Budgeting 101: How it works and helps you to manage money
Author: Melanie Lockert
Source: Fortune
One of the building blocks of personal finance is budgeting. But the word budget can be confusing or feel restrictive. Adding to that, there are many ways to budget—but what it boils down to is creating a plan for your money and tracking where it goes. Ideally, a budget creates more freedom, not less.
What is a budget?
A budget is a system that allows you to plan for your income and expenses over the course of a set period of time. For example, creating a monthly budget takes into account where your income and expenses will go for that month.
“A budget is often a bad word or has some negative connotation. So typically, we call it a ‘spending plan.’ But either way, it's about knowing your income and understanding the inflows and outflows of your money,” says Ryan Fleming, CFP. “So for us it's trying to give our clients a sense of what they can spend on their needs, their wants, and their wishes or their dreams and trying to figure out if they can do a little bit more with what they have.”
Budgets can provide much-needed insight into what you’re bringing home each month and where that money is actually going. The budgeting process can be outlined in three steps.
- Creating a budget using take-home pay (after taxes) and current expenses
- Tracking income and expenses to see where you’re at
- Revise and adjust as needed
Creating a budget is useful as a planning tool for your personal finances and provides greater clarity about where money is going.
5 ways to budget
There are different approaches to budgeting. Some approaches may work better for certain people than others. Oftentimes with budgeting, the best budget is the one you can maintain without losing consistency. Here are five ways to budget.
1. 50/30/20 budget
The 50/30/20 budget is a formula for budgeting that offers specific income percentage benchmarks for your needs, wants, and savings and debt obligations.
The 50/30/20 budget breakdown uses the following percentages of your income toward specific categories:
- 50% toward needs (housing, food, transportation, insurance, minimum debt obligations etc.)
- 30% toward wants (streaming services, movie tickets, classes, concerts, travel, etc.)
- 20% toward savings and debt (emergency fund, investing for retirement, additional monthly payments toward debt, etc.)
This budget can provide a much-needed framework for people who are looking to get a handle on their expenses. But it may work better for some more than others.
Fleming recommends this type of budgeting for people who are looking for a fresh start—either younger people starting to budget for the first time or people leaving a partnership whose finances may be different as a single person. This rubric can provide basic guidance on how to save and spend.
However, this budgeting method may not work for people who live in very high-cost of living areas where housing alone may cost 50% of income. Plus, this isn’t ideal for people pursuing aggressive debt repayment.
2. Zero-based budgeting
Zero-based budgeting refers to allocating every dollar of your income toward expenses and financial goals like saving and debt repayment. The net result of allocating all of your income toward specific categories is that you can get “zero” when subtracting your expenses from your income, hence the name.
“In this budget method, the goal is to make income equal to expenses. To do this you treat contributions to savings as another expense in the same way you list housing or your phone bill,” says David Blaylock, CFP. “This method can be effective for those that track their expenses closely and have a high degree of predictability in their income.”
So if a single person with no dependents earns $4,000 per month, total expenses including savings and debt should also equal $4,000. A rough budget might look like:
- Rent: $1,300
- Food: $300
- Utilities: $100
- Transportation (gas, car insurance, repairs, public transportation, ride sharing): $400
- Entertainment: $200
- Insurance (health, renter’s insurance, etc.): $300
- Car payment: $300
- Student loan payment: $300
- Savings and retirement (20%): $800
Of course expenses will vary based on the cost of living in your area and may be much higher in some areas or much lower in others. Your expenses will also be based on your lifestyle and needs when it comes to your particular job as well as if you’re married versus single, are financially supporting children and/or parents, etc.
This budgeting method takes into account every dollar you earn and has a plan for it. If you’ve wondered where your money is going, this could be a type of budgeting to try out.
3. Pay yourself first
If you struggle to set aside money for your future, you may feel like after paying all your expenses there’s not much left to actually save. That’s where “paying yourself first” can come in handy.
Paying yourself first means setting aside a lump sum or percentage of your income each month toward your savings and investments. Doing so ensures that you’re preparing for the future and building a habit of saving and investing. Since you’re paying yourself first before allotting the remaining funds towards your other expenses, you may have some more freedom.
