A budget is a written plan that outlines how you’ll spend your money each month. It shines a light on how much money you make and where it goes, so you can use your money to reach your life goals.
Let’s explore how a budget works, why it’s important, and popular types of budgets you can use.
Definition and Examples of a Budget
A budget is a financial planning tool in which you write down how much money you expect to earn (i.e. your income) and how you plan on using it (i.e. your expenses). Individuals and businesses alike use budgets to track their cash flow and reach their goals.
- Alternate name: Spending plan
One popular budgeting method is the 50/30/20 budget. You use 50% of your income for needs (such as rent and utilities), 30% for wants (such as shopping and eating out), and 20% for savings (such as an emergency fund, paying down debt, or building up your retirement fund).
How Does a Budget Work?
The purpose of a budget is to help you track your spending so you can use your money to reach your goals.
“Budgeting helps you decide upfront how to spend your money,” said R.J. Weiss, CFP and founder of The Ways to Wealth. “Everyone has different priorities and goals. By budgeting, you're making sure your priorities and goals are being put ahead of expenses that aren’t as important.”
After you set up your budget, one of three things will happen:
- You’ll have a balanced budget: This means your income equals your expenses and you aren’t spending more money than you make.
- You’ll have a deficit: This means you’re spending more than you make and possibly going into debt.
- You’ll have a surplus: This means you’re spending less than you earn. You can use the extra money to save, pay off debt, and reach your goals.
Here’s a closer look at how a budget works for individuals and businesses:
The whole point of a personal budget is to help you spend less than you earn so you can use the difference to reach your savings goals. In its simplest form, a personal budget works like this:
At the beginning of each month, you create a written plan for how you’ll spend your income.
- Fixed expenses: These expenses cost the same amount of money every month and are typically non-negotiable. Some examples are rent or a mortgage, car insurance, your phone bill, and some utilities.
- Variable expenses: These expenses are necessary, but the cost varies month to month. Examples include groceries, electricity, transportation costs, and vehicle maintenance.
- Discretionary expenses: These expenses are 100% fun and optional. They include anything from clothing and new gadgets to vacations and entertainment purchases.
Finally, at the end of each month, you review your progress and use this month’s spending to plan next month’s budget.
Personal Budget Example
|Starting monthly income||$4,000|
|Health and Car Insurance||$100|
|Clothing and beauty supplies||$220|
|Debt payments and bank fees||$700|
|Ending monthly budget||-$200|
Your income is higher than your expenses, so you have a deficit budget. You already had a gut feeling this was true because you couldn’t pay your bills on time. But now, thanks to your budget, you know exactly where your money is going each month.
You need to free up at least $200 in your budget, so you start trimming expenses on takeout food, clothing, entertainment, and subscriptions—all things you want to spend money on but you can’t necessarily afford right now.
You cut $50 from your takeout food budget, another $50 from subscriptions, $40 from entertainment, and you cut your clothing budget in half to free up another $110.
Before you know it, you have an extra $250 in your budget. You put $200 of it toward bills and use the other $50 to start an emergency fund so you have a safety net to protect you from unexpected expenses.
Types of Budgets
There are almost as many types of budgets as there are flavors of ice cream. Consider trying out a few different types of budgets until you find which “flavor” you like best.
With the envelope budgeting method, you set spending limits for each of your budgeting categories and put that amount of cash in a physical envelope to help track your spending. Once you empty one envelope, that category is off-limits until you get paid again.
With the 50/30/20 budget rule, you spend 50% of your income on needs, 30% on wants, and 20% on savings and debt repayments. So, if your take-home pay is $5,000 a month, you’d spend:
- $2,500 on housing, transportation, and other necessities (50%)
- $1,500 on fun things like dining out, shopping, and subscriptions (30%)
- $1,000 to pay off debt and reach your savings goals (20%)
If you don’t like the idea of having to figure out what’s a “need” and what’s a “want,” consider the 80/20 method. With this budgeting rule, you save 20% of your income and use the other 80% however you’d like.
Keep in mind, the 20% savings rate is just a guideline. You can change it to be a 70/30 budget, a 60/40 budget—whatever works best for you. This method is also called the “pay-yourself-first” budget or the “reverse budget.”
A zero-based budget is a strategy where you give every dollar a job so your income minus expenses equals zero. It’s not to say you spend every penny you own. Rather, you go ahead and divide your paycheck out among all your expenses, debt payoff, and financial goals so there’s none left over.
Do I Need a Budget?
Yes. A budget is important because it helps you pay your bills on time and save for the future. It also helps you find ways to spend less money on things you don’t value so you have more money to put toward your goals—such as saving for retirement, a vacation, a house, or a new car.
Everyone can benefit from a budget, no matter how small or large your income is. Without one, it’s hard to know where your money is going each month.
If the idea of manually creating a budget each month sounds tiring, give a budgeting app a try. These apps take the load off by syncing to your financial accounts and automatically importing and categorizing transactions for you.
How To Create a Budget
Whether for personal or business use, here’s how you’d go about creating a budget:
1. Add Up Your Monthly Income
First things first, you need to figure out how much money you make each month. Use your net take-home pay for this step, which is the amount of money you bring home after taxes and deductions.
If you earn a salary, you can find your net take-home pay by looking at your paystubs. If you have irregular income, add up all the money you made last year and divide it by 12. This will give you an estimate to work with.
Don’t forget to include any other sources of income, such as Social Security, child support, side hustles, and more.
Looking for a free budgeting template? The Consumer Financial Protection Bureau offers a simple but effective template.
2. Estimate Your Monthly Expenses
Now it’s time to calculate your spending. Dig through your old bank and credit card statements to see how much money you spend each month. Some common expenses to add to your budget include:
- Rent or mortgage payments
- Utilities (gas, water, electricity, sewage)
- Internet and cable
- Cell phone bill
- Groceries and take out
- Health expenses
- Transportation costs
- Education and childcare costs
- Pet costs
- Debt payments
“If you're brand new to budgeting, consider budgeting just one spending category over the next month,” Weiss said. “For best results, pick a category you tend to overspend, such as eating out, grocery shopping, or entertainment. The idea is to start small, to give yourself the highest possible chance of success. From there, you'll gain confidence and skill in your ability to budget, and be able to apply it to other areas.”
Don’t forget about budgeting for seasonal expenses. If you want to save up for holiday expenses, make sure you add a “Holiday expenses” line to your budget for August through December. Doing so will give you time to save up what you need for presents, parties, and other expenses.
3. Subtract Your Expenses From Your Income
Once you subtract your expenses from your income, you’ll have a better idea of if you’re living within your means or taking on more debt.
- If your income is higher than your expenses: You have money left to save or spend. Consider putting some of this money toward the financial goals you set in Step 4.
- If you broke even: You’re living within your means, but just barely. Ideally, you want some extra money left over each month to put toward your financial goals. See if there are a few expenses you can trim to give yourself a buffer to work with each month.
- If your expenses are higher than your income: You’re spending more than you make. Look for ways to trim expenses or increase your income.
4. Build Some Financial Goals Into Your Budget
As you build out your budget, incorporate some financial goals you’d like to reach in the coming months or years. For example, you could create budgeting categories for goals such as:
- An emergency fund
- Down payment on a house
- Security deposit on a new apartment
- New car
- Kid’s college fund
- Extra debt payments
5. Make Adjustments as You Go
Your life is dynamic and constantly changing, so your budget should be, too. When you get a new job, add a new expense, or earn a bonus, adjust your budget to reflect the changes.
As you move throughout the month, track your spending and make adjustments as needed. If you consistently overspend in one budget area, you may want to move money from another spending area to cover the difference.
“There is no one perfect way to budget,” Weiss said. “It's important to go in with the expectation that budgeting is a skill that takes practice. You'll likely fail in month one, but what's important is you take what you learned and apply it down the road.”
- A budget is a written plan that outlines how you’ll spend your money each month.
- Both individuals and businesses use budgets to manage their cash flow and reach their goals.
- A budget is important because it shows you how much money you make each month and how you’re spending that money.
- Some popular types of budgets include the 50/30/20 budget, the 80/20 budget, the envelope budget, and the zero-based budget.