Budgeting Part 1: The Basics
Knowing how to budget is essential skill for financial success. It is the first step towards understanding your overall financial picture and planning for your future. Unfortunately, budgeting can be intimidating and overwhelming due to the sheer number of methods and techniques that exist. In this introduction, I will break down the fundamentals of budgeting, discuss some popular approaches, and provide a summary of key takeaways. With a solid understanding of budgeting basics under your belt, you’ll be ready to tackle any challenge that comes your way!
If you need convincing that you should budget, check out the 8 Benefits of Budgeting!
Importance of Mindset and Expectations
Before I dive into the different budgeting techniques out there, you need to know that budgeting is not natural for everyone.
Budgeting is a skill that is learned. If you have never budgeted before, you will not be great at budgeting right away, and it will take longer at first. You’ll also need to take time to learn about your finances and what different categories or sources of income you have. You may even switch between budgeting techniques or budgeting software before finding the one that works best for you. Like any skill worth learning, if you stick with it, it’ll get easier and faster. Who knows… you may even learn to enjoy it!
Your budget is uniquely yours. Everyone has a unique financial situation and different goals. Simply living in a high-cost area versus a low-cost area can significantly alter what categories and amounts you put in your budget. The purpose of budgeting is not to align your finances to someone else’s goals but to your own! Below, I’ll lay out some popular budgeting suggestions, but you do not have to follow those exactly as prescribed. The suggestions may help you start a budget, but they will not be the final product. As you begin to develop a budget, feel free to customize it and make it your own.
Be kind to yourself. Budgeting is a process to help you gain control of your finances, not a means to constantly beat yourself up over your spending. If you go over a spending category or come across expenses you didn’t consider, learn from it and move on (oh… and don’t forget to add it to your budget). There is not much value in fretting over what happened in the past. Sometimes the person that is most critical of you is you.
The best budget is the one you stick to. The most advanced and detailed budget is only helpful if you stick to it. If you are hesitant to budget because of the effort, start with a simple budget. As you learn more and get better at budgeting, you can add more detail later if you are trying to accomplish a specific goal.
It is OK to ask! Finally, if you need help with your budget, it is OK to ask someone. There are plenty of resources and people out there who can help craft a budget that works for you.
Four Budgeting Techniques
Spending
Tracking
Time Required
Useful For
Use as a budgeting stepping stone.
Pay Yourself
First
Time Required
Useful For
High Positive Cash Flow where basic expenses are not a concern.
Target
Percentages
Time Required
Useful For
Tight Cash to Moderate Wealth
Zero-Based
Budget
Time Required
Useful For
Tight Cash or Aggressive Wealth Building
Spending Tracking
While not strictly budgeting, simply tracking your spending is an easy way to gain insight into where your dollars go. The goal is to create a record of how much money you have coming in and where it all went. What you do with this information depends on your goals, but it may give you the motivation to make modifications to your spending when you see the actual numbers and achieve the benefits of budgeting. Starting to track your spending can be created in as little as 15 minutes using an app and can quickly give you insight into your situation.
Strengths
- Easy to Implement
- Low Time Commitment
Weaknesses
- Reactive rather than proactive
- Savings and Emergencies not planned for in advance
Example: Charlie has a bank account and two credit cards through which he runs all his monthly expenses. He uses a budgeting app and links the app to his three accounts. The app pulls in transactions as they occur from all three accounts. Charlie reviews the transactions regularly to see how much he spends in each category. Early on, Charlie identifies that he is paying $25 per month for subscriptions he no longer uses. He cancels those and saves that money instead.
Pay Yourself First
One of the simplest forms of budgeting, Pay-Yourself-First prioritizes saving for your future first before spending anything else. All other spending can be done knowing the future is taken care of. With this in mind, Pay-Yourself-First can be boiled down to two budget categories: savings, and non-savings. The challenge with this form of budgeting is calculating the appropriate savings rates given your unique situation and balancing taking on future obligations such as debt. The target percentage guidelines below can help establish an initial savings rate target. If you are naturally frugal, this strategy can work well.
