There are two ways to approach your budget. The most popular method is to examine your income, then cut your spending until it aligns with your income. A less common but equally valid approach is to decide how much money you want to spend each month, then force your income to match your expenses. Let's look at the pros and cons of both of these approaches.
Much has been written about the 50/30/20 budgeting method, which was proposed by Senator Elizabeth Warren and her daughter, Amelia Warren Tyagi. It says that people should devote 50% of their income to needs, 30% to wants, and 20% to savings and debt reduction. This budgeting method starts by looking at your income and using it to decide how you're going to spend money.
Most other budgeting methods, like You Need a Budget or Dave Ramsey's EveryDollar, also use your income to determine your budget.
The main advantage is that it ensures that you live within your means, but it can also feel like a chore. Focusing on cutting costs rather than increasing income can seem more like deprivation.
This approach may be best for people who have a stable, steady income and don't have the time or resources to pick up additional work.
With this technique, you want to first make a list of all the expenses you'd like to pay and then figure out what type of income you need to aim for. Let's assume that you want to spend the following monthly:
- Mortgage (including insurance and taxes): $2,000
- Groceries: $400
- Cellular phone: $100
- Household goods: $100
- Car and life insurance: $100
- Utilities: $200
- Entertainment: $800
- Car payment: $300
- Retirement savings: $1,000
- Savings for vacations and holidays: $250
- Savings for home and car repairs and emergency fund: $250
Total: $5,500 per month
Now, let's assume that you currently earn $4,000 per month. The objective then becomes to earn an extra $1,500 per month, which is, of course, easier said than done. Perhaps you'll decide to earn extra money on the side. For example, freelancing 50 hours per month (roughly 14.3 hours per week, or two hours a day) at $30 per hour will bring you an extra $1,500.
Perhaps you'll start looking for investments that can bring you part of that money. You might, for example, decide to buy a rental property that produces $200 per month in net positive cash flow (the money left over after paying for all expenses), or maybe you'll decide to start looking for a new job with a higher salary.
The bottom line is that by using the expense-income approach (rather than the income-expense approach), your attention shifts away from trimming your bills and towards generating more money. That's a powerful mental shift.
Don't use this approach as an excuse to start living above your means. If you earn $4,000 and you hope to live like you make $5,500, you have a great goal. But you should cut your spending until you reach that $5,500 mark. You also want to avoid lifestyle hyper-inflation and spend with every pay raise. Both your spending and your savings should increase proportionately with each pay increase.
The main advantage of this approach is it shifts your attention to making money rather than cutting costs. You begin with a list of what you want to do and then you figure out a way to make that happen. It's empowering and opportunity-centered. The main drawback is the temptation to live above your means with this increased income and forget your savings goals.
This method is best for people who have or want to have multiple streams of income.
The Bottom Line
Just because it's the most common way doesn't necessarily mean it's the best way. There is no single best method for budgeting. Personal finance is personal, and you need to choose a method that suits your personality and style. The method you choose is less important than the result you achieve.