Budgeting is one of the most important tenets of personal finance, and it’s no small thing. Everyone should know exactly what goes into making a budget — it dictates your current living situation, and determines how much you can save to support your future living situation. Follow these five steps to get started.
Step 1: Automate essential, recurring living expenses
Let’s start with the basics: Add up all monthly household income and make a list of all necessary monthly expenses, like housing, utilities, and groceries. Since these are nonnegotiable expenses, take time to set up automatic payments to cover as many of these items as you can. In many cases, you can even choose the day you’d like your bills to be debited from your account, so consider when you get paid each month. Arrange to have your bills automatically deducted when you know you’ll have cash available.
Next, subtract your bills from your income. If there’s no money left over after paying your bills, or you’re not able to cover your bills, there are only a few viable options: Make more money, get another job, or spend less. If you’ve got extra money after paying your bills, move on to step two. (See also: Build Your First Budget in 5 Easy Steps)
Step 2: Automate savings
Generally, you’d like to get your personal savings rate to 15 percent of your gross income. If you’re saving for other big-ticket items, like a home or college education, in addition to retirement, you may need to save more. Yes, everyone’s situation is different and everyone is at a different point in their lives — but if you have available cash, you should be saving something. Set up automatic transfers from your checking account to your savings account on the same schedule as your other essential bills. (See also: 5 Ways to Automate Your Finances)
Step 3: Establish a debt reduction plan
Debt and credit are vital aspects of our financial system and allow individuals to accomplish their dreams, like owning a home or paying for college. But high levels of consumer debt, including student loans and credit cards, can stunt your ability to save and can negatively affect your borrowing ability. One common benchmark is to limit your consumer debt repayment to 20 percent or less of your net monthly income.
If you’re having a hard time meeting your financial obligations and goals because of a heavy debt load, make a list of all outstanding debts owed, including the total amount due, monthly payment, and interest rate. Always make at least the minimum payment due on all accounts to remain in good credit standing. (See also: 5-Day Debt Reduction Plan: Pay It Off)
Next, focus on one debt — either the lowest balance or the highest interest rate — and send any extra money that you may have toward that debt. When that debt is paid off, take the money you were sending to that paid-off debt and redirect it toward the next debt in line. Continue this process until all debts are paid in full. If you’re struggling to come up with a workable repayment plan, check out PowerPay.org, which offers a free tool that you can use to run various payback scenarios that can illustrate how to best utilize any extra funds you have to pay off your debt. (See also: Snowballs or Avalanches: Which Debt Reduction Strategy Is Best for You?)
Step 4: Commit to a spending plan
Once you’ve met your financial obligations for the month, including bills, savings, and debt, your lifestyle expenses are dictated by your remaining balance — not the other way around. After tracking your spending over a period of time, you should have a clearer picture of your money habits as well as where your money is going and where you can make cuts. Start with your monthly bills and look for ways to trim some easy expenses, like your TV or phone services, or setting a tighter food budget.
Then examine your lifestyle spending. If you find that you overspend in certain areas, try using an envelope saving method, whereby each month you take out a set amount of money for a specific expense — like eating out — and put cash in an envelope marked specifically for that expense. Spend only what’s in that envelope and when it’s empty, there is no more spending on that area for the month.
There are various recommended spending and saving plans out there, but I’d argue that as long as you’re meeting the obligations in steps one through three, you can go ahead and spend the rest of your cash flow however you’d like.
Step 5: Account for irregular expenses
This may be one area that everyone overlooks. We all have a few bills that come only once or twice a year. Whether it’s an insurance premium or a property tax bill, these infrequent yet yearly expenses can ruin a budget fast if you don’t plan for them. Setting up a cash cushion in your checking account or keeping a separate reserve fund can help prevent you from having to dip into your emergency savings to cover these bills.
One straightforward way to account for these expenses is to divide the total amount of irregular yearly bills by 12 and set that amount aside every month as part of the cash buffer in your checking account.
Irregular expenses also include special occasions, like birthdays and holidays. Here’s a neat idea I heard about recently: Choose an amount of money you’d like to have saved for something; for example, Christmas. Divide that number by 12, and every month, buy a store gift card for that amount. This probably works best if you choose one or two stores that you can buy various gifts from, like Target. By the time Christmas comes along, go ahead and spend only what you have saved on the gift cards. It can be a somewhat painless way to save a good amount of money, and by using the store cards, it can protect your savings account from overspending during this time. (See also: 5 Common Budget Mistakes You Can Fix Right Now)
Your budget is your personal financial blueprint; it determines where you are and where you’re going. That’s why getting it right should be a priority for everyone.