Oh Budgeting, the one personal finance thing you’ve been hearing about since you were a kid. You probably always dreaded making one and having to keep track of expenses. Having a piece of paper tell you how to live your life? No thank you. But it doesn’t have to be that way! You make the budget, the budget doesn’t make you. Personal Finance is all about finding the proper balance between being responsible and living your best life. A budget is no different. That being said, the exercises involved in creating a budget can have extremely beneficial results. This is often the first time a person is actually taking a look at their own personal finances, analyzing it, and thinking critically about it. They can help educate and motivate people that make them part of their personal finance routine. A budget is nothing but an estimate of your income coming in and expenses going out during a certain period. I like to use monthly periods. Starting your budget is easy, there are only 4 steps to follow.
- Calculate your maximum allowable expenses
- Allocate your allowable expenses
- Track your budget
Calculating your maximum allowable expenses
A simple formula will help you do this:
Income – Savings Goal = Allowable Expenses
Look back at your historic income, estimate what your income will be for the period you are using. Using your finance goals, estimate how much you will have to save each period to achieve them. Subtract your goals off your income, and this will give you your allowable expenses for the period. Your maximum allowable expenses is the amount of total money you can spend on anything in that period to accomplish your goal.
How is your previous spending looking compared to your new budgeted amount? If it is already lower than the allowable amount, the rest of this task will be easy!
We will build a monthly budget for John Smith. John Smith makes $2,000 every two weeks. This will give him an income for his monthly budget of $4,000. However, because he is paid every two weeks, that means he gets paid 26 times a year (52 weeks divided by 2). There are 12 months in a year, so he actually gets paid an AVERAGE of 2.16 (26 pay periods divided by 12 months) times a month. You can use this as your monthly income – or just determine which 2 months you will be paid 3 times and adjust those months individually. You can plan your budget so those 2 months are your extra saving months, your extra spending months, or a combination. We will factor them in as extra spending months – something to look forward to. For that reason we will continue to use the $4,000 for the monthly budget. John Smith also plans to pay off his debt and build an emergency fund over the next year. His calculations determined he will need to save a minimum of $750 a month to accomplish his goal.
Income – Savings goal = Maximum Allowable Expenses
$4,000 – $750 = $3,250 for maximum allowable expenses.
Allocate your allowable expenses
Allocating your allowable expenses is breaking down your maximum allowable expenses into the different categories you will be spending money on. You can use broad categories such as: Entertainment, Living, Children, Debt, etc. Or you can use more specific categories, for example, you could break entertainment down into: Eating out, Travel, Games, etc. If you use our spreadsheet, it will have examples of a variety of different categories you can break things down into. To allocate your expenses properly, you should have an idea of how you are currently spending. To do this, review your previous spending for the last 2-3 months and sort the spending to the different categories. If your historic spending is already below your maximum allowable numbers, you can use numbers very similar to your historic spending when allocating your new budget. If you are over-spending, however, you will have to do some analyzing to see if there are any areas you can cut. The sum of your allocated amounts cannot be higher than your maximum allowable expenses.
John Smith calculated his maximum allowable expenses is $3,250. Reviewing his spending over the last 3 months, he determined he spends an average of $3,550. $1,500 on Living expenses like rent and utilities, $600 on food, $750 on vehicle expenses and $700 on entertainment like going to the bar and buying video games. John knows he will have to reduce his expenses by at least $300, but he also likes to go on vacation once a year, so he wants to save an extra $100 a month to allow for that. Analyzing his spending, John figures he could save $150 on food each month by eating out less, $25 on vehicle expenses by renegotiating his insurance costs, $200 of his entertainment costs by going out less and buying less entertainment items. John can’t think of an easy way to reduce his spending for the last $25 a month. He is thinking about changing his living situation to reduce costs (getting a roommate or smaller place). He can reduce spending a lot this way and have room to add a little back to his entertainment budget that he will be missing out on. John is also considering just taking a cheaper vacation so he won’t need to save all of that extra $100. At the end, John decided to allocate: $1,500 to living expense, $450 to food, $725 on vehicle expenses $500 on entertainment and $75 for a vacation. This all equals $3,250 – Johns maximum allowable spending.
Track your budget
Your budget is ready, now you need to track your income and expenses to see if you are meeting the goals you set. The most common way is through a spreadsheet. VIP Finance offers a free budget spreadsheet, but you can find lots of other free ones online or even make your own if you so choose. If you decide to use the VIP Finance spreadsheet, it comes with instructions on how to keep track of your expenses. The hard part of tracking your expenses is turning it into a routine, but also the most important. You should be updating your budget frequently, at the end of a period is an easy way to plan. Committing to budgeting will keep you motivated, help you make improvements and force you to face your bad habits.
Assess your progress
You have a budget and have been committed to tracking your progress to it, great! Are you meeting your goals frequently? If not, why not? Assess yourself honestly. Life also changes. Sometimes you’ll need to reassess your budget from the start to ensure your current one still fits. Sometimes you set your goals a little out of reach, perhaps they need to be reevaluated as well.