The most important step to understanding your finances and becoming ‘financially healthy’ is to create a budget. A budget will help identify and track your monthly debt payments, your splurge spending and how much you can and are saving. If you’re spending more than you earn a budget will help pinpoint areas of spending that may be reduced, unleashing the potential for more money to be saved.
Steps to Creating a Budget
The first step to creating a budget is finding a budget template. The template will start with your after tax income, subtract your monthly debts and expenses that are ‘needed’ and the result is what is left for savings and discretionary spending.
A good rule of thumb is that 50% of your after tax income is spent on expenses that are ‘needed.’ These include bills you have to pay like your mortgage, car payment, utilities as well as items essential for living such as groceries, health care, insurance and child care.
The next category of spending are your ‘wants.’ This list includes items like a new purse, cable and streaming services, eating at a restaurant, vacations and other forms of entertainment. The target allocation for this category should be around 30% of your after tax income.
The final category is for savings. You should shoot for 20% of your pay to go into this bucket. That will include your emergency fund, retirement account and investments. I will mention that you should not include any employer match into your 401k towards your goal of 20%.
Here is an example of how this 50/30/20 rule applies.
After tax income – $2,100
50% for ‘Needs’ – $1,050
30% for ‘Wants’ – $630
20% for ‘Savings’ – $420
Determine Your Net Earnings
If you receive regular paychecks, you use the amount you receive on a monthly basis. Depending on the budget template you’re using, you may need to add back items such as retirement savings, health insurance and other expenses that may be accounted for in the budget.
If you are self employed or retired, your income may come from dividends, distributions, and/or interest. If taxes were not taken out, you’ll want to be sure to add an expense line for all taxes paid at year end.
Create a List of Fixed Monthly Expenses
Fixed monthly expenses should include any and all payments that may be due during the month:
- Mortgage and/or rent (including taxes, assessments, security, parking, landscaping) – I like to add a fixed amount to home repairs to be conservative
- Car Payment(s)
- Personal Care (necessity)
- Public transportation for work
- Student Loans
- Credit Cards (if you have a set amount – if not it can be added to the variable monthly expenses)
- Gym Membership
- Pet needs
Create a List of Variable Monthly Expenses
- Dining out
- Personal Care (non-necessity)
- Household items
- Car Maintenance/Repairs
Calculate What You’re Saving Each Month
The goal is to allocate earnings to savings before it’s spent on your ‘wants.’ I certainly fail to do that often. The budget is a way to help show how much you are spending on these non-necessities and hopefully reduce that spending and reallocate to your savings. These are the types of savings you should have in order from most to least important:
- Emergency Fund
- College Savings/529
- UTMA/Kids Savings
Understand How Much You’ve Spent on “Wants”
Now that you have basically completed your budget, you can spot areas of potential savings. These typically come from your variable fixed expenses and are those that are not essential for you and your family to survive. Here’s the list items of non-essential expenses listed above:
- Dining Out
- Personal Care (nail salon, spa, massage)
- Household Items (to an extent)
There are definitely ways to save on the fixed expenses as well. Did you buy a new car that you didn’t need? Do you need cable/Netflix/Streaming? Are you assuming your credit card spending is essential when you’re loading up debt on coffee and donuts? Have you shopped around for a better deal on your insurance? Do you really need that gym membership? The budget is meant to show you where your money is going and possible ways to reduce your expenses.
Now that you’ve completed your budget, you can dig in to see where you stand. Is your income greater than your debts? If it is congratulations, these funds can be put to good use by paying down debt or added to one of your savings vehicles. How close are you to the 50/30/20 rule? Have you already found areas you can reduce your spending? Here are some great savings tips.
Just remember, a budget is fluid and always changing. You should review and update your budget constantly to be sure you’re on a path to success. There will be months your spending is way too high but also those that you’re able to put more than 20% into savings. That’s ok as long as you stay on top of it and continue trying to better your position.
- If you earn commission, assume the lowest income level for your budget to be conservative
- Try to exclude bonuses from your budget, even if they are fairly consistent.
- If you use credit cards, make sure you’re adding those purchases to your monthly spending and not just the monthly payment on the credit card. This can be a deception to yourself in not identifying non-essential spending
- For variable expense such as car repair, gifts and vacation allocate a fixed monthly amount to that expense. Those types of lumpy expense can wreak havoc on a budget
- Instead of calculating 50/30/20, go with 50/20/30. Subtract your essential monthly obligations (50%), then savings (20%), then see what you’re left with for non-essential spending
- If you tend to go over budget and use credit cards, take a few months off and use only cash