Most of us avoid the word “budget.”
It’s uncomfortable. It’s time-consuming. And worst of all, it has the potential to reveal our bad financial habits. Nobody likes to be in that position.
However, we’ve found that the key to creating a sound financial plan for your life begins with creating a budget. Why? Because your budget is what keeps your spending under control, and when you keep your spending under control, you have the opportunity to use your money for more than just paying off credit cards and appeasing debt collectors.
Think of your budget like the bridle on a horse. It’s a really simple piece of equipment that helps you keep your horse on track as you trot down a trail or gallop down the home stretch of a racetrack. Without that bridle you’ll have a hard time keeping your horse under control. The same goes for your finances.
If you don’t have a budget, chances are you won’t be able to control your spending and it will run every which way except where you need it to go. And like a bridle, it’s a very simple piece of financial equipment.
So, we’re going to help you understand why a budget is important, how to create one and give examples of how a budget can change the way you view your money.
Why Do You Need a Budget?
There are a couple of different reasons why a budget is important to your financial life. To get some insight as to why it matters, we did some research on our own and also talked with a few personal finance experts.
We’re going to start with a very basic explanation of what a budget is before we get to why you need it.
A budget is a method of keeping track of your expenses based on pre-determined spending amounts you choose. Those spending amounts include fixed costs (they don’t change month to month) like rent, mortgages and car payments and variable costs (they change month to month), like how much you spend on food and going out.
We’re going to talk about this later in the article, but this explanation will do for the moment. Now, let’s discuss the “why” factor.
Going back to our bridle metaphor, creating a budget is important because it will help you control your finances. It brings all of your spending habits to light and sets a limit on that spending. So, if you’ve forked over $200 this past month to eat out, you may say to yourself, “I want to limit that spending to $100.” If you follow through on that goal, you’ve just created an extra $100.
In that example, you’ve done two things: identify how much you’re spending and then identify how much you actually want to spend. When you apply that process to each category in your budget, you can get a really good sense of how much you need to spend each month.
We like how Investopedia’s Amy Bell put it: “If you create and stick to a budget, you’ll never find yourself (overspending). You’ll know exactly how much money you earn, how much you can afford to spend each month and how much you need to save.”
We talked with Broke Millennial’s Erin Lowry about several other reasons why budgeting is important. She brought up some great points.
First, creating a budget helps you figure out exactly how much money you have left at the end of the month. If you’re spending $3,000 and making $2,700 after taxes, then you know you have to cut back in certain areas.
“Without knowing your budget,” Erin said, “it’s easy to live well outside your means and you’ll find it impossible to save and pay down debt.”
Budget Brings Out the Ugly Truth
Creating a budget gives you freedom. Many of us are chained to this constant worry that we won’t have enough money to pay our bills. Yet we rarely set aside time to find out exactly where our money is going and how much is coming in.
I’ll give you an example from my own life. My wife and I moved to Florida from Spain just a few months ago. The first couple of months we were here, our spending was all over the place because we were starting from scratch, minus the clothes and keepsakes we brought from Spain.
As time went on, I started to worry about our finances. I knew we were spending a lot, but I wasn’t quite sure how much we were spending. So, a few weeks ago I sat down and decided to take control of the situation by writing out all of our bills.
Once I saw how much we were spending each month, it was a relief because I realized we had some cushion. Not a lot, but enough to keep us from going into debt.
It’s kind of like how some of us are afraid to go to the doctor when we feel pain in our knee, for example. We don’t go because we worry we’ll get bad news. But once we muster up the courage to go to an appointment, we realize it’s just a minor case of tendinitis. Totally manageable, right?
And even if it’s something worse, like a torn ligament, we’ve taken control of the situation by bringing it to light. Now that you know what the problem is, you can work together with your doctor to create a plan for physical therapy, surgery or both.
Most likely, your doc will praise you for coming in because, if you’d waited a few months longer, things could’ve gotten much worse.
Same thing with your budget. Once you know where your money is going and where you’re overspending, you can come up with a plan to “treat” it.
You’ll hear similar stories from financial experts, many of whom found themselves in debt or wasting money like the rest of us.
Grayson Bell, founder of the personal finance website Debtroundup, said when he created a budget for the first time his spending habits and the money he was paying on credit card balances was pretty astonishing.
“I never budgeted before I got into debt. I was spending like crazy,” he said.
But once he had a sense of what was happening, he was freed up to transform his financial life.
“You can’t make a change if you don’t know what’s going on, and that’s what a budget does,” Grayson said.
How to Make a Budget in Six Steps
Let’s get one thing straight before we begin – budgets aren’t as complicated as you think.
Gyutae Park, one of the financial experts at personal finance site Money Crashers, told us budgets are simple in nature but pretty powerful in influence.
“A personal budget may seem simple, but it’s actually a great tool to keep yourself on track and accountable to taking the necessary steps to meet your financial goals,” he said.
Creating a budget takes two sets of information: what you make and what you spend.
1. Track What You Earn
If you have a traditional salaried job or a set amount of hours you work every week, this is pretty easy. If you’re a freelancer, it can be a little more difficult.
The key is to know your situation, says Holly Perez, a spokeswoman for popular personal finance sites Mint and Intuit.
“It starts with understanding your financial situation,” Holly said. “Once you understand what money you have, then you can prioritize how and what to budget for.”
2. Know How Much You Spend
Once you’ve figured out how much you’re earning, you need to calculate how you much you spend. This is a little trickier than it sounds, only because you have to decide whether you want to split your spending up into categories or just calculate how much you spend overall.
