The first step to achieving financial freedom is to determine your current financial situation, whether you are a student, self-employed business person or currently employed at a firm or a school. Once you know where you stand, you can begin to set financial goals that tie in to your financial vision for the future, if you choose to think long term. Alternatively, your financial dreams could be more short-term and immediate in nature, where they pertain to simply repaying your student debt or saving money to buy a car. In all cases, you need to figure out where you stand financially, and for that, you need a budget, and budgets are what we talk about in today’s blog post, specifically, how we define personal budgets, the different methods of budgeting, the budgeting process and the purpose of various household budgets.
What is a budget? A basic definition
In simple words, budgets are ‘plans’ that account for every dollar you earn, save and spend during a week, month or even a year. Once the ‘plan’ has been made, you record your actual income, savings and expenses and compare the projected (planned) values with the actual values in each category.
A more sophisticated definition by Investopedia goes like this:
A budget is an estimation of revenue and expenses over a specified future period of time; it is compiled and re-evaluated on a periodic basis.
Although the definition is generic, it can be applied to personal finance if one simply replaces the word “revenue” with “income”. Essentially, your budget states how much you earn and spend during any given time, say, a week, a month or a year. You must go over your budget on a regular basis to determine (re-evaluate) if the budget is realistic to begin with. Say, you have been consistently over-spending in the groceries expense category, you may need to set a higher, more realistic budget for groceries. Alternatively, the excessive spending may be because of wastage too. Whichever the case, the budget will figure it out for you.
5 Steps – How to setup a personal budget
Let’s have a look at the different elements of a budget to further understand what a budget is and how it works. There are four basic components of a personal budget:
- Step 1: Income streams in a personal budget – these can include any salaries, investment income and business profits that you choose to spend personally at the end of the month.
- Step 2: Expenses in a personal budget – these cover a wide variety of spending categories, such as entertainment expenses, education expense, groceries, rent, utility bills, credit card payments, mortgage payments, car lease installments, investment expenses, transport costs, sinking funds, emergency funds and so on.
- Step 3: Saving category in a budget – many people like to consider savings and expense and set aside a fixed sum of money as their savings fund before budgeting for various expenses. Others prefer to save whatever is left at the end of the month.
- Step 4: Subtract expenses from income – this will show you how much money you have leftover at the end of the month, as well as year. As mentioned above, some people like to save the remaining money while others like to set aside money to be saved before they allocate their income to various expenses. The extra money, if any, can be invested, saved or consumed (if your savings target has been met).
- Step 5: Tracking your expenses – throughout the month, you will record and track your actual expenses to compare them to the ‘budgeted’ expenses. For instance, if you have set aside $500 as an entertainment allowance in your budget, each time you go to the movies, hang out with friends or host a party at home, you will record the money you spend on these activities to make sure they add up to $500 or less. Once you hit the $500 budget ceiling, ideally, you should switch to free ways to entertain yourself, by going on a bike ride, hiking or visiting a public museum, monument or something similar.
All these elements of a personal budget come together to help you determine how much financial flexibility you possess, when to curb your spending, and whether you are meeting your budget goals. We talk more about this later.
Different approaches to budgeting – manual versus automated budgeting systems
All budgets involve the same components, yet there are different budgeting methods you can pursue. Here are a few different ways you can make a personal budget:
The manual budgeting system
Everything is written with a paper and pen. The method is time-consuming but simple enough for beginners to get the hang of recording their incomes and expenses. You may choose to either print out a budgeting spreadsheet for this, or create a simple one yourself on some paper. Once the expense categories have been decided along with the projected spending limits, you can grab a bunch of envelopes to hold the various cash amounts for different categories. For instance, your grocery allowance may be projected at $750, so you go ahead and place $750 in the envelope, marking it with ‘Groceries Expense’. Each time you head over to the grocery store, you withdraw money from the envelope, making sure you even out your spending so as not to run out before the month ends. This is called the ‘Envelope Budgeting System’ and is as manual as it gets.
The automated budgeting system
There are two ways to setup an automated or computerized budgeting system:
- A budgeting spreadsheet on your phone or computer: instead of writing down the various incomes and expenses with a pen, now you simply type them out with a keyboard. It sounds straight forward but you need to be proficient in computer skills to be able to navigate to your spreadsheet software and run some basic calculations in Excel, or whichever software you choose to use. Some calculation formula you need to be aware of are adding. subtracting, multiplying multiple numbers and creating pie charts or line graphs to depict your financial performance pictorially. You can also download personal budget templates that already have all the formulas inserted with various graphs that automatically generate as you record your incomes, expenses, savings and investments.
