A budget is a simple estimate of the income and expenses that an individual, a family, or a business has in a given period of time. Companies use budgets to identify how much money they will use for future expenses. This system of budgeting is just as useful on a personal scale as well. Knowing how much money you spend today can give you a good idea of how much you will spend in the future.
A budget is not meant to restrict you; it is to help you make smart decisions concerning the allocation of your money. Tracking where your money goes can help you see if there are areas where you are spending too much.
There are two basic things you need to know in order to prepare your budget – your income and your expenses.
Think of your income as the total amount of money that you will receive in a given period of time. Figuring out your income is the easiest part because you know your salary and you will typically earn the same amount each month unless your pay is commission based.
Expenses are the opposite of income, think of your expenses as the money that will be spent over the same period of time. As we discuss expenses beware that the list can get very long because of all the different things you can spend your money on. This is normal so don’t worry if your list of expenses looks lengthy.
When going over your expenses consider “The 50/30/20 Rule”. This is a rule of thumb that breaks down the percentages that are recommended for income allocation.
It’s suggested that 50% of your income be used for your essential expenses, which includes your mortgage/rent, food, clothing, and transportation. The 30% from the rule represents your life style choices. These things are the non-essential items that we enjoy such as cable, brand name clothing, a smart phone, a luxury car, and other items that are optional or items that you could go without. The 20% is made up of your financial priorities. This includes any debt that you may have, contributions to retirement accounts, savings accounts, and investments.
Remember that this is just a rule of thumb. You do not have to have your essential expenses up to 50% of your income. You could adjust to make them 40% and have some extra money for other things. You might have a lot of credit card debt to pay, so you may want to reduce more in the other categories so that you can pay your debt faster. It is also recommended that you have three to six months worth of expenses in savings just in case something happens.
There are two classes of expenses, fixed and variable. All expenses can fit into these two categories. When creating a budget these expenses should be calculated independent of each other and then added together at the end. Fixed expenses should be accounted for first. After you budget for your fixed expenses you should move to your variable expenses.
Fixed expenses are expenses that stay the same month after month. They are ‘fixed’ in place and won’t change unexpectedly. Examples of fixed expenses are mortgage/rent payments, automotive loan payments, insurance, or any other bills that do not change between billing periods. These expenses should be calculated first since this will give you a reasonable idea of how much income you have left for less predictable expenses, like variable expenses.
Just because the expense changes from month to month, doesn’t make a variable expense any less important. Examples of variable expenses include utility bills, gas, food, entertainment, or any other bill that varies from month to month. In order to effectively plan for these expenses, try to budget for the higher end of the average of each variable expense.
In order to help prevent confusion later on, try to make your budget as simple as you can. Be sure to use actual numbers and include every expense you have so that it is accurate. After organizing your budget there are two possible outcomes; the first is that your income is greater than your expenses, while the second is that your income is less than your expenses.
If your income is greater than your expenses you are in a good place because it means you have money left over. If this is the case, you could start thinking about building your savings, save/contribute more to a retirement account, or invest your extra money.
If your income is less than your expenses then you will need to make some changes and see where you can cut back. If you continue down the path of spending more than you earn you will end up in debt. Be sure to evaluate your finances and see where you could spend less so that you are not accumulating debt.