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.
→ Related reading: 13 Things You Can Do TODAY to Improve Your Finances
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 Excel or OpenOffice please enter your email below.
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.
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.
→ Related reading: How to Calculate Your Net Worth
Step 2: Add Up Your Expenses, and Categorize Them
Next, go back through the past few months, add up your expenses and categorize them. 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 how much you’ve been spending in each category over the past few months, you can set a goal for how much you want to allocate each month per category. Probably the best way to do this is to work backwards. At this point you already know your monthly income, and you know you don’t want expenses to be any higher than that income. Start with your most critical expenses in the budget and assign each category a dollar amount for the month.
There’s no exact formula that you should follow, but there are some suggested guidelines that might give you a good idea about how much you should allocate for each category. Here are some suggested ranges (as a percentage of your after-tax income):
- Housing: 25-35%
- Utilities: 5-10%
- Food: 5-15%
- Transportation: 5-15%
- Medical: 5-10%
- Insurance: 10-25%
- Household Items: 5-10%
- Education: 0-10%
- Gifts: 0-5%
- Entertainment and Recreation: 5-10%
- Charitable Giving: 5-10%
- Debt: 0%
- Savings: any excess
So if you have an after-tax income of $5,000 per month, your budget might look something like this:
- Housing: $1,350 (27%)
- Utilities: $400 (8%)
- Food: $450 (9%)
- Transportation: $400 (8%)
- Medical: $250 (5%)
- Insurance: $700 (14%)
- Household Items: $300 (6%)
- Education: $150 (3%)
- Gifts: $100 (2%)
- Entertainment and Recreation: $250 (5%)
- Charitable Giving: $400 (8%)
- Debt: 0%
- Savings: $250 (5%)
Keep in mind that your budget and percentages could be very different. Every person or family has a different situation, so don’t feel like you need to strictly follow the percentages listed here. For example, if you don’t have health insurance through an employer, you may need to allocate a higher percentage of the budget for insurance. Just keep in mind that for every time you increase the budget in one area you’ll need to reduce it somewhere else to offset the difference.
Now, after you’ve gone through this step you’ll know exactly how much you have allocated for each category per month. No more guessing!
→ Related reading: 9 Steps to Financial Independence (How to Retire Early)
Step 4: Continue to Track Your Actual Expenses Each Month
Creating a budget is a huge step, but it’s really only the beginning. It’s equally important that you track your actual expenses so you can see if you are sticking to the budget. Make it a habit to record all of your expenses. You can use a spreadsheet to create a new tab for each month, use pen and paper, or use an online tool or budgeting app.
Expenses paid with credit card, debit card, or check are easy to track. If you’re paying with cash you may need to record your expenses at the end of each day so you don’t forget. This is just one reason why I prefer to use a credit card, it’s so much easier to track and go back and look at old statements. Another reason is the cash rewards you get from many credit cards now.
Get in the habit of recording all of your expenses. Then, at the end of each month total them up. Check to see if your category totals and the overall total stayed within the budget or went over.
→ Related reading: 50+ Financial Freedom Quotes to Motivate and Inspire
Step 5: Adjust Your Budgeted Amounts Where Needed
As I mentioned earlier, budgeting is a fluid process. Your budget will change and adjust as you go. Obviously, you’ll want to keep your expenses under control, but sometimes there are increases that are beyond your control.
At the end of each month when you check to see your total expenses in each category, take a look and see if you need to adjust your budget. If you are consistently going over the budget in a particular category, that means you need to either increase the budget in that category or be more disciplined with your spending.
And, of course, if you increase the budget for that category you will need to lower the budget in another category to offset it.
For a lot of tips on how to budget, save, make, invest & better manage your money, see this list of 89 personal finance tips.
Step 6: Save and Invest the Excess
You’re interested in budgeting because you want to improve your financial situation. With that in mind, ideally you’ll have excess money after you’ve paid all of your bills and expenses for the month. In order to secure your financial future you’ll need to save or invest that excess.
This is where budgeting can actually be fun and exciting! You’ve disciplined yourself to live according to your budget, and now you can see the rewards. It’s exciting to know that at the end of the month you have a few hundred dollars (or more) to invest for the future. The discipline that you have now will pay big dividends in the future.
→ Related reading: How Should I Prioritize My Savings?
How you choose to save or invest is up to you. My recommendation is to have an emergency fund in a savings account that you can easily and quickly access whenever you might need it. A high-yield online savings account like one from CIT Bank is a great option. My wife and I have moved our savings to a CIT money market account because of the high-interest rate. CIT’s interest rates are more than 20x the national average!
Step 7: Increase Your Income if Needed
If your expenses are consistently higher than your income, there are two ways to fix your budget: 1) spend less money, and 2) make more money. Ideally, you’ll be looking for ways to do both.
But maybe you’ve cut back everywhere you can and you still aren’t able to stay within your budget.
Or, maybe you’re staying within your budget and you have things under control, but you’d like to be able to put more money into savings or investments each month.
In either case, increasing your income will make a huge difference. If you’re looking to increase your income there are a few basic possibilities. You could 1) get a raise, 2) work overtime, 3) get a higher-paying job, or 4) start a side hustle.
Getting a raise is ideal because it will give you more money for the same amount of work. Unfortunately, it’s not always possible.
Working overtime isn’t a bad idea, if it’s an option for you. Many people are salaried and not paid for overtime, or not allowed by management to work overtime.
Getting a higher-paying job can work too, but it’s not always a good long-term fix. It’s also easier said than done, in many cases.
A side hustle is a great option if you want or need some extra income. There are all kinds of options and possibilities. Even if you only have a very limited amount of time available, there are still some options. If you’re looking to increase your income I recommend that you check out my list of more than 150 possible side hustles (including my favorites). You’re bound to find something on that list that will allow you to start making more money.
READ NEXT: 100 Amazing Websites for Saving Money