Creating a Budget
In this Coronavirus new normal in which we find ourselves, many of us are thinking about how to reduce our spending. Creating and using a budget is the best way to manage your expenses so you can spend less and save more.
How do I create a budget?
This is the most frequent question I’m asked in personal finance workshops that I lead. 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 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.
3. Based on #1 and 2, set your monthly saving and spending targets.
The two should add up to your net income in #2 — i.e., what you don’t spend, you save.
4. Once you have your savings goal, 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 actual 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.
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 tool that people use, as well as various apps for your phone.
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, cut back your discretionary expenses. When you have your total spending in line with where you want it to be, then begin to relax these restraints.
Create a habit to monitor your spending every month. You’ll have some good months and some bad ones, so view it over a longer time period to see 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.
Other Reasons to Use a Budget
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 are:
1. Expresses 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. Compares 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. Assesses 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. Ensures 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? Contact me about my Eliminate Consumer Debt service.