, you may pay insurance premiums twice a year, but the payment is identical and predictable. Some common examples of fixed expenses include:
- Rent or mortgage payments
- Insurance premiums
- Health or car insurance
- Phone plans
- Bus pass
- Payments on fixed-rate personal or student loans
- Daycare or school tuition costs
Saving for retirement, emergencies, and other financial goals could be considered a fixed expense to ensure you're working towards building wealth and preparing for the future.
Variable expenses are still necessary costs, but the amount changes every month, often in concert with your usage or choices. Your monthly utility bill might cost much less in September when you don't have to run the air conditioning in July or use heat in January.
Some examples of variable expenses include:
- Electricity costs
- Transportation/gas expenses
- Vehicle maintenance
- Gas or oil
- Clothing costs
- Payments on variable-rate loans
With variable expenses, you probably have some control over how much you spend. For example, you need clothing, but you can reduce costs by switching to shopping at consignment shops instead of buying brand-name items from more expensive stores.
Finally, discretionary expenses are those that are desirable, but you have discretion (or individual choice) over whether to spend on them or not. To determine whether something is a discretionary expense, consider whether it's a want or a need. You need food, but you don't need it to come from a restaurant. So, groceries are a variable expense, but dining out is a discretionary expense.
- Dining out at restaurants
- Video games, magazines, and comic books
- Streaming TV subscriptions
- Personal care (nail salons, haircare)
Some expenses can contain discretionary, variable, and fixed categories. For example, you may need a cell phone for work or health reasons. Choosing between a brand-new phone or an inexpensive or refurbished phone is a variable expense. The basic, limited monthly voice plan is a fixed expense. However, an unlimited data plan is unnecessary. That would be a discretionary expense.
Budgeting for Expenses
Go through your credit card or bank statements to sort your expenses into the three categories. How much have you been spending? Which costs will remain the same, and which can change? If your spending is greater than your income, how can you cut your expenses?
Start With Fixed Expenses
Then, when making your budget, always start with fixed expenses. These are the simplest to account for and often the most difficult to change. However, it is possible to reduce your fixed expenses. You can refinance to lower your house payment, or move somewhere the rent is lower.
Even if a fixed expense arrives only once a year, you can account for it in your monthly budget. If a $5,000 tuition bill comes in one year, set aside $417 per month for 12 months in an interest-earning savings account until the payment is due.
Next Come Variable Expenses
Variable expenses should come next since these are also required costs. Reducing variable expenses can be easier than reducing fixed expenses. If you want to cut energy costs, you could lower the thermostat setting or unplug power-hungry (but infrequently used) appliances.
The Rest Goes to Discretionary Expenses
Finally, allocate remaining money for discretionary expenditures. Discretionary expenses are often the first cut when looking for money-saving opportunities. Spending money on these expenses is optional, and unnecessary to maintain your health or safety.
One popular budgeting option—the 50-30-20 budget—involves dividing in the following manner:
- 50% for household spending, including fixed and variable expenses
- 30% for your wants or discretionary spend items
- 20% for your savings account and for paying down debt
If sticking to your budget is challenging because you've already slashed discretionary expenses, consider cutting fixed costs to help you stick with your financial plan.
The key is to make sure that the total amount of your expenses doesn't exceed the income available to you and budgeting for savings. Your resulting financial plan can help you avoid debt and build wealth.