You’ve seen in several of our other personal finance posts that sticking to a budget is simply essential to good money management. It prevents shortfalls and overdraws, helps with building up savings, makes it easier to pay off debts in a systematic way, and just generally provides peace of mind. But how do you go about it?
This is your ultimate guide on making a personal budget. Read this carefully, learn the basic principles, and follow all the steps we provide. At the end, you will have a budget that fits your life and prepares you to deal with whatever may come in the future.
What Is a Personal Budget?
People aren’t just born knowing what it means to have a personal budget, so we’re making no assumptions here. Feel free to skip this section if you are already very familiar with the idea — though it doesn’t hurt to get a refresher.
At its heart, a personal budget is a plan that guides what you do with every dollar that comes into your hands. This plan’s job is to make sure that nothing goes unpaid that must be paid, that money is spent on the things that you really value, and that there is a financial safety net in case bad things happen.
Usually a budget is a list of bills and expenses (by name) with the money allotted to each next to it. It also includes a list of possible or future expenses for which money has been saved or set aside and how much money is available for each of those. The budget isn’t something that’s made once and then forgotten. Instead it is something that should be checked and updated frequently so that it always has current information.
Why Make a Budget?
Before we get into the process, let’s talk about that question. If you aren’t living paycheck to paycheck, if you don’t have a lot of expenses, if you are very well off, you may not feel that you need a budget. After all, most people only start reading about personal finance when they’re facing financial problems. The fact is, though, that everyone can benefit from having a clear and meaningful personal budget. For the person who is well off, it’s never a bad idea to prepare for a rainy day – or month, or year. For the person who has few expenses currently, chances are more will come up and it’s good to have a budget now that can be adapted than to have to start from scratch. College students, wouldn’t it be nice to graduate with as few student loans as possible? Budgeting is one great way to achieve all of these.
Possible Pitfalls of Making a Budget
Any time you sit down and think hard about your money situation, it can be stressful. That’s especially true if you are not the only person involved. Deciding to make a joint budget as a couple or as a whole family can bring up disagreements, frustrations, and even hurt feelings. However, in the long run the stress of facing all those money questions and actually answering them is preferable to the risk of facing real money problems in the future or being unable to get out of the money problems you have in the present.
Basic Principles
There are a few things to keep in mind as you go through this process. These are not steps to take or tasks to do, rather they inform the general approach to budgeting. If you remind yourself of these three principles it will make the entire process more approachable.
Start Off Easy, Then Build
Some of the steps in this process will be harder than others. You don’t have to master everything at once. By focusing first on the simpler things, you can build momentum and confidence which will make it easier to get to the harder stuff as you go along. This is true in any new undertaking but especially when it is something that scares people as much as money management does. Try to make a small change or take a small step here and there and then add to those as you feel ready.
Get Started No Matter What
Don’t procrastinate on this process because of something getting in your way. Can’t find your account balance? Use an estimate for now or work on gathering your bills instead. Unsure what a certain monthly cost is? Again, estimate it or work on another aspect of your budget. Can’t find a calculator? Work on making the list to add up later. Or use your phone. Or break out scratch paper and try your hand at some good old fashioned “carry-the-one” arithmetic. The worst thing you can do is to wait until everything is perfect before you get started. Waiting for all the pieces to be in place is a great way to never accomplish a thing.
ANYTHING You Do Can Be Frustrating – So Embrace That
Have you ever reached for a pen only to have it roll away. Then slip between your fingers. Then you couldn’t get the cap off? Maybe not that exact experience, but chances are there’s been some time that something that “should have been” easy turned out to be weirdly hard. Well, budgeting isn’t necessarily hard or easy, but at least once it’s probably going to get really frustrating. When that time comes, just remember this principle, remind yourself that you knew it was coming but that you also know you can handle it. Try to laugh it off, shake it off, or take a quick time-out, then jump back into it. You CAN handle this.
Phase I: Getting Started
1. Gather Your Supplies
Making a budget is all about having the right information arranged in a way that makes sense to you. So the first thing you need is the information itself. Try to find all your bills, recent pay-stubs, bank statements, credit card statements, and even receipts if you want to be really comprehensive. Since this is the 21st century, a lot of that information will be available online through the websites of your bank, credit card company, and the like. Gather it whatever way works best for you: a folder of files on your computer, a filing cabinet, arranged in piles on your desk, etc. Try to do a little basic organization as you gather it – separate bills from pay-stubs and bank statements for example.
This is also the point at which to gather your organizational supplies. Again, depending on the person that may be starting an electronic spreadsheet, buying an expanding file folder, investing in a ledger or budgeting software, whatever you think will work best for you. Try to keep everything in one place and always use that place as new information needs to be added.
