How to Make a Budget That Works For You
KEY POINTS
You need a budget approach that fits your style. Try one of the 6 options highlighted below.
Find your lifestyle balance while achieving your financial goals
Reduce your stress and increase your credit score
What is a budget?
A budget is an estimation of your income and expenses over a given period. At a minimum, you should prepare an annual budget broken down by month.
Revenue can consist of active and passive income. Active income is earned from providing a direct service or selling a product (e.g., salary, hourly wage, commissions). Passive income is earned with minimal or no labor (e.g., dividends, interest, royalties, rental income).
Expenses can be capital or operating in nature. Both types can further broken down between non-discretionary and discretionary. The following chart provides a snapshot of the most common types of expenses.
It is possible for non-discretionary expenses to become discretionary. For instance, a $1,000 stove may meet your basic requirements. Therefore, any amount spent on a stove over $1,000 would be considered discretionary.
Similarly, some discretionary expenses may be considered non-discretionary. For example, commuting to your job may make financial and personal sense; therefore, your automobile would be considered non-discretionary if you could not reach your place of employment utilizing public transit.
Sometimes the classification is in the eye of the beholder. For example, you may consider a large wedding culturally essential and non-discretionary. Whereas others would consider anything more than a legal wedding at city hall to be discretionary.
Do you really need a budget?
A budget is critically important as detailed in part two of our series titled Financial Literacy - Saving and Budgeting. A budget is a living document. It should evolve as your circumstances and financial goals change. It can provide the following benefits if you keep it current and stick to it.
Budgeting Methods
Let’s be honest, no one really loves creating a budget, let alone sticking to it. It requires time, commitment, and sacrifice. Thankfully, there is more than one approach to budgeting. Here are a few common approaches that may fit your style.
Zero Based Budget System
This approach is well suited for individuals that can create a budget and stick to it. If you are already experienced with budgeting, this system will allow you to maintain control of your cash flows.
It is based on allocating every dollar earned to savings, non-discretionary expenses, and discretionary expenses. Although every dollar is accounted for, you always have the option to reallocate your discretionary expenses to meet changing circumstances.
This budgeting system does not leave any cushion as every dollar is accounted for. Therefore, you may want to consider the other budgeting options below before committing to this one. If you do implement this system, be sure to create an emergency savings account to reduce the risk of incurring unforeseen debt.
As with most budgets, this system can be challenging when your monthly income is not consistent (e.g., commissions, seasonal work). You will need to learn how to save your income during above average earning months and smooth it out over below average earning months.
Envelope Budgeting System
This system is great for those lacking financial discipline and need to eliminate credit card usage.
The system can be utilized in combination with the other options described in this post. The only extra component is a stack of envelopes.
You can break out the envelopes as soon as you have created a balanced budget. On payday, go to the bank and withdraw the exact amount of funds required to cover your expenses that will occur between now and your next payday.
Next, label your envelopes for each expense category (e.g., rent, groceries, entertainment, alcohol, tobacco) and fill them with the cash equal to the budgeted amount. Be sure to securely store your envelopes.
Until next payday, you can only spend what is in each envelope. So, if you empty the entertainment envelope before the next payday, you either go without any additional entertainment or you need to find an envelope to borrow from.
You cannot use your credit card.
This envelope process forces you to make tough choices regarding how you allocate your money. The cash only component also teaches you the true cost of your expenses as such is often not appreciated when paying with credit cards.
Pay Yourself First Budget System
This system is great for focusing on your short-term and long-term savings goals as well as paying down debt (e.g., credit cards, mortgage, auto loan).
The first step is to determine the amount you need to set aside to meet your savings and debt related goals. This amount is your first deduction from your after-tax cash flows.
Now that your savings and debt obligations are covered, you are forced to cover your other non-discretionary and discretionary expenses with the remaining funds. It may be tempting to reduce your savings when things get tight.
Therefore, like the taxes you pay, we recommend your savings and debt allocation be set-up as automated payments to their designated accounts. You are less likely to touch if it needs to be redeemed or withdrawn from a third-party account.
Tip
Try living below your means. Find ways to stretch your dollars so that you can increase your savings, debt repayment, or charitable endeavors. The more you save, the sooner you will reach your goals and the better prepared you will be if an emergency arises.
70/20/10 Budget System
This system is easy to understand and allocates your funds as follows:
70% Living expenses
20% Savings and debt repayment
10% Discretionary expenses
These percentages are very broad and may not work for you. For example, you may have large mortgage and auto loan payments that exceed the 20% threshold. In obvious cases like this, you should tweak the percentages before you begin.
Many people will find this model a good starting point as the discretionary component is low. Therefore, 90% of your funds will hopefully be sufficient to cover any unforeseen spending patterns.
As you become more aware of your spending patterns, you may tweak the percentages to better align with your short-term and long-term goals. Which leads us to our next budgeting model.
50/30/20 Budget System
This system is a slight variation of the previous one and is allocated as follows:
50% Living expenses
30% Discretionary expenses
20% Savings and debt repayment
The higher allocation to discretionary expenses allows for a more balanced and flexible lifestyle. We kept the 20% allocation to savings and debt repayment static; however, the higher discretionary allocation gives room to increase savings or manage more debt.
These proportional models are a good starting point. You can transition to a more detailed model if you are not tracking towards your goals.
Intervention Budget System
Sometimes your financial realities demand a self-imposed intervention. Poor spending habits or financial turmoil beyond your control can destroy your cash flows and lead to extreme stress. Financial stress can quickly impact relationships.
An intervention may be just the cure. It may not be sustainable, but it may put you back on track.
The idea is to eliminate all discretionary spending. No more trips, movies, dinners out, coffee on-the-go, streaming services, car sharing services, or anything beyond the absolute necessities.
Financial turmoil usually causes a rapid increase in debt. This debt often attracts a higher-than-average interest rate (e.g., credit cards). In these cases, the cash flows should be redirected from discretionary expenses to debt repayment.
We said this budget model is likely unsustainable over the long-term. However, it should quickly accomplish several goals simultaneously.
Reduce high interest rate debt
Reveal unsustainable spending patterns
Reduce stress
Increase your credit rating
Bottom Line
You have many budgeting tools at your disposal. We encourage you to try out one of the options above. Feel free to modify it or try another if it does not feel right or help you accomplish your goals. The key is to commit to finding a budget system that works for you and to maintain the discipline to apply it to your day-to-day routine.
On a related note, your budget will have a direct impact on your credit score and the interest rates you pay. The following posts will provide you with the tools to ensure you maximize your credit score while reducing your borrowing costs: How to Improve Your Credit Score, How Can Your Credit Report Increase Your Net Worth?, and Financial Literacy - Credit Scores.
We encourage you to reference these government resources for additional information on creating a personal budget:
