How to Create a Budget That Works

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If you’re serious about improving your financial situation, the first step is to create a budget. The budget is the foundation of effective money management, and without a budget you’re practically guaranteeing that you’ll make costly mistakes in how you use your money.

Although budgeting isn’t complicated, most of us don’t actually bother to do it. Maybe it’s because we feel like we’ll be too restricted and life will be no fun if we have a budget. Maybe it’s because we don’t want to see the reality of how we’re spending our money. Or maybe it’s because we think it’s too difficult or complicated. Regardless of the reasons, in this article we’ll look at how to make a budget.

Budgeting is actually quite simple. Unfortunately, it’s not usually taught in school, but anyone can learn to do it. All you need is a little guidance, and you’ll get that guidance in this article.

It may seem like creating a budget and sticking to that budget would create more stress in your life, but actually the opposite is true. With a budget you’ll be able to know where you stand, and as long as you’re sticking to the budget you can have confidence that you’re doing a good job with your money.

Why is a Budget Important?

Here are a few convincing reasons why you should have a budget:

1 – A budget will help to keep you accountable for how you manage your money.

2 – A budget will help you to identify problem areas where you are spending too much money.

3 – A budget will give you a plan that you can follow each month, and the result will be less money wasted and more money saved.

4 – With a budget you’ll actually be able to live a higher quality of life, because you can identify the expenses that are important to you, and the ones that don’t matter as much to you. By cutting back in the areas that aren’t important to you, you’ll have more money for what matters most.

5 – You’ll be motivated to manage your money better, and get excited as you see the results of saving and investing more.

6 – If you’re married or you have a significant other, a budget can help to get both of you on the same page and prevent tension caused by finances.

→ Related reading: 101 Practical and Realistic Ways to Save Money

How to Create a Budget

If you recognize the importance of a budget and you’re ready to get started, let’s look at the basic steps that you’ll need to take. If you’d like to be able to download a template that you can use to create a budget in Google Docs, plus a printable PDF version, please enter your email below.

You can also use one of the best budgeting apps like Mint or EveryDollar to create your budget and track spending.

The goal of budgeting is to know where your money is going, and to have control over it. You’ll want to have money left over each month that you can save, invest, or pay off debt.

Before we get started, one thing I want to point out is that your budget will be fluid. It’s not something that you’ll create today and it will stay that way forever. Your income will change and your expenses will change. That’s ok and it’s all part of the process. The key is to stay on top of your budget and make the changes when needed.

→ Related reading: Best Cash Envelope System Wallets

Step 1: Calculate Your Monthly Income

The first step is to know how much money you make. This could be very easy or difficult, depending on your situation. If you’re an employee and you have a steady salary it’s probably pretty clear-cut. (Remember that income tax withholding will impact your takehome pay. If you need to make any changes to what you are claiming, be sure to fill out a new W4 form with your employer.)

If you’re self-employed, commissioned, or you have some other job with an income that constantly varies (like seasonal jobs), you may have a harder time knowing what you should use as your income. If that’s the case, try to calculate an average. I recommend being very conservative if you have a variable income. I like to assume that my income will be low and budget accordingly. It’s a lot easier to figure out what you should do with excess money than it is to figure out how to make up the difference if you made less than expected.

One thing to note here is that your monthly income will likely vary even if you have a consistent salary. Most employees are paid every two weeks, and that means there will be two months out of the year where you’ll have three paychecks instead of two. You may also have bonuses or other things that impact how much you make in a given month. When we get to the next step we’ll see that the same situation applies to expenses. Because of the varying income and expenses, you may want to review and adjust your budget each month as needed.

Step 2: Add Up Your Expenses, and Categorize Them

Next, go back through the past few months, add up your expenses and organize them into your budget categories. You can use your checking account, credit card statements, and any receipts that you may have to see how much you were spending, and on what. Since you haven’t been tracking your expenses up to this point your numbers here may not be perfect, especially for those things that you typically pay with cash. Make your best guess for now, and going forward you’ll track your expenses and then you can adjust the numbers in your budget as needed (based on your real expenses, not an educated guess).

As you go through your expenses, put them into categories. The categories in a budget may vary from one person or family to another. Below you’ll find a list of common categories and expenses that may fall into those categories (these are also the categories that you’ll find in my budget spreadsheet). If you have no expenses in one of these categories you don’t need to include it in your budget. And if you have expenses that don’t fit into any of these categories you can create your own category.

Housing: mortgage or rent payment, property taxes, HOA fees, upkeep, and maintenance.

Utilities: electricity, gas, water, sewer, trash, phone, cell phone, internet, cable or satellite TV.

Food: groceries, restaurants.

Transportation: car payments (loan or lease), gas, public transportation costs, parking, routine maintenance, inspections, and repairs.

Medical: doctor’s visits (including dental, vision, OBGYN, and other specialists), medical devices, and medication.

Insurance: homeowner’s or renters, health, auto, life, long-term care, disability, and jewelry.

Household Items: clothing, personal care products, toiletries, and cleaning supplies.

Education: tuition, books, and school supplies.

Gifts: Christmas and holidays, birthdays, and weddings.

Entertainment and Recreation: vacation, travel, amusement parks, concerts, sporting events, museums, movies, Netflix and other subscriptions.

Debt Payments: credit cards, student loans, personal loans.

Savings: emergency fund, retirement, college fund, for a new car, and for home improvements.

Taxes: income and capital gains.

Charitable Giving: church, charities, and non-profits.

These categories are only suggestions. Make sure that the categories in your budget fit your lifestyle and make sense to you. Also, there is some flexibility in how you place expenses within the categories. For example, property taxes could fall under the taxes or housing category. Car insurance could fall into the insurance category, or maybe you prefer to have it as part of the transportation category. Just do it in a way that makes the most sense to you.

Also keep in mind that you can work off of your before-tax income or after-tax income. If you’re an employee and taxes are automatically taken out of each paycheck (which is the case for most people) it will probably be easier if you don’t include income taxes in your budget and just base things on your take-home pay. I chose to put income taxes in the budget because I’m self-employed and I need to account for taxes since they are not withheld. If you do decide to base things on your pre-tax income, be sure that you include income taxes as an expense in your budget.

After you have set up your categories and gone back and recorded your expenses for the past few months, you should be able to total it all up and see how much you spend on average per month by category. And of course, how much you spend on average per month overall.

How does your overall expense compare to your monthly income? Have you been spending more or less than you make? If you’ve been spending less than you’re making, you’re in good shape! If you’ve been spending more than you’re making, don’t panic. You’re going through this budgeting process for a reason, and you can fix the issues once you know where you are spending too much.

Step 3: Set Your Target Monthly Spending

Once you know ho