2. Calculate Your Income
This may be the easiest step if you have only one job, that job is salaried (the same amount every payday), and you have no investments or other sources of income. If you have more than one job or other sources of income, or if your income is irregular, gather all the information you can find. Add up all your fixed monthly sources of income. To calculate a budget number for irregular income (e.g. hourly work; tips; side jobs) there are three options.
1. Add up the past 12 (or fewer if necessary) months of income and average it out
2. Use the lowest monthly income from the past 6-12 months and use that number to play it safe
3. Look at your income from the past 12 months (or more) and look for a general trend. If the last 6 months is significantly different from the previous 6 months, use the average of the most recent. If you work in a field that has strong fluctuations throughout the year (e.g. heating and air; party planning) consider developing 2 budgets. This may be preferable if you struggle with leaving savings in savings instead of spending it for day to day living.
3) Calculate Your Current Assets
Add up all the money you have saved in different places. Make note of what is easily accessible (e.g. cash on hand or a savings account that can transfer directly to your checking account) and what is not (e.g. 401(k)). This money can be included in your short and long-term savings funds in your budget.
Phase II: Building the Budget
1) List Your Monthly Expenses
This can include a number of obvious fixed costs (rent or mortgage, cable, car note), obvious but variable costs (utilities), and easily forgotten costs (6 month car insurance, Home Owner’s Association fees). This should absolutely include debts such as credit cards, medical bills, student loans, and the like. Don’t even worry about the numbers right now, just name everything.
Using your computer spreadsheet, ledger, or just a pad of paper, start from the top and work your way down one column writing the names of all the expenses: rent/mortgage; credit card 1, 2, etc.; car note; cable; cell phone; etc. Make sure this list includes things you pay only once a year or once a quarter like some sorts of insurance, homeowner’s association dues, and certain subscription services. Try to be comprehensive but combine unscheduled purchases into manageable categories. If you buy a movie online, what category do you put that in? Does the groceries category include other household items like shampoo and fabric softener? Those categories will be different from person to person so decide what makes the most sense to your life.
2) Add In the Numbers
This is one of the areas where you may need to start with the easiest parts and build your way up to harder ones. For example, chances are you already know what you owe each month for your rent or mortgage, but you may have no idea how to estimate your grocery costs for a month. Bills that only come around every year or quarter should be divided into monthly payment amounts even if you can’t send those payments in monthly. This can also include costs that are not scheduled but can be expected, like medical costs and car repairs. A little money set aside each month for these can keep you on budget when they inevitably come up.
The approach to getting the number for variable bills is similar to the approach for variable income: look at the costs over the last 6-12 months and average them out. This works for gas, water, and electric bills. However, you can also contact your utility company and ask to get put on a year-round fixed cost plan that is based on your previous usage. This has the benefit of making those bills fixed and easier to adjust your budget for. It can have the downside of resulting in higher cost over the course of a year.
Likely the hardest costs to calculate will be categories like groceries, entertainment, and incidentals like clothing or gifts. You can approach this by digging through you previous statements (if almost all of your shopping is done through one debit or credit card) and calculating monthly expenditures on these categories. You can also take a month to write down every purchase you make and divide those up. Be aware that adding this level of awareness to your spending may impact it. We are less likely to splurge on an unneeded item or indulgence when we are recording it for analysis. Of course, that is often a good thing.
3) Start Building the Budget
At the end of the last step, you should have a comprehensive list of all the places your money goes in a month and how much you can expect to go to it. You also have your monthly income and assets. To turn this information into a plan, start by entering all of it into an electronic or paper spreadsheet or budgeting software. Whatever you use, make sure you are comfortable with it and understand how it works.
If you are building your own budget in a ledger or electronic spreadsheet, put your total income in the top row and then list every expense row by row below it. Subtract the total of all expenses from the income and this will give your net monthly income. If the result is a negative number, you are spending more each month than you are earning and so you are getting deeper and deeper into debt or eating away at your savings. If the number is positive, that is the number you currently have left over for savings, making extra payments on debts, or additional spending.
Phase III: Take Action
1) Play with the Numbers
Now, just because you’ve been spending and earning that much each month doesn’t mean that is what your budget has to be. Especially in the case of a negative net monthly income, now is the time to look at that spending and figure out some changes. For example, if you have routinely been spending $50 a week on eating out and $500 a month on groceries, can you make some adjustments to bring that down to $40 and $450? Are there expenses that are not needs for right now and can be left off altogether (subscription services, coffee habit, etc.)?
Ideally, you not only want to spend less than your income, you also want to set money aside each month for emergencies, future major purchases and less frequent recurring costs. You also want make strong progress on paying off your debts. That can all be overwhelming, especially when you are in the red each month. So don’t feel that you have to achieve it all immediately. Making a change to save $5 more each week is better than doing nothing because of feeling overwhelmed.
