Ask a CFP: How Do I Create a Budget?
A realistic budget can help you get control of your money and plan for the future.
A budget is one of the most effective ways to get control of your financial life. However, many people don't know where to start. In addition, many budgets end up failing.
As a Certified Financial Planner®, I've been creating budgets for some time now. With that in mind, here are the steps I use when formulating a budget, as well as some practical advice to make sure your budget is successful.
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Determine your monthly income
For budgeting purposes, it's important to know how much money you're bringing in before you try to plan for any expenses. And to be clear, this refers to after-tax income, or take-home pay.
If you're an employee with a salary, calculating your monthly income depends on how often you get paid:
- If you get paid monthly, this is just the net amount on one of your paychecks.
- If you get paid semi-monthly, add your last two paychecks together.
- If you get paid biweekly, multiply your paycheck's take-home amount by 26, and then divide by 12.
- If you get paid weekly, multiply your paycheck's take-home amount by 52, and then divide by 12.
If you're paid hourly, use these rules but be sure to use a typical paycheck. In other words, if you base a budget on a paycheck where you had an unusual amount of overtime, it won't be very accurate. When budgeting, it's extremely important to be realistic, or even to err on the side of caution when making any estimates.
If you have a second job or other source of income, be sure to include that as well.
As we go through these steps, I'll use an example of how this might translate to a real-world situation. Let's say that you get paid a salary, and that your after-tax paychecks are $1,500 every two weeks. Based on the biweekly paycheck guideline, this means that your monthly take-home pay is $3,250.
List your fixed recurring expenses
The next thing I like to do is to analyze fixed recurring expenses, meaning those that are the same dollar amount month after month. This includes your mortgage or rent, car payment, insurance, loans, and other such expenses.
Continuing our example, let's say that we have the following fixed recurring expenses:
- Rent - $900
- Car payment - $350
- Auto insurance - $70
- Internet service - $50
- Cable - $60
- Credit card payments - $100
As a side note, this is a great time to determine whether your fixed recurring expenses are all necessary or not. Try this: Print out copies of your latest bank account and credit card statements. Take a highlighter and highlight those expenses that you pay each month. Many of these are indeed necessary, but during the budgeting process it is worth taking the opportunity to get rid of things like old gym memberships you don't use, subscriptions to magazines you barely read, and other things of that nature.
List your variable, but necessary, expenses
Next come your expenses that are necessary, but that don't have a fixed cost. Groceries are a perfect example -- you certainly need to put food in your pantry, but your grocery bill isn't the same every time you go to the store.
There's no perfect way to estimate these expenses, but here's a technique I often use. Gather your recent bank and credit card statements and add up how much you spent over the past three months on a certain type of expense and divide by three to take an average. For example, if you spent $900 at the grocery store over the last three months, your average monthly spending is $300.
The same process can allow you to estimate how much to budget for things like gasoline, utilities, and other necessary but variable costs. With utilities (particularly electricity) it's a good idea to take an entire year's average ino account because of seasonality -- my own electric bills are twice as high during the summer months as in the winter.
So, here's a list of how this part of your budget might look after using this method:
- Groceries - $300
- Electricity - $120
- Water - $30
- Gasoline - $100
- Clothing - $100
Don't forget about savings
Before we get into discretionary expenses like entertainment and dining out, it's important to address savings.
There are two things to consider here: retirement savings and emergency savings. For retirement savings, I generally suggest setting aside about 10% of your pre-tax income, not including any retirement contributions your employer makes. If you have a retirement plan, like a 401(k), at work, you are probably already contributing a certain percentage of your income for retirement. However, if you're self-employed or don't have retirement benefits, you'll have to budget for this on your own or risk financial insecurity in retirement.
For emergency savings, an ideal amount to shoot for is six months' worth of your expenses. However, this can be a lot of money, and any amount is better than nothing. By simply setting aside a reasonable amount of money each month in a readily accessible savings account, you'll be well-positioned to deal with unexpected expenses faster than you might think.
In our example, let's say that you have a 401(k) at work and that you decide to put $150 per month into your emergency savings fund.
Then budget for discretionary expenses
The last component of your budget should be for discretionary (not necessary) expenses. I like to use a few broad categories here -- dining out, entertainment, gifts, and miscellaneous. It is important to have the last category, miscellaneous, to allocate a fair amount of money towards it. It gives you the freedom to treat yourself and prevents your budget from becoming too constrictive. In my experience, budgets that don't allow for any "wiggle room" generally don't last.
For the time being, you can use a three-month average for these categories. These categories of expenses can be easily molded to fit into your final budget, so we'll tweak them a bit in the next section.
Here's how this might look in our example:
- Dining out - $300
- Entertainment - $200
- Gifts - $150
- Miscellaneous - $400
Putting it all together
The next step is to combine everything we just discussed into one budget. Start with your income on the top, and list all of your expenses below it. This will be your preliminary budget, so don't worry too much if the numbers don't quite add up in this step.
Here's how our preliminary budget would come together in our example:
|Credit card payments||$100|
Data source: Author's calculations.
So, just based on a three-month average of our expenses, we have a deficit of $180. If this happens to you, don't be alarmed -- after all, trying to control your cash flow is probably one of the reasons why you're making a budget.
Make changes to balance things out
After you have your preliminary budget, the next step is to make changes to balance your budget.
To be perfectly clear, you want the number on the last line to be zero. In your budget, every dollar should be accounted for somewhere, even if it's in a vague category like "miscellaneous." If you have a deficit, you'll need to figure out where to trim expenses in your discretionary categories. And if you have a surplus, you can decide to make your budget a little more generous in your discretionary categories or better yet, increase your budgeted savings.
As you can see, in our example we had a $180 deficit in our preliminary budget, so we might decide to trim $100 per month from our "miscellaneous" spending and the other $80 from the "dining out" category. So, our final budget would look like this:
|Credit card payments||$100|
Data source: Author's calculations.
Do regular checkups, especially as you're getting used to budgeting
As a final point, it's important to think of your budget as a living document. That is, it can (and should) change over time. While you're first getting used to your budget, I'd even go so far as to say that a monthly assessment of your budget is a good idea.
For example, you might get through the first month under budget and decide that $150 per month in emergency savings isn't quite enough. Or find that it's difficult to limit your grocery spending to $300 per month if you aren't dining out so much. As long as the numbers balance, it's perfectly fine to make some adjustments. And you may have to add new expense categories over time -- you might be surprised how a major life event like having a child will change your budget!
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