With the fundamentals in place, let’s go through putting a budget together. To do so, you will need to collect some preliminary information.
1) Choose how you will budget. This goes back to the last article in which I discussed YNAB and possible alternatives. If a spreadsheet is more your thing, LibreOffice is a great free and open-source replacement for Microsoft Office.
Choose what you want to work with and don’t feel bad if you end up not liking it. Keep going until something resonates.
2) Know your net income. Your net income is the amount of money you bring home each paycheck after deductions.
You may have been hired at $X amount per hour/year (your gross income), but after deducting taxes, social security, etc. you actually make less (your net income). If you feel too much is being taken out of your paycheck (or you always get a lot back during yearly tax filings) there’s a chance you’re overpaying and should look into adjusting your W-4.
Net income is important because it’s what actually gets deposited into your bank account.
3) Track fixed expenses. Now list your recurring fixed monthly expenses.
Fixed expenses are monthly bills with a relatively unchanging price month-to-month (rent/mortgage, utilities, phone bill, internet, memberships, credit card minimum payments, etc.)
It’s important to know how much this consumes from your net income so you can try to cut back if possible. Other than canceling though, there isn’t much you can usually do to easily pay less.
4) Track variable expenses. Next list your variable monthly expenses.
Variable expenses are everything else you spend on in the month (groceries, gas, entertainment, etc.) and vary from month to month. Some months may have some that others do not.
This is a crucial area where budgeting is concerned because it is the easiest to reduce spending in. Eating out less and not buying clothes is much easier than finding a cheaper place to live (though that should be done too if needed).
5) Track annual expenses. List out expenses that get paid once a year.
There are always some expenses that come up once a year that need to be paid (ex. vehicle registration). Instead of getting hit with a massive payment at once, spread it out throughout the year. Take the amount you expect to pay, divide it by twelve, and “pay” towards the bill monthly (by keeping the amount stored in cash, checking, or savings). Keep a categorized list so that you know what you have saved towards what.
6) Set realistic financial goals. What are you hoping to accomplish within six to twelve months? Two years? Five years?
Maybe you want to get rid of debt and start investing for your retirement. To do so you will need remaining income after you subtract your expenses (fixed + variable + annual) from your net income.
This will be used to pay off debt, add to savings, invest, or stow some away towards vacation, a large upcoming purchase, etc. Having this breather creates opportunities for you.
7) Plan. How much will you spend on groceries this month? On entertainment? Set reasonable figures and don’t be discouraged if the numbers don’t line up the first few months. This is not to say that you should intentionally overspend, but after a few months, you will have a clearer idea of where your money is going and can adjust from there.
8) Revisit & Revise. A budget is continually changing based on what is happening in your life. Every paycheck I recommend revisiting and revising it as necessary to coincide with new developments including a raise, changes to fixed/variable expenses, etc. By keeping it updated it will also keep you on track towards fulfilling your financial goals.
Tying it Together
After following these steps a basic budget will look like this:
Over time you might decide you want to track your expenses further. For example, how is money under “Entertainment” being spent? You can use this information to create sub-categories (books, video games, movies, etc.) and go from there.
Your budget is a living, breathing document that can be changed to whatever works for you. Don’t be afraid to play around with it! Tailor it to the needs of your life. As long as you follow the formula of taking your income and subtracting all of your expenses, you can then pay down debt, save, or invest.
Saving an Emergency Fund
Once you know how much you tend to spend in a given month, you should multiply it by X and work towards saving that amount (where X is the number of months you feel comfortable having saved). The conventional wisdom is 6 months so that if you were to run into hardship (i.e. job loss) you would be okay for a time while searching for another. However, you have to decide for yourself what your comfort range is. For some people, it means having 12 months of expenses saved.
As an aside, over time this amount will depreciate because inflation outpaces the interest gained from savings accounts. Combat this by putting your money into a high-yield savings account.
Investing for Retirement
To outpace inflation and grow our money in a more meaningful way, we have to invest. I recommend starting this as soon as you have paid down debt and have a comfortable amount in savings. Look into low-cost index investing through the group that started it, Vanguard.
For more information on this, J. L. Collins wrote a great book on the subject called “The Simple Path to Wealth“. For now it is the best book I have found for a newcomer to begin learning about investing.
If you still have questions on how to approach this process, please let me know by contacting me.
Continue to Part 4 – Forecasting the Future.