Strengths
- Easy to Implement
- Prioritizes Savings
Weaknesses
- May overcommit on spending
- Savings and Emergencies not planned for in advance
Example: Charlie determines that he should save 20% of his income to reach his financial goals. He sets the 20% up to be saved into his retirement plan and an investment account regularly before spending anything else.
Target Percentages
A more advanced version of Pay-Yourself-First, Target Percentages budgets your income based on percentages of your income. For example, the popular “50/30/20 Budget” assigns 50% of income to Essential Expenses, 30% of income to Financial Goals, and 20% of income to Lifestyle Expenses. Within these overall buckets, there is some flexibility to customize what you spend in that category.
Strengths
- Moderately Easy to Implement
- Breaks down Essential vs. Discretionary Expenses
Weaknesses
- Guidelines may not reflect goals, personal situation, or values
Example: Charlie makes $6,000 per month in income. Charlie establishes his budget as $3,000 per month for essential expenses, $1,800 per month for financial goals, and $1,200 per month for lifestyle expenses. Within lifestyle expenses, Charlie would like to use $500 per month for travel leaving $700 per month for other lifestyle expenses.
Zero-Based Budget
A more advanced version of Pay-Yourself-First, Target Percentages budgets your income based on percentages of your income. For example, the popular “50/30/20 Budget” assigns 50% of income to Essential Expenses, 30% of income to Financial Goals, and 20% of income to Lifestyle Expenses. Within these overall buckets, there is some flexibility to customize what you spend in that category.
Strengths
- Proactive Budgeting
- Creates plan for irregular expenses
Weaknesses
- Takes time to learn and implement
Budgeting Terminology
Budgeting guidelines use all sorts of terminology. Here are the most important ones you should be aware of as you start crafting your own budget.
Essential Expenses
Essential Expenses are those you cannot reasonably live without. What does that include? That’s where money is more of an art than a science and is different for everyone.
For example, most agree that your mortgage payment falls within the essential category. What if your mortgage payment is from an 8,000-square-foot home with a pool and private tennis court? Essential or not?
Generally essential expenses include the following:
Anything related to maintaining a residence.
Mortgage or rent, property tax, utilities (electricity, etc.), homeowners/renters insurance, and condo/home association fees.
Generally, groceries only. Dining out is typically only included if necessary for your living situation.
Health insurance premiums, out-of-pocket expenses, prescriptions
Car loan/lease, gas, car insurance, parking, tolls, maintenance, and commuter fares
Daycare, tuition, and fees. If you have children, you have to take care of them.
Credit card payments, student loan payments, child support, alimony, and life insurance
Discretionary or Lifestyle Expenses
Discretionary or Lifestyle Expenses are those expenses that are Not Essential. If you can live and work without them, they are discretionary. Dining out, vacations, entertainment, etc., are all found in the discretionary spending category.
Gross Income vs. Net Income
Gross Income is just all your income before any deductions are made for things like taxes or insurance. Total salary, bonuses, self-employment income, etc. Gross income is also sometimes referred to as “Pre-Tax Income”.
Net Income is more complicated to address. When looking at the different popular budgets below, most are based on Net Income which most will say is your “Take Home Pay.” You’ll want to be clear about what is included or excluded in Net Income when implementing your budgets as factors like tax withholding (varies by income and situation), savings, medical premiums, and life insurance premiums can change it.
Popular Budgets
Backward Budgeting or Reverse Budgeting: These are really just another form of Pay-Yourself-First. In these budgets, you set your savings first, then have the freedom to spend the rest, knowing that you have your future taken care of.
Value-Based Budgeting: Rather than categorizing your budget by category of expense, Values-Based Budgeting aligns your expenses to your values. For example, you might have a values-based budget with Family and Friends as a category. Within Family and Friends, you have budgeted $25 per month to have coffee out with a family member or friend because it is being used to further your value of deepening your relationships. Values-Based Budgets are interesting exercises to go through but can be difficult to set up as you must be in tune with your values system.
