While vital to financial success, budgeting is a topic that makes many people cringe. The popular notion seems to be that tracking income and expenses are far too difficult for the average person or household.
But learning how to budget is easier than you might expect.
There are a few basic principles that back every financial budget. These concepts are easy to understand and put in place. Likewise, there are now many software tools that will make budgeting an even more straightforward task.
Budgeting can be the key to breaking free from the paycheck-to-paycheck lifestyle that so many Americans fall victim to. So, let’s see what it takes to create an effective budget that works for you.
Understand Your Income
Before you can begin budgeting, you need to know your income. Your income after taxes is the essential parameter that will dictate your budgeting strategy.
Start by calculating your monthly take-home pay. That number represents the absolute maximum for your monthly spending.
Ideally, your spending will be significantly lower than your monthly income. But reaching that goal relies on a clear knowledge of how much money you are bringing in.
It is important to note that you should base your monthly income figure on your take-home pay. Since a percentage of your income will go towards taxes automatically, failure to distinguish net pay from gross pay may cause you to live beyond your means.
Once you have an idea of your monthly income, you are ready to begin allocating portions of that income towards your expenses.
Recognize Your Expenses
It goes without saying that every person has many expenses every month. But not all expenses are equally important.
In considering your expenses, you need to determine which are essential and which you can reasonably go without. Here are a few of the most common non-negotiable expenses that the average person must confront:
- Loan Payments
For each individual, those requisite expenses may vary. But every adult has at least a few payments that they have no choice but to honor.
It is also the case that everyone has expenses beyond those which are necessary. Those discretionary expenses are essential, and you should account for them. But at this stage, allocating funds towards your mandatory expenses is the most critical task in developing your budgeting scheme.
In the next few sections, we’ll cover a fairly common budgeting strategy that will give you a clear idea of how you should divide your income and what that money should go towards.
Use the 50/30/20 Rule
There are many ways that you can approach your budgeting plan. But for someone who is just getting started, it is best to keep matters simple.
After all, very few people enjoy spending hours making complex monetary calculations. Rather than let your head swim in a dizzying array of confusing figures, why not follow one easy rule.
The 50/30/20 rule is a straightforward way to approach a budget, which helps differentiate expenses into three distinct categories. Each one calls for a specific percentage of your income. Let’s take a look at how this process works.
Put 50% Towards Fixed Costs
The expenses we listed earlier, rent, food, etc., are fixed costs. Whether you want to or not, you need to pay them each month. Failing to do so will lead to hardship and potential legal action.
To avoid that damaging outcome, make sure that you have your fixed costs covered every month. When following the 50/30/20 rule, half of your monthly income will go towards those fixed costs.
Of course, if your finances are not in order, or you have a low income, you may need to put a higher percentage towards these mandatory expenses. For those with a bit more leeway, 50% is an excellent place to start.
Just remember, your most pressing goal is to cover the necessities first. If that means spending more than 50% of your income, so be it. Only after meeting those needs can you begin to consider any more spending.
Put 30% Towards What You Want, But Don’t Need
We all buy things we don’t need, and a thorough budget should account for that. While unnecessary, these expenditures make our lives more fun and are hard to avoid altogether.
Unless you are in a dire situation, you are still allowed to incorporate purchases you desire, rather than need, into your budget. Here are some examples of discretionary expenses that many people have:
- Eating out
- Entertainment such as streaming services
Each list of wants will differ based on a person’s lifestyle and preferences. But regardless of what those expenses are, the 50/30/20 rule permits you to put 30% of your income towards unneeded purchases.
Now that we have covered essential and nonessential spending in our budget plan, let’s see where we will put the other 20% of our monthly income.
Put 20% Towards Debt and Savings
The segment of the 50/30/20 rule is debt and savings. After spending on the essentials and some entertainment, it is time to start saving. But before you can save, it is a good idea to eliminate your debt.
Let’s be clear here. There are certain forms of debt that you should include in the 50% fixed costs part of your budget. Those are the official legally binding debts such as:
- Personal loans and lines of credit from a bank
- Credit card debt
- Car loans
- Student loans
The debt we are referring to in the 20% part of your budget is a bit less formal. What we are talking about here are debts such as an off-the-books loan from a friend or relative.
If you have that kind of debt, use the remaining 20% of your income to pay it off. Once that gets paid off, continue following the same 50/30/20 rule by putting all 20% towards savings.
What’s So Important About Savings?