- Get a budgeting app on your phone or a budgeting software for your computer: If you have a basic level of proficiency with your smart phone, you can easily download a budgeting app, usually for free, and use it to setup, record and tracks your personal finances. Similarly, an automated budgeting software can be bought to help you manage your money.
Different personal budget techniques
Once you decide which approach is best for you, you may move on the different budgeting methods, which included:
- The traditional budget – list your incomes and expenses in a spreadsheet and find the difference between the two. You may choose to spend or save the remainder of the money, if the difference is positive, which only happens if you are earning more than you are spending each month. If the difference is negative, you are most likely spending more than you earn and accumulating debt.
- ‘Pay yourself first’ budget – In this budgeting method, you save a portion of your income first to meet a savings target and then allocate the remaining funds to different expense categories. This ensures you live within your means and prevents the accumulation of debt.
- The envelope budgeting method – This method helps with the distribution of your income to different categories so you limit your actual spending to the budgetted spending. The envelope budget requires you to set aside money in various envelopes labelled with different expense categories and limit your spending to the cash within the envelope.
- The 50/20/30 budget – This is a type of proportionate budget and it sets out rules of thumb to help with the distribution of your income so you can avoid over spending and ensure that your savings target is met. Under the 50/20/30 budgeting method, you simply divide your after-tax income into three proportions, 50% being used to fund your needs, 30% goes to covering wants and 20% of your income should be saved, placed in an emergency fund, used to payoff debt or added to your retirement fund.
- The 80/20 budget – Yet another type of proportionate budget is the 80/20 budget but it is a simpler variation of the 50/20/30 budgeting method where you lump together the spending categories (50% of income for needs and 30% for wants) to make 80% of your income that is spent on necessities and discretionary expenses (needs and wants) and the remaining 20% is saved. This method makes it easier to keep track of your spending because you don’t have to meticulously segregate your spending into different categories.
- Zero sum budget model – In this method, you simply subtract your total expenses from your total income and make sure the answer is zero. If there’s a surplus, the money should be used to pay back debt or it should be added to your savings account. This means every dollar has a job.
- No-budget budgeting system – Under this method, you may do away with the idea of tracking your daily expenses and following budgeted spending limits. Instead, you might try to be as consciously frugal as possible, every time you make a purchase and put away as much money as possible for savings.
Each of these budgeting methods has its own set of pros and cons and we’ll briefly look at them next.
Which budgeting technique is best for you?
Each budgeting method has unique features and unique advantages as well as disadvantages too.
- The traditional budgeting method is easy to use but do not provide a detailed picture of your financial position, nor does it help address your financial problems.
- The ‘pay yourself first’ budgeting method ensures you save s portion of your income every month but does not offer guidance about how to spend the rest of your money wisely nor offer any advice about avoiding debt.
- The envelope budgeting method neatly divides your income into different expense categories and makes sure you do not overspend in any area, but this method requires you to track your spending pretty closely and meticulously. You must deduct money from each envelope as and when you spend it, which can be tiring and overwhelming to deal with regularly.
- The proportionate budgets, which include the 50/20/30 budgets as well as the 80/20 budgets are pretty effective at limiting over-spending because they limit the amount of money you can use to purchase needs and wants. At the same time, the 20% savings target ensures you regularly build your savings for an emergency fund, retirement and possibly early debt repayment. However, if keeping track of numbers is not your forte, this budgeting method may put you off, but when it comes to quickly restructuring your financial habits for the better, the 50/20/30 budgeting method is a winner.
- The no-budget budgeting method is not really a budgeting method in the strict sense because you don’t record your income or expenses, however, if you are natural saver and love frugality, you can use this method to keep your spending in check. While this method is easy to follow, it’s not a reliable way to improve your financial situation or plan for your future goals.
The best way to determine the most suitable budgeting method is to simply experiment with a bunch of them and see which one feels most natural and yeilds the best results, in terms of:
- Meeting your savings target,
- Ease of use,
- Measurable improvement in your financial situation.
Who should be responsible for creating a personal budget?
Once you figure out which budgeting method to use, you can begin to think about who is in charge of the household budget.
If you happen to live alone, it’s easy to determine who makes and enforces the budget – you. If you’re living as a couple or a social unit, say, with friends in a shared apartment, the responsibility of creating a personal/household budget can fall upon the person who brings home the money or the person most interested in financial management, even if they are not the earning party. For instance, one spouse may have a job while the other completes the task of paying the bills on time, meeting saving goals, tracking expenses and so on.
If you have a family, you can also include them in the budgeting process, the benefits of which are significant. However, this idea is only practical if your kids are old enough to understand the importance of frugal living and money management. It all depends on your family dynamics and what you’re comfortable with.
Budgets are a great way to get your personal finances in order. The task may seem daunting but there isn’t much to it apart from carefully watching what you do with your money.