Percentage Budgets: Financial Bloggers and Media Outlets love percentages because people are attracted to simple percentages, and they can say the percentages apply to everyone (they don’t)! Here are some of the most common out there:
50/30/20 Rule (Sometimes also titled the 50/20/30 Rule)
The 50/30/20 Rule provides three broad categories of spending that is based on Net Income. You can get more granular within each category and allocate a percentage to subcategories. For example, out of the essential expenses, you might make home expenses 25% and auto expenses 10% leaving 15% for the other expenses in the category.
- 50% of Essential Expenses (Home, Transportation, Utilities, Food, Loan Payments)
- 30% to Financial (Retirement, Medical, Short-Term Savings)
- 20% to Discretionary (Entertainment, Personal Care, Clothing, Dining Out)
50/15/5 Rule
The 50/15/5 Rule is a percentage technique that does specify between net income (take-home pay) and gross income or pre-tax income. What is nice about this budget is that it breaks out short-term unplanned savings.
- 50% of take-home pay to essential expenses
- 15% pre-tax income to retirement
- 5% of take-home to short-term unplanned expenses
70/20/10 Rule
The 70/20/10 is another simplified version of the previous percentage techniques that breaks the budget into three categories based on after-tax income.
- 70% Monthly Spending (All Essential and Discretionary)
- 20% Savings
- 10% Donations or Extra Debt Repayment
80/20 Rule
The 80/20 Rule says to set aside 20% for financial goals first and spend freely the remaining 80%. This is a “Pay Yourself First” budgeting strategy.
- 20% Financial
- 80% All Other Expenses
A variant of this is the 10/10/80 Rule, which budgets 10% charity, 10% savings, and 80% All Other Expenses.
60% Solution
The 60% Solution breaks down the budget broadly into two main categories, with the second category being broken into equal increments of 10%. Interestingly, Fun receives its own 10% category separate from discretionary expenses, where other budgets would include it. This strategy is based on after-tax income.
- 60% to Needs and Wants (Essential & Discretionary)
- 10% each to Retirement, Long-Term Savings, Short Term Savings, and Fun
How to Track and Implement
Budgeting Program
Using a budgeting program is a great way to develop and implement a budget. Here are the three general flavors.
Aggregation Tools
I love aggregation tools because it makes managing a budget so much faster. The less work you have to put into just getting the data, the more likely you are to stick with it. Aggregation software automatically pulls in transactions from your banks, credit cards, and other accounts; performs some basic categorization for you; tracks your progress in the budget; alerts you to overspending; and can provide some useful graphics to help you visualize your spending. This takes a lot of the leg work out of budgeting and allows you to spend more of your budgeting time confirming the information and assessing your situation.
Aggregation software can be fully online, in a spreadsheet, or on a desktop application.
Non-Aggregation Tools
Some of the budgeting tools you’ll come across either not provide aggregation or require an up-charge to get it. Or you could just be using a spreadsheet. Again, these tools are good but I prefer ones with Aggregation.
Pen and Paper
Yes, just writing everything out in a notebook or piece of paper and track it monthly. Operating your budget this way will add more time to each budget time estimate above because you have write in every transaction, add up the category ongoing totals, and repeat that every month.
But, if that is how you are most comfortable budgeting and it gets you started, go for it!
Cash Envelope
The idea of this budget is that you allocate cash to envelopes (yes, physical cash to physical envelopes). You can only spend money in the envelopes for that category. Once the envelope is empty, you can no longer spend in that category. The great part of this technique is it is very tangible, and you can see the dollars go throughout the month. While some advocate doing this entirely, it could be a very useful tool implemented in difficult to control budget areas. For example, if you want to cut back on buying coffee out, you could use an envelope system for your coffee budget. Once the cash is out, no more coffee out.
Check out the next part of the budgeting series to keep learning: Budgeting Part 2: Income and Expenses – Gilbert Wealth