How to Budget in Four “Easy” Steps
Step 1 – Your Net IncomeThe first step in budgeting is determining your net income from all sources. To do this, ignore your salary and instead determine how much money you net in your hands at the end of every month. Your pay stub will likely start at a much higher figure than it ends at after taxes, insurance and the like are deducted. Once you have this net figure, you should add in any other income sources that you may have, whether it be dividend income, child support and alimony or money earned from a second or third part-time job. Again, you are looking for the total net amount of money you have in your pocket at the end of every month. Once you have this figure, it is time to turn to Step 2.
Step 2 – Your Total ExpensesThe second step in budgeting is determining your total expenses. To do this, first look at your recurring fixed charges that stay fairly constant from month-to-month. Think mortgage payments, car payments and insurance premium payments. Once you have this figure, turn your attention to your variable expenses. These are expenses that typically change each month based on the personal spending choices you made for that previous month. Some examples include your grocery bills or entertainment and clothing costs. Once you know both of these figures – your monthly fixed expenses and your average monthly variable expenses – you are ready for Step 3.
Step 3 – Trim Some FatThe third step in budgeting requires some math. Take your income figure from Step 1 and subtract from it your fixed expenses figure from Step 2. For example, let’s say your disposable income from Step 1 each month added to $3,500 and your fixed expenses, on average, totaled $2,350 each month… that would leave you with $1,150. Now, compare your variable expense figure from Step 2 to this $1,150 figure. If your variable expense figure is more than 50% of $1,150 then it’s time to trim some spending fat. You need to start getting rid of any non-necessities and start bringing down your variable expense figure to less than 50% of your disposable income after fixed expenses. In other words, you want your variable discretionary spending to total less than 50% of the $1,150 figure in our example. Easier said than done, right? Yes, for many it is but when you start prioritizing what you really need and what is just spending bloat you would be surprised at how much you can manage to cut out. And, really, doesn’t financial freedom sound and feel more rewarding than some fancy meals or designer jeans. Following Step 4 you can find some common places to cut budget fat.
Step 4 – Track Your SpendingKeep a monthly spending tracker. Now that you have a handle on the numbers it is time to see if your plan works in real practice… and not just for this next month but for every month going forward. There are many ways you can keep track. For one, you can build a simple spreadsheet in Word, Excel or on a good old plain paper. You can use an online budgeting tool or, as we recommend, a budgeting app for your cell phone. We like cell phone apps because they are with you all of the time on your phone so you can track your spending in real-time on the go. Some will also sync your bank accounts, credit cards and loans with your spending so you can easily review your overall financial picture every month, every week or every day. As time goes on, with the picture in front of you and your numbers clear, you can adjust your spending to keep your budget in check. Patterns will emerge that you can identify and, if positive, reinforce and, if negative, change. Information is power and numbers don’t lie. Use them and the available technology to make it easy to track your spending and live within a healthy financial budget. Some examples of free budgeting apps we like are Level Money, Mint.com and Budget Ease.
Examples of Budget FatHere are some common examples of where people can cut some budget fat:
- Downgrade your mobile phone and cable plans;
- Skip the daily Starbucks for home-brewed coffee;
- Limit the restaurant meals to a few times a week or less;
- Trade in your car for one with a cheaper lease;
- Do “stay-cations” instead of flying out-of-town and staying at a hotel with the kids for school breaks;
- Wear that dress or suit a few more times instead of buying new… no one will notice;
- Skip the taxi and walk some more;
- Cut the grass yourself instead of paying a landscaper;
- Limit the kids’ extracurricular activities to those they really love;
- Create homemade and personalized gifts instead of spending a lot on store-bought ones; and
- Use coupons whenever and wherever you can.
Key Points to RememberPoint 1 – A main goal of budgeting is to live within your means so that you have money left over each month for savings and life’s unexpected events. Think of this “surplus” as your family’s personal safety net. Boilers break, roofs need repair, a family member gets sick… life is full of unexpected events. Preparation for these is key for financial (and emotional) health. If you have not budgeted and, thus, have no built-in savings, then when the unexpected happens, you will turn to borrowing on credit which can lead to more debt. That is the cycle you are trying to break so a safety net for life’s unexpected emergencies or events is a must. As such, part of your budget surplus should go into a personal savings account so that emergencies will not result in more debt.
Point 2 – Rule of thumb is you want to have six to nine months’ worth of living expenses saved in a reserve account. Even if you can’t reach that nine-month marker, any savings is better than none. So as you budget adjust your variable spending to ensure that you are putting away money into your emergency fund. If you follow the steps outlined above then money should be left over each month to contribute to the unexpected. Based on how much you need and want will affect how much you budget for spending.
Point 3 – And, finally, your safety net money should optimally be kept in an easy-to-access account such as a money market or savings account. While interest will be low, accessibility will be easy and that is the goal with an emergency fund. We recommend you set up automatic transfers out of your checking account and into a personal savings account through your bank or online banking center. That way you do not have to even think about it and you can list that as a fixed expense in Step 2 of your budget.