When you start budgeting, it is tempting to forgo savings and spend the second half of your income on purchases you enjoy. But this is not a reliable method of budgeting.
Saving money is critical to your financial future. And, though delayed, the gratification that you will have from savings is more valuable than the short-term purchases that please you at the moment.
Saving money allows you to:
- Create an emergency fund
- Build a retirement fund
- Escape the paycheck to paycheck lifestyle
Along with those clear benefits, savings opens the door to an entire world of new financial opportunities.
For instance, you could save your money then invest it into the stock market to watch your money grow on its own. You can also plan for big spendings such as higher education or a wedding.
Most importantly, a well-funded savings account will relieve a lot of your monetary stress. Knowing that you have a savings safety net is what permits you to live a life of financial freedom.
Other Budgeting Strategies
The 50/30/20 rule is just one of many budgeting strategies. In case you find that this method is not ideal for you, consider one of the following alternative budgeting methods.
The zero-balance method is one of the more traditional methods of budgeting and is perhaps the most stringent. When using this form of budgeting, you will sit down at the start of every month and give every single dollar you earn a purpose within your budget.
By every dollar, we mean every last dollar.
This approach is hard to do at first, but it guarantees that you won’t be overspending. As with any other method of budgeting, you should focus on fixed costs then take care of savings and discretionary spending.
At first, this will be a tedious task. But the benefit of the zero-balance budgeting method is that you will have absolute clarity about where your money will go in the following month.
If you are among the many people who struggle financially and wonder where your paycheck goes, give zero-balance budgeting a try.
The Pay-Yourself-First budgeting strategy is easy to understand. This strategy calls for you to automatically put money towards your future as soon as you receive it.
After dedicating that part of your paycheck, you can then spend on all your other important expenses. Often, people using this method will immediately put their pay into a retirement fund such as a 401k.
This plan may not work for everyone, especially those who are struggling to meet their fixed costs. For those individuals, there are other budgeting options that help to address more immediate needs.
Envelope budgeting is all about eliminating all the abstract representations of your finances. Instead, this tactic helps you see your money as a physical reality.
This strategy can help you become more conscious about your income and expenses and is a great option for those on a tight budget. Here is how it works:
- Cash your paycheck as soon as you receive it
- Dedicate individual envelopes to each of your monthly expenditures
- Seal the required amount of cash in each corresponding envelope
For many, direct deposits and card payments almost seem unreal at times. While convenient, the digital nature of these transactions makes them hard to fully comprehend.
Using the envelope method makes your money real. By only opening the envelopes when it is time to use the cash inside for its intended purpose will help prevent you from overspending.
Of course, this system only works if you are honest with yourself about using cash for its agreed-upon purpose. If you can manage that, you will soon have a much better handle on your finances.
Try Budgeting Software
Modern technology affords us many conveniences. Those conveniences now extend to the world of personal finance.
One of the main reasons why people are reluctant to begin budgeting is because it can be an admittedly dull chore. It also takes up time during your non-working hours that you could spend with friends and family or engaging in your favorite pastimes.
Budgeting software offers a remedy to those complaints. Below are a few of the best budgeting software options that can help you keep your finances organized in a time-efficient manner.
Mint is an app that you can connect to your bank accounts to track all of your financial transactions. This platform offers an intuitive user interface and allows you to set a clear personal budget.
As an additional benefit, Mint also offers credit monitoring. Since credit scores are so important in your financial ventures, it is advantageous to have unlimited access to yours.
One of the best aspects of using an app like Mint is the notifications. These notifications alert you when you are making large purchases or going beyond the set spending limits of your budget.
You Need a Budget
You Need a Budget (YNAB) is budgeting software that works across multiple platforms. Whether you prefer to use a desktop, tablet, or mobile device, you have the freedom to access your finances as you please.
The zero-balance method is the basis for the YNAB software. The tools included will guide you through the process of putting every dollar into use for every month. This software makes a somewhat involved process much more comfortable and can save you plenty of money over the long haul.
EveryDollar also adheres to the zero-balance philosophy. Financial guru Dave Ramsey and his team developed this app to help the average person get out of debt and create the financial life they dream of.
There are two versions of the app. The free version may suffice as it offers you all of the basic functionality. But if you want to link your bank accounts, you will need to make the upgrade to the paid version of the app.
Knowing how to budget is a foundational tool for anyone hoping to improve their financial life. All you need to do is find the budgeting strategy that fits your goals and lifestyle. Only then can you enjoy the rewards of a well-planned budget.