Budgeting is the personal finance tool for taking control of your money.
A budget is a written plan for how you will spend your money. It allows you to make financial decisions ahead of time, which makes it easier to cover all your expenses along with paying off debt, saving for the future, and being able to afford fun expenses. Budgeting consistently can help you turn your finances around and start the process of building wealth.
Why Budgeting Is Important in Personal Finance
A budget is a powerful tool because it allows you to determine how and where you want to spend your money. When you master budgeting, you make sure that every dollar is being used how you want it, and can track your spending to determine whether it matches your priorities.
Often when people start budgeting, they are surprised to see how much money is going to things that are not important to them, like eating out, mindless online shopping, or high-interest payments on credit cards.
Budgeting allows you to monitor your progress on financial goals and stick to your financial plan. Eventually, it creates opportunities to eliminate debt and build wealth.
Create a Budget in Nine Steps
To create a budget, you have to start by creating a picture of your financial situation. It helps to have a list of the bills that you must pay each month, as well as your pay stubs, and either bank records or receipts from the past three months.
Step One: Determine Your Income
Begin by listing your monthly income. This should include any paychecks you receive, as well as income from other sources, such as:
- Child support
- Government benefits
- Social Security
If you have a business, you should include the amount you pay yourself each month rather than the business's total income. If you do not get paid monthly, look at how much income you had last year and divide it by 12 to determine your likely monthly income this year.
Step Two: List Categories of Mandatory Expenses
Mandatory expenses are the expenses that you must pay every month and are vital to your housing, work, or legal obligations. These should include things like:
- Health insurance
- Prescriptions you take daily or monthly
- Child care
- Transportation to and from work
- Child support
You can usually identify mandatory expenses because they are fixed amounts, although some, such as electricity or water, can vary month to month. If you have debt payments, such as student loans or credit card payments, they should also be included. Don't worry about assigning values yet; simply make a list of the categories.
Step Three: List Categories of Discretionary Expenses
Next, identify your discretionary expenses. These are things you can go without but often choose to spend money on. They are wants, rather than needs, and may include:
- Fitness memberships
- Cable TV
- Streaming subscriptions
- Eating out
- Leisure travel
- Personal grooming
- House cleaning
- Home decor
You can also include savings goals, such as retirement accounts or a down payment fund, as discretionary expenses for now. There will not be immediate consequences if you scale back on these for a little while, although there may be long-term consequences if you ignore them for an extended period of time. Once your budget is under control, you can move these to mandatory expenses with fixed monthly contributions.
Step Four: Estimate Expenses
Once you have all your spending categories listed, it's time to assign monetary values to them. Without looking at your spending patterns, write down what you think you must or will spend in each category in a month.
Step Five: Compare Estimated to Actual Expenses
Now, go back through your spending history for the last three months and determine what you actually spent in each category per month. You can use your receipts or bank statements to determine what you actually spent. Compare these to the numbers you estimated.
If there is a big difference between the two, that is a strong indicator you need a strict budget to manage your spending and keep track of your finances.
Step Six: Assign Spending Limits Within Your Income
Once you have a sense of how much you are spending per month compared to what you think you spend, it's time to set spending limits. Start by budgeting for mandatory expenses, then add up these values and subtract them from your income.
The amount you have left is what you can budget for discretionary expenses and savings goals. What you budget for expenses should not be more than your income; otherwise, you will end up in debt.
If you have debt payments, start by budgeting for the minimum payment, then add more if you have available funds leftover. If you have additional money after you plan your budget, you can add it to the categories for financial goals like saving for retirement or building an emergency fund. After that, you can budget more for discretionary expenses and luxuries.
Step Seven: Look for Places To Cut Expenses
If you have more expenses than income, you will need to find ways to cut back on your expenses. Start by lowering the spending limits in the discretionary section of your budget or eliminating them entirely.
Next, look for ways you can reduce your mandatory expenses, such as:
- A cheaper monthly insurance premium
- Using less electricity at home
- Taking the bus to work instead of driving
- Spending less on groceries
If your expenses are still more than your income, you may need to increase the amount you earn by negotiating a raise, adding a second job, or taking on gig work.
Step Eight: Track Your Spending
Once you have your budget set for the month, you will need to track your spending and stop when you have reached the limit in each category. When you stop spending, that's called sticking to your budget.
If you end up spending more in one category than you had planned, you can transfer money into that category to cover it from another category. For example, if you budgeted $400 for food for one month and you ended up spending $450, then you can move $50 from another category to cover it. To do this, you will need to check your spending before making purchases to see how much you have left.
Step Nine: Plan for The Next Month
After you have completed your first month of budgeting, it will be easier to plan for the next month. Look at how you spent your money, make adjustments for categories in which you spent more than you planned, and cut back on the categories that had additional funds in them.
