How to Create a Budget and Stick to a Budget

Budgets. Not only do they make finance nerds happy, but it’s essential to your financial health. They allow you to keep a modicum of self-control on your spending. They will show you, clear as day, where you can start saving money. In fact, I would go as far to say that trying to make ends meet without a budget is like trying to drive a car without a brake pedal. And here’s the wildest thing about them: they only take mintues to set up; shorter than the time it takes to read this post. If you haven’t started yet, you’d be crazy not to.

 

Create a budget: List Monthly Income

1. Start with listing your Monthly Income. Budget out with four weeks of take-home pay. If you’re starting a new job and planning ahead, use an after tax paycheck calculator to get some rough numbers.

  • If you’re bi-monthly, you might want to grab your February pay stubs (or a calculator) and see what 10 workdays of pay looks like, then multiply by two. This will help you budget out the worst-case scenario.
  • If your monthly income fluctuates, list your worst-case or lower-than-average scenario. Budget out for that instead, and anything that’s left over should be allowed to float in your checking as a buffer.

First thing you want to do is budget out for four weeks of take-home (after-tax) pay. This means if you’re paid weekly, your monthly income is based on four paychecks. If you’re bi-monthly, you might want to grab your February pay stubs or a calculator and see what 10 workdays of pay looks like, then multiply by two.

You probably noticed that you’re missing a couple of checks, or at least part of your checks. In fact, you just calculated a year to be only 48 weeks long. This is a good thing. You are assuming the worst-case scenario, which will happen at least once a year: February. Only base your monthly income off of your minimum, guaranteed income.

So what does this mean? If you’re bi-monthly, you get paid a little more than you expect a month. If you’re weekly, you get four “bonus” checks spread throughout the year. Bi-weekly, you get two or three “bonus” checks per year.

Using this method—whether you’re bi-monthly, weekly, or bi-weekly—you’re earning on thirteen months, while spending on twelve. All of your “bonus” money should go toward Step 4.

 

Create a Budget: List Mandatory Spending

2. Take a look at your Mandatory Spending. This is all the spending that is related to safety and survival. This kind of spending includes:

  • Mortgage, rent, and insurance.
  • Electric, natural gas, water/sewer.
  • Groceries
  • Transportation

Not included in this list are discretionary items (which belong in Section 4):

  • Cable TV
  • Dining out, bars, and clubs
  • Shopping

A few Rules of Thumb: You should consider making a major change to your lifestyle if one of the following scenarios is happening:

  • Your monthly mortgage/rent is more than 30% of your take home pay. You might want to consider getting a roommate, or moving to some place cheaper.
  • Your monthly expenses on your car is more than 15% of your take home pay. You might want to consider carpooling to work, traveling less, or taking the bus or a bike. You may also want to consider moving closer or selling your car, if either’s an option.
  • Your groceries cost more than $300 per person. If you’re trying to cut costs, you might want to look at more frugal options for buying groceries, such as buying in bulk, going for store-brand foods, or frequenting less expensive grocery stores.

Create a Budget Review Debts, Goals, and Retirement

3. Take a look at your Debts, Goals, and Retirement. How much you put here is subjective, but the faster you take care of this, the quicker you can become financially independent.

  • You want to pay debt down fast (especially debts with high interest rates), so you pay as little interest as possible. There are tools to help you, and Mint has a paydown calculator if you chose their service. (Some investors would advise you to pay low interest debt, like debts that are only a few percentage points above inflation, more slowly. You can instead invest in retirement and get higher returns. More on this later.)
  • You want to save up for an emergency to cover 3-6 months of expenses in case something goes horribly wrong. You will need this money available to you in a separate, liquid savings account, not an investment fund. I will elaborate why in next week’s post.
  • You want to invest as early as you can into retirement, so you can take advantage of compound interest and live a wealthy lifestyle.

Your ultimate goal in this section is taking steps toward total, financial independence. This can take years or even decades, but don’t fret about the timeline. The point is that this should be your biggest financial focus, and the more you put toward this step, the more your money compounds. Your money can work harder than you do.

“Those who understand [compound interest] earn it. Those who don’t, pay it”

—Albert Einstein

 

Create a Budget: Discretionary Spending

4. Discretionary spending is anything that’s left over from your goals. Shopping, hobbies, cable, coffee, fast food, dining, and so on. Just remember: always live within your means, and try to save up for capital expenses before buying.

Dining out is more expensive than a lot of people think. It’s easy to blow $250+ in a month just eating by yourself, or going to the bar with friends. If you’re looking to cut back on this, consider making food at home, or inviting friends over for beer and homemade wings over a football game instead of going out.

 

Budget Tools and Budget Websites

Commercial Software

  • Mint is free and automates much of the process by linking up with most large financial institutions to help track your spending and other aspects of your finances.
  • Personal Capital is free and automates much of the process by linking up with most large financial institutions to help track your spending and other aspects of your finances.
  • YNAB is commonly recommended here. Here are some notes on pricing:
    • Currently a subscription service at $5/month (or $50/yr)
    • The “classic” software (version 4) has a 34 day free trial.
    • The “classic” version (version 4) costs $60.
    • Students with a .edu e-mail address may be able to obtain Classic YNAB (version 4) for free.

 

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