Creating a budget is crucial to maintaining a healthy financial situation. According to Debt.com, around one-third of Americans utilize a budget. The same article goes on to say that around half of Americans also live paycheck to paycheck. If those same individuals don’t have an emergency fund or solid savings, one unexpected expense could send them into bigger financial struggles. In order to control overspending and work towards financial goals, a budget becomes necessary.
Determine Your Financial Goals
When you are creating a budget it is important to establish what your financial goals are. In order to work towards a different financial standing, you need to determine what it is that you are reaching towards. Are you trying to save up for a house, or do you need the extra income now to get out of debt? Do you want to take out a loan for a new business, or start a side hustle to earn a little extra cash? Maybe you suffered an accident and can’t work, or have sudden medical bills to pay. Financial goals can encompass both aspirations as well as emergencies.
Financial goals vary between individuals based on what is being prioritized, what resources are available, and whether they are long-term or short-term. Once you sort out what your goals and your timeline looks like, you have created the basis on which to develop your budget.
Calculate Your Monthly Income
In order to allocate money to specific areas in your budget, you need to figure your monthly income. This includes all sources of income including wages from work, side hustles, child support, as well as any payments from a structured settlement, insurance, or government benefits. Calculate your monthly income based on your take-home income (income after taxes). You can’t budget based on money you do not have access to.
How to Calculate Monthly Income
Monthly income calculations depend on whether you are receiving paychecks in the form of salary or hourly.
Salary: Annual Salary (after taxes) / 12 (months) = Monthly Income
Ex: 72,000 / 12 = $6,000
Hourly: Hourly Pay (after taxes) x Weekly Hours x 52 (weeks) / 12 (months) = Monthly Income
Ex: $12 x 40 x 52 / 12 = $2,080
List All of Your Expenses
In order to budget your money effectively, you must accurately understand how you spend your money. This should include both fixed, recurring expenses (bills, utilities, housing) and any variable, elective spending (dining out, entertainment, shopping). Additionally, if you have any current or pending debts (eg, medical bills waiting for insurance to pay, credit cards with an introductory interest rate that is about to expire, etc.) you’ll want to include those in your expense sheet.
Keep close track of what your current spending habits look like, as it is important to be accurate when analyzing spending habits. Being accurate requires the inclusion of all types of purchases — big and small — from a quick gas station coffee to a new puppy. Even if you aren’t making payments toward debt or a bill, you still need to include them in your budget.
Analyze Your Spending Habits
Create a running list of monthly expenses starting with your fixed expenses. Fixed expenses are costs that do not change month over month. Typically fixed costs are things like:
- Housing (rent, mortgage);
- Debt Payments (loans, car, medical, etc.);
- Insurance (health, car, home, etc.);
- Subscriptions (internet, streaming services, etc.).
After you have an understanding of your fixed expenses, factor your variable expenses into your list. Variable expenses are costs that change based on interest rates, frequency of use and even impulse buys. Common costs that can fluctuate between months are:
- Food and Groceries;
- Utilities (wifi, water, electric, etc.);
- Shopping (clothing, haircuts, entertainment, etc.).
When you compare fixed, recurring expenses with your variable, elective spending, you should be able to see trends and opportunities to cut back. Are you paying for a streaming service you rarely use? Is your water or electrical bill higher than you realized? Should you consider a cheaper cell phone plan? Maybe housing would be more affordable if you got a roommate? Both fixed and variable expenses can yield ways to save.
Make a Plan to Adjust Your Expenses
Now that you have an understanding of both your monthly income and your monthly expenses it is time for some calculations. Subtract the total of your expenses — fixed and variable — from your total income to get a look into your financial situation. You want to aim for earning significantly more than you are spending. If your spending exceeds your earning then you will need to make changes to avoid putting yourself into financial distress.
If you calculate your income versus your expenses and you come up with a negative number, or a number that doesn’t leave you much, you may need to adjust your spending to avoid going into debt, but also to meet your financial goal(s). Find areas that you can decrease spending in to allocate that money elsewhere.
One way to avoid adjusting expenses is to cut down on unnecessary spending. Although what is defined as a “necessity” is subjective, a good rule of thumb to help determine is to ask yourself questions like:
- Do I need this right now?
- Does this align with my financial goals?
- Can I live without it?
Alternatively, you may be able to get a windfall or a short-term increase in your income. You may be able to sell an annuity payment for a lump-sum, or sell some items to generate extra income and get a head-start on paying down debts. A strong plan to stick to your budget will involve both your income and your spending — maximizing your earnings and minimizing your spending in order to reach your goals.
Change Your Budget As Needed
Although effective budgeting depends highly on how closely you stick to your budget, sometimes as time goes on you should take the time to change your budget. You may achieve short-term goals like paying off debts, freeing up income for long-term goals like saving for retirement or building up your credit score.
Unexpected expenses can also arise in life such as move-in costs with new housing, car fixes, and medical bills. You may need to prioritize creating an emergency savings fund before you can move on to more fun financial goals like taking a dream vacation or buying a new car.
While you should change your budget as needed for the curveballs in life (and in order to avoid financial troubles), you shouldn’t let breaking your budget become a habit. Only adjust your budget when your goals, resources, and priorities change.