Creating a Budget
What is the most effective way to spend less and save more? Using a budget is the best tool to manage your spending.
How do you create a budget?
Everyone’s situation is a bit different but here’s an approach to consider.
1. Determine your average monthly spending over the past year.
To do this, sum up your total spending — debit, credit, bill payments, and cash — over the past 12 months. Spending can be seasonal and inconsistent so don’t just use a few months. Don’t include savings and income tax payments in this tally. Divide by 12 and this is your starting point for your actual monthly spending.
2. Determine your monthly net income.
This is the amount after any payroll deductions for things like health insurance and 401K contributions. If you’re paid bi-weekly, use two paychecks per month for your net income. The two months of the year when you get a third check, as well as any windfalls such as a tax refund, will be for catch-up, emergencies, or paying down debts. Similarly, if you’re paid weekly, base your monthly income on 4 checks per month.
3. Set your monthly saving and spending targets, based on your numbers in 1 and 2.
The two should add up to your net income in #2 — i.e., what you don’t spend, you save. If you’re spending more than you’re earning, you’ll have negative savings each month. You can do that for a while, but not forever.
4. Once you have your savings target, 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, the money won’t be there. Use a payroll deduction or an automatic debit to make these transfers — you want the money out of your checking account before you’re tempted to spend it.
5. Track total spending each month.
Managing to a budget is a process — set a target, review results, adjust, and repeat next month. If you don’t measure what you’re doing, you have little chance of succeeding. Don’t fret about month to month variations as spending can be lumpy — e.g., heating bills, travel, insurance, and medical expenses aren’t consistent every month — and you’ll have some good months and some bad ones. Instead look at trends and average spending over a longer period of time.
What if you’re spending too much?
If you’re exceeding your spending target, scrutinize your expenses and see where you can cut back. There are different tools to do this and you should use whatever is most convenient. Many bank accounts and credit cards provide a spending summary, Mint.com is another popular option, as well as various phone apps.
But, be prepared to make choices.
A simple framework is to put your spending into two categories — mandatory (“needs”) and discretionary (“wants”). If your spending is too high, put the brakes on your discretionary expenses. When you have your total spending in line with where you want it to be, then relax these restraints.
Another strategy is to use “mental accounting buckets.” Don’t spend the money until after you’ve saved it. This may help you prioritize which categories are most important to you.
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.
Other Reasons to Use a Budget
Creating a budget offers you other benefits and these are particularly helpful if you have a partner with whom you share financial decisions. These are:
1. Express 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. Compare 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 actual 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.
Need help with managing your spending? Get in touch.