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

budgeting 101

A budget measures your actual spending over a period of time (typically, monthly) and compares that to your intended level of spending. It allows you to understand how much money you are spending, where it is going, and assess whether you’re meeting your spending goals.

Four Reasons To Use A Budget

1. Express your spending prioritiesLife is a series of trade-offs and using a budget allows you to make your own choices, rather than having them imposed upon you. If you live with a partner with whom you share financial decisions, this becomes even more important.

2. Track your intended versus your actual spending. Your intent may be noble, but it is actual behavior that matters. A budget allows you to objectively examine your spending choices.

3. Assess your capability at managing your financial affairs. 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. You don’t want to find yourself in the situation E.E. Cummings described:  “I’m living so far beyond my income that we may almost be said to be living apart.”

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, checks, online banking, ATM withdrawals, etc. — 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 becomes your target or budget. 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 as necessary, and repeat. Without a plan, you have little chance of succeeding.

5. Lastly, 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, you will have spent that money before it ever makes it into your savings account. This is why payroll deductions are effective — the money is gone before you are 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

More important than the tool is the discipline. Track your spending for a number of months because not all of your expenses will fall cleanly and evenly into monthly intervals. You’ll likely 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 at managing your spending.

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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