You should also look ahead to large expenses coming up, such as insurance premiums that are only due every few months or upcoming holiday expenses. Plan for these larger expenses as you set your budget for the next month.
Every person is different, and one strategy may work better for you than another. If you are new to budgeting, try out different options to find the one that works best for your spending habits and financial mindset.
How it works: In an envelope budget, you assign money to each category and deal with cash for as many categories as possible. At the beginning of each month, take the appropriate amount of cash out of your bank account and put it in a designated, physical envelope labeled with the name of each category. When you run out of money in that category, you either stop spending, or you have to take cash from the envelope for a different category to cover the difference.
Good for: People who are not good at tracking expenses or who need to stop using their debit or credit cards.
If you want to pay bills online or transfer money into a savings account, set those to be paid at the very beginning of the month, then take cash out for the remaining expenses after those bills have been gone through.
How it works: The 50/30/20 budget breaks down how much you should be spending on different categories. Fifty percent of your after-tax income is to be spent on your mandatory expenses, or needs; 30% should be spent on discretionary expenses, or wants; and 20% should be tailored toward savings and debt repayment.
Good for: People who want to focus on financial goals.
Make sure to separate savings and debt repayment from other expenses, rather than including them in either living expenses or discretionary spending.
How to works: A zero-dollar budget involves planning how you are going to spend your income down to the last penny. Every dollar of income you make for the month should be assigned to a spending category. This allows you to know where all of your money is going at any given time. It also makes it more important to monitor your budget regularly.
Good for: People who need to get control of spending.
Be sure to include a category for surprise expenses. If you have any extra income to budget at the beginning of the month, it can go into this category, then roll over into the next month if you don't spend it. This will allow you to build up a short-term emergency fund.
How it works: The five-category budget sets up five basic categories and determines the percentage you should spend on each one. For housing, you can spend up to 35% of your income. Living expenses, which include mandatory expenses such as groceries, your cellphone bill, and discretionary spending, should make up 25% of your spending. Allocate 15% each for transportation and debt payoff. Finally, set aside 10% of your income for savings.
Good for: People who have some wiggle room in their finances but may have small amounts of debt.
Housing expenses include your mortgage payment or rent, as well as household utilities, home maintenance, HOA fees, and homeowners or renter's insurance.
How To Make Budgeting Easier
It takes a lot of work to track your expenses, and for many people, budgeting can feel restrictive. If you share finances with another person, disagreements over spending can cause resentment or fighting.
The first two or three months of budgeting are the hardest, as you adjust categories and work on cutting your spending. Luckily, there are ways to make budgeting easier.
- Use a budgeting app: Tools like You Need a Budget (YNAB) or Mint will import your transactions for you and make it easier to assign categories, adjust the amounts, and track your spending. A single account can be shared between multiple people who need to track spending together.
- Use cash: Consider switching to cash for some categories, even if you aren't using an envelope budget. If you consistently overspend in a single category, such as eating out or groceries, take out cash at the beginning of the month for this category rather than using a debit or credit card to cover those expenses.
- Check on your budget each day: Set aside five minutes in the morning or evening to look at your spending and bank account. This can keep you from making a mistake or overdrawing your account.
- Find ways to save: The more money you can save on your daily expenses, the easier it will be to stick to your budget. Look for ways to save on your groceries, lower your utilities, negotiate on bills, and more. Shopping around for the best deals can make budgeting less stressful.
- Open an online bank account: If you don't already have a bank account, open a checking account through an online bank. These often have lower minimum deposits and fees than accounts through brick-and-mortar banks. Once you have a bank account, you can set up online payments, create savings or retirement accounts, and more easily track where your money is going.
- Make budgeting automatic: Schedule rent, loan repayment, or other mandatory expenses to be automatically paid on your payday. This will prevent you from accidentally spending that money on discretionary expenses. You can also schedule automatic transfers into your savings or retirement accounts. You can either do this automatically through your online bank accounts, by setting up different accounts where percentages of your paycheck can be deposited, or by using a budget app that can access your bank account.
- Work towards a goal: Sticking to a budget can be difficult, especially if you aren't used to regulating your spending. To motivate yourself, set a goal that you are saving toward: eliminating debt, building an emergency fund, getting to the point where you have more discretionary income, saving for travel, or any other goal you are determined to meet. Working toward a set goal can keep you focused and remind you why sticking to a budget is worth it.
Why You Should Keep Budgeting
Once you have your finances under control, have eliminated debt, or have met other financial goals you set, that doesn't mean you should stop budgeting.
Sticking to a budget makes it less likely you will accumulate debt or end up with large expenses you have no way to meet. It also allows you to save money for fun expenses, such as travel, and eventually get to the point where you can build wealth through investing.
Even when you have plenty of money to meet your mandatory and discretionary expenses, budgeting is still an essential part of smart personal finance. Using a budget allows you to understand your financial situation and manage your money. It puts you in control, rather than allowing your money to control you.