This piece is part of a series I'm calling Money 101 and is designed for those who might not be as advanced in their personal finance knowledge and experience.
In my last post we discussed why you should track cash flow and how establishing a budget facilitates this. Today we'll cover the steps to creating a budget.
Step 1: Track Your Spending for 30 Days
The only way to get an accurate budget is to start with what you're actually spending. And if you haven't been tracking your expenses up to this point, you're going to need to record your actual expenses over a month to see what they actually are.
For the next 30 days you are going to write down what you spent, where you spent it, and what you purchased (i.e. "$30 at Target for a pair of pants") EVERY SINGLE TIME you spend money. When you pay your car payment with a check, write it down. When you transfer money to your credit card company via your bank, write it down. When you pay for a Big Mac with your debit card, write it down. When you put $1 into the machine at the car wash, write it down. When you give your daughter a dollar to buy a brush, write it down. Write down EVERY SINGLE PENNY you spend -- whether it's cash, credit, check, or anything else -- for 30 days.
If you've never done this, believe me, it will be very enlightening. It will show you where your money is really going (versus where you think it is going.) I've had a few hundred people do this exercise over the course of the past 20 years and there are ALWAYS surprises -- even for those who think they know where every penny is going.
So write down your spending (and if you're in a family, this includes everyone in the family who spends money) for the next 30 days. Don't question it. Don't dismiss it. Just do it.
Your financial well-being is worth the effort, right? I thought so.
Step 2: Collect the Rest You'll Need
During the 30 days you're tracking your expenses, begin to collect the other information you'll need including the following:
- Income -- Gather all your pay stubs, deposits from side businesses, and documents detailing any other regular source of income you have.
- Expenses -- Review your accounts (checking, credit cards, etc.) and look for irregular expenses that your 30-day tracking won't identify. Some examples: annual insurance premiums, real estate taxes, water bills (we get/pay ours quarterly), and vacations. You're looking for expenses that may not happen every 30-day period but that will sometime in the year.
Step 3: Put It All Together
At this point you're ready to develop your first budget. I suggest one of two methods for doing so: spreadsheet or paper. They both have their pros and cons and which one you use is simply personal preference.
The process is simple now that you have all the information. In one vertical column write down the names for the various sources of income (first) and expenses (second). For income you might write "work", "second job", and/or "side business". For expenses you'll include "mortgage", "taxes", "food", and the like.
Label the next 12 columns to the right of this one with the names of the months -- January through December.
Now that you have the basic format, fill in the information from the data you've collected. Add in the income you'll get from each source in each month as well as the expenses you'll have each month. Once that's completed, add up the income monthly and the expenses monthly. Subtract the expenses from income and list a number at the bottom of each month as "surplus". This number then gets set aside for savings/investment.
Step 4: Evaluate the Budget
Once you get all the information in the right place, you're now ready to evaluate the data.
The first place to start is whether or not you have a surplus over the course of the year. While you may run a deficit in a month or two, over 12 months you should have a net gain. In addition, you want to make sure that number is where you want it to be (are you saving enough to meet your goals?). If the surplus is negative or if you're not saving enough, you're going to need adjustments. And even if you are doing ok in your mind, you need to give the information a closer look.
Look at your income first. Are there things you could do to increase it? Work more hours, get a second job, start a side business, something else? Take some time to think about how you could grow your income.
Next look at which expenses can be cut or decreased. For some general guidelines, you should be spending no more than the following on these major categories (except for savings, of course):
- Housing (35%) -- Mortgage or rent payment, taxes, insurