What is the most effective approach to set up a budget for yourself?
In this post-Coronavirus new normal in which we find ourselves, many of us are thinking about how to reduce our spending. Using a budget helps you 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. It is a different process for everyone but here’s an approach to consider.
1. Determine your actual spending for 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. Do not include savings in this tally. Divide by 12 and this is your starting point for your actual spending. Also, if you use a credit card, pay it off in full every month so the total is based on what you spent, rather than what you paid. Don’t worry about bucketing the various categories of expenses.
2. Determine your net take-home income per month.
This is the amount after any payroll deductions for things like insurance and 401K. If you’re currently diverting a payroll deduction into savings add this back for now. 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 target.
The two should add up to your net income in #2.
4. Once you have established 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.
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. If you don’t measure what you’re doing, you have little chance of succeeding.
What if you’re spending too much?
You need to 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. Most bank accounts and credit cards provide a spending summary and Mint.com is another tool that many people use. Be prepared to make choices.
A simple framework that I often use is to put your spending into two categories — mandatory versus discretionary. You decide which is which but if your spending is higher than you want, cut back on all your discretionary expenses. When you have your total spending in line with where you want it to be, then you can begin to relax these restraints.
Continue To Track Your Spending
Create a habit and discipline 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 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.
Lastly, 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. 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. Assessing 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. Ensuring 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? Get in touch about my Eliminate Consumer Debt service.