What is the most effective approach to set up a budget for yourself?

budgeting 101

A budget helps you manage your expenses with the focus on spending less and saving more.

Creating a budget offers you other benefits and these are particularly helpful if you live with a partner with whom you share financial decisions. These include:

Four Reasons To Use A Budget

1. Expressing your spending priorities. You may have heard that life is a series of trade-offs. Using a budget allows you to make your own choices, rather than having them imposed upon you.

2. Comparing your intended versus your actual spending. Your intent may be noble, but it’s actual behavior that counts. A budget allows you to objectively judge your spending behavior.

3. Assess your capability at managing your financial affairs. We’re not all good at everything and you will learn how competently you manage your financial affairs and whether you need to seek out support. As Mark Twain said, “Denial ain’t just a river in Egypt.”

4. Ensure you do not run out of money before you run out of month. Perhaps most importantly, we need to make our cash flow last through the end of every month.

How do I create a budget?

This is the most frequent question I’m asked in the personal finance workshops that I lead. It is a different process for everyone but I’ll suggest an approach to consider.

1. Determine your actual spending for the past year. To do this, go back through all your spending — debit, credit, bill payments, and cash — and sum up the total amount spent over a full year. Spending can be seasonal and inconsistent so don’t just use a few months. Do not include savings in this tally.

2. Review your spending to make adjustments for any expenses that were clearly one-time or omissions that you know you will incur going forward. If you are unsure, leave the expense in. Take this adjusted actual spending for the past year and divide by 12. This is your starting point for your new monthly budget.

3a. If you are comfortable spending this amount, it’s now your target. Going forward, track your actual spending for each month and compare it to this target. If your spending comes in below this, pat yourself on the back and find something else to worry about. If your spending is higher, then you need to scrutinize your actual spending to see where you can cut back.

3b. If you need to reduce your spending from the amount in #2, determine your new monthly target. Once you know this new target and how it compares to your actual spending, you know how much you need to cut back. Now the hard part:  scrutinize your various expenses and determine where you will reduce. Be realistic as these new targets will be your budget.

4. Track actual spending each month and compare it to your target. Managing to a budget is a process — set a target, measure results, adjust, and repeat. Without a plan, you have little chance of succeeding. To quote someone wiser than I, “If you don’t know where you’re going, any road will get you there.”

5. Importantly, pay yourself first. Transfer your savings goal into a savings account at the beginning of the month. If you wait until the end of the month and then decide how much to save, it won’t be there. Use a payroll deduction or an automatic debit to make these transfers — you want the money gone from your checking account before you’re tempted to spend it.

There are different tools and you should use whatever can work for you. A spreadsheet is fine but so is Quicken, Mint.com, or a pad of paper and a pencil.

Track Your Spending

Discipline is more important than the tool. You’ll have some good months and some bad ones, so view it over a longer period of time to get insight into how successful you are.

This won’t be the most exciting part of your month but if you’re consistent, you’ll be on a path to achieving your financial goals.

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