For example, you may not need to track as rigorously if you feel you’re prioritizing savings and preparing for the future. Paying yourself first and meeting savings goals and not worrying as much about other expenses is sometimes referred to as the “Anti-budget” from Paula Pant of Afford Anything.
4. The envelope system
The envelope system is a type of budgeting method that is geared toward people looking to pay off debt. You use different envelopes to put cash away for various budget categories. The cash in each envelope is used for the specific category and nothing more. If the cash is gone, the budgeting limit has been hit and no more should be spent in that category.
Budgeting this way is used to combat overspending and help pay off debt and takes a bit more planning. You should get envelopes and label them as well as the cash required for each envelope.
Credit cards can unintentionally lead to overspending or debt, so this budget method helps avoid those issues. But it also has its drawbacks. “The challenging part is that with our increasingly cashless society it can be difficult to manage but can be considered for those that have had difficulty budgeting in the past,” says Blaylock.
Additionally, cash can easily get lost or stolen and doesn’t help build credit.
5. Values-based budgeting
Everyone wants to feel good about where their money is going. But sometimes you can be on autopilot and spending on things that aren’t important to you. The remedy to this dissatisfaction is creating a values-based budget.
This is less about percentages and procedures and more about identifying your spending patterns and matching them with your values. For example, you may value dining out and having new experiences, donating to worthy causes, or paying for dance classes.
Through this method, you can ensure you have funds set aside from the things you value so you’re not wasting money on things that don’t bring value to your life. So instead of mindlessly getting coffee out everyday or shopping online just because, this requires more mindfulness and intentionality.
Start by writing a list of what you value. Then allot funds for each category to ensure your money supports your values. This type of budgeting can bring more satisfaction and clarity and help avoid trivial spending.
Common budgeting pitfalls
Just as there are many different budgeting methods to try out, there are budgeting mistakes to be made. Budgets should be revised on a regular basis, especially during big life changes such as marriage, childbirth, divorce, moving, or a job layoff.
As part of the budgeting process, it’s helpful to review a few months of previous expenses to see what you actually spent. This can help inform your budget so you’re not guessing and can match where you actually are, not just where you want to be.
Some other budgeting mistakes include:
- Not planning for all of your expenses. The fixed payments that are the same each month may be easy to plan for. But you may not properly plan for variable expenses that can shift from month to month. Plus, you may underestimate your discretionary spending. For example, you may be hopeful you can spend $50 per month on dining out but if you eat out more than once a week, that’s not going to happen.
- Not tracking your expenses. If you set a budget but don’t track your spending, how will you know you’re actually sticking to it? Keep track to see if you’re on target.
- Not revising your budget. Your budget should change and be revised on a regular basis. These can include transition times like after a layoff or divorce as well as if you consistently go over or under budget and need to update the amounts in each category.
- Forgoing a budget because of a variable income. If you’re a freelancer, gig worker, or in a commission-based job your income is variable and changes month-to-month. That can make it tough to budget, but it doesn’t mean it’s impossible. The 50/30/20 budget may be a good fit, so you have percentages as a guide regardless of how much you’re making.
- Using funds for other purposes. You may dip into other budget categories if you’re at capacity in one area and use it as an excuse to spend. For example, if you set a $200 dining out budget that is already spent, you might “find” more money in a different category that hasn’t been spent. While it’s not necessarily bad if you avoid debt, it can muddy the budgeting process. You want budgeting amounts to fit the stated categories.
The takeaway
Budgeting can be intimidating if you’ve never done it, but it’s a process. You can try these various budgeting methods to see which option works for your needs and lifestyle. The best one will be the one you can stick with and use on a regular basis. Just be sure to update your budget as needed and continue tracking where you’re at and where you’re going.
“Budgeting requires you to be diligent. Looking at progress on a daily or weekly basis is important especially early in the budgeting process,” says Blaylock. “This will allow people to course-correct themselves before the end of the month and adjust their spending if necessary.”
This article was written by Melanie Lockert from Fortune and was legally licensed through the Industry Dive Content Marketplace. Please direct all licensing questions to legal@industrydive.com.
