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.
Choosing What Works for You
When it comes to selecting the right budget for you, the most important thing is not which method you choose. The most important thing is that you get started doing something.
As the Latin Proverb says, “He who has begun has the work half done”.
Your first budget will not be perfect and it will certainly change over time. Find something that works for you.
I prefer the zero-based budgets myself but others prefer using a pre-defined budget and that’s ok. Read more on predefined budgets here: A Guide to Popular Budgeting Methods
With that said, here are four broad budgeting techniques that you’ll hear about:
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
Check out the next part of the budgeting series to keep learning: Budgeting Part 2: Income and Expenses – Gilbert Wealth