Our suggestion? Break your spending up into categories. It will be easier to know how much you’re spending in each category, which means you’ll be able to decide where you can cut back and where you can spend more.
As we mentioned earlier, these categories fall into two types: fixed and variable. Your rent/mortgage is a fixed cost because it’s the same every month. Same for your car payments, auto insurance and health insurance. Other fixed expenses are phone, internet and cable bills and subscription services like Netflix and Hulu.
Variable expenses are things like food, clothes, gas and all the other random stuff you need every month like hygiene products, clothes and things for your kids (if you have them).
Here’s a sample budget:
- Rent: $1150
- Food: $500
- Health insurance: $200
- Car payment: $200
- Gas: $150
- Utilities: $130
- Hyegenie products/baby stuff: $100
- Internet/cable: $120
- Going out/entertainment: $150
- Car insurance: $60
- Phone: $60
- Hulu/Netflix: $17
- Total: $2837
Now, let’s say you earn $3,837 a month. Guess what? You’ve got about $1,000 left over at the end of the month. That’s not a hard one grand, though. You might have some emergencies pop up during the month (doctor’s visits, car repairs, etc.) that will cut into that.
3. Find a Budgeting Style that Works for You
But here’s the thing – not everyone is the same. Some people spend a lot of money on haircuts and some people spend a lot of money on food. There’s no single rule that says you have to stick to a certain kind of budget.
For instance, Gyutae at Money Crashers doesn’t use specific categories for his budget because they tend to fluctuate.
“My wife and I dine out more in the summer months when the weather is nice, whereas we like to stay in, away from the crowds, during the colder months,” Gyutae said.
So, in his opinion, you have to remember the goal is to earn more than you spend.
“At the end of the day, the goal is to spend less than you make,” he said.
Holly Perez from Mint has a different take on the matter. She referenced the 50/30/20 philosophy, where 50% of what you earn is spent on fixed costs, 30% is used for variable costs and 20% is tucked away in savings or investments.
In our opinion, it’s useful to create categories because it will help you identify areas where you can cut back. And when you know you can trim off a little extra spending, you can start putting your money toward debt or maybe a future vacation or big purchase.
For instance, if you create an “eating out” category, you might find that you spend $150 a month. At the same time you’re sipping down lattes and hitting up Panera for lunch, you’re dreaming of heading to Barbados for a summer vacation.
If you trim your eating-out budget in half, that’s an extra $75 a month you can put toward that trip. At the end of one year, that monthly $75 becomes $900 for Barbados.
4. Track Your Budget
When we say “track your budget”, we’re referring to the practice of recording how much you spend in certain areas. My wife and I have a simple spreadsheet stuck to our fridge with three columns on it: food, hygiene products (toothpaste, mouthwash, toilet paper, diapers, etc.) and miscellaneous. There’s one row for every day of the month, plus one extra row at the end of the week.
When we get home from shopping, we write down how much we spent in each of the three categories. At the end of the week, we total everything up and write it in that extra row I mentioned. This way, we can get a weekly running total of how much we’re spending in those three categories.
So, if we see that, at the end of two weeks, we’re on track to be $50 under budget on food, we can plan on stashing that away in savings or use that extra money for a date night.
I’ll admit this is a little old school, but it’s a hands-on way of controlling your spending.
If you hate writing things down, try Mint.com. They offer a free budgeting tool that links to your bank accounts and credit cards to track your spending. You set up your budget, purchases are tracked and categorized for you and Mint keeps a running count of where you are in your spending.
5. Be Disciplined
Now that you know what’s possible with a budget, we need to cut through the idealism and get to the heart of what makes a budget work: discipline.
“A budget is effective only as much as your ability to maintain discipline and follow it,” Gyutae said. “You can have the best budget in the world … but it’ll be completely useless if you don’t’ have the willpower and motivation to use it to reach your goals and improve your finances.”
Creating a habit of checking how much you’ve spend can be really tough, mainly because discipline doesn’t come naturally to most of us.
So, start with a one-month practice period. Crunch all the numbers and see how much you’re spending and earning. Then, pick three variable-cost categories and set a limit you think is reasonable.
For the next 30 days, try to keep your spending within those limits. Once you’ve got that down, include all your other categories and/or spending limits.
Using this practice month will help ease you into a budgeting mindset. It’s going to be tough for the first few weeks, but remember why you’re doing it. That’s what we’ll cover in the next section.
6. Focus on Your Goals
If there’s one final piece of advice we can give, it’s set a goal for your budgeting. For some of us, that’s going to be paying off debt. For others, it could be freeing up money to save and invest. And there’s also the nice perk of saving up for something awesome like a vacation, a new laptop or a new car.
We suggest you write these goals down and put them somewhere you can see them every day. The research is extensive and pretty clear that those who write down their goals are much more likely to achieve them than those who don’t.
A budget does two huge things: it gives you control over your finances and frees you up to achieve a sound financial future.
Creating your budget is a pretty simple matter. Add up how much you make, then look at the past few months of your bank and credit card statements to find out how much you normally spend. Create categories for your fixed costs (mortgage, rent, insurance, etc.) and your fluctuating costs (food, gas, entertainment).
You’ll start to see the difference between how much money is going into your bank account and how much is going out. Set your spending limits in each category and you’re set.
You’ll need to be disciplined in order to stick with the budget you create, but that becomes much easier when you write down your financial goals. Knowing where you’re going can sharpen your plan for getting there.
If you want to fine-tune your budgeting skills even further, check out an article we wrote about budgeting and holiday spending. The article will help you formulate a sort of mini-budget to help you spend wisely leading up to Dec. 25. One of the key things you’ll learn is how to project spending so you can be prepared for your Christmas bills.