2) Prepare for Emergencies
We already noted that it’s important to set monthly money aside for predictable but unplanned costs like car repairs or medical bills. Beyond that, it is vital to your long-term financial health to have an emergency fund. This protects you in case of some unpredictable and potentially catastrophic occurrence. Generally, $1000 is a good first target but two months’ worth of expenses is preferable. This may seem like an impossible goal but starting somewhere and sticking with it in the long run will get you where you need to go, even if it’s slower than you want it to be. One option is to add any windfalls or extra income directly to the emergency fund rather than spending it. Think of it as investing today’s good luck as a protection against bad luck down the road.
In your budget spreadsheet, include contributions to the emergency fund and other short and long-term savings as monthly expenses. In another section, keep track of how much money you have saved in each of these funds. Where you save this money will depend on a number of factors but can range from envelopes of cash held in a safe place, to separate accounts at your bank. Be careful if the money is set aside on paper but is actually kept in your general checking or savings accounts; it will take a lot of discipline to leave that money untouched until it is time to use it for its official purpose.
3) Get Out of Debt
One of the best ways to have more money each month is to get debts paid off. If you have three credit cards with monthly minimum payments of $50, $75, and $100, that’s $225 dollars that could be going to an emergency fund, long term savings, or paying off a more important debt like a car or house note. What’s worse, those payments are not getting all the bang for their buck because much of it will go to interest. With credit card debt you can transfer balances to a 0% interest card to save on interest payments.
You can use your budget to help you get out of debt in two different ways.
1) Add up how much money you owe right now or how much money you owe on the debts that you want to get paid off in the first phase. This should probably include your highest interest debts such as credit cards. Simply divide that number by 12 (or by the number of months you want to take to pay it off) and use that number for those combined debts as a single monthly budget item. You will probably want to bump up that number a little bit to account for the increase in principal each month from interest accruing. That may result in a difficult to attain number. See what adjustments you can make to your budget to reach it or start to figure out ways to increase your income for those 12 months. Repeat the process with the next phase of debts you want to pay off until you are debt free.
2) Alternatively, order your bills from smallest to largest. Now put all your efforts into paying off the smallest bill as soon as possible. This should not include skipping out on other bills. Instead, get all your bills in good standing (either by paying the minimum or making phone calls to get a grace period or other adjustment) and throw any extra money at the first small bill. If you adjust your budget to take money away from one area, put it toward that bill. Once that first bill is paid off, the budget for it is applied the next month to the next smallest bill. In the case of the three credit cards mentioned above, this would eventually result in putting all $225 each month toward the last credit card, knocking down the principal by leaps and bounds instead of inches.
We mentioned getting extra income as one way to reach your monthly pay-off goals. Another is to work on the interest rates that keep adding to your debt. One option is to transfer high interest credit debt to a new 0% APR card so you entire payment is going to principal. Another is to check out current mortgage rates and see if you may qualify for a lower rate by refinancing your mortgage. Both of these can affect your credit score (and you’ll want to have as good a credit score as possible to qualify for a good credit card or for a new mortgage) so you may want to discuss these options with your financial institution.
Phase IV: Stick with It
1) Life Changes: So Should Your Budget
It is said that the reason the Constitution of the United States has been so successful is that it is a living document. It has been changed repeatedly as times have changed. Your budget should be no different. You should be looking at your budget several times a month to check off bills paid, update savings balances, and account for any forgotten or unexpected items. This should make it natural to make bigger changes like accounting for increased income, subtracting from the emergency fund when there have been setbacks, and increasing debt payments as other debts are paid off. Unfortunately, this will also include rate hikes, adjustments for inflation in food or gas costs, and at times accounting for the effects of lost income. But if the foundation is there and you work on developing the skill of using a budget over time, these adjustments will be less painful.
2) Nobody’s Perfect
One way to be sure NOT to stick with your budget is to expect perfection from yourself (or from your household). There will be months where it is a struggle to spend within the limits you’ve set for yourself. There will be months where you don’t even want to look at let alone update your budget. Expect this to happen but don’t give up. Lifelong changes aren’t made by one huge effort at the beginning but instead by small repeated efforts made over and over again over time.
Also, we all need to have indulgences in our lives. Try to account for that in your budget. While it is possible to discipline yourself for a period of harsh self-denial, it is easier to stick with a combination of self-denial and treating yourself. Like a dieter who tries to avoid all sugar and processed foods, then has a binge, you may be at risk of splurging spectacularly if you attempt to never splurge at all.
A Note of Encouragement
You now have all the pieces you need to make a budget and stick with it. Even though it may be frustrating or even scary at times, you can do this. Just remember the basic principles, take your time, and come back to this post as often as you need to until you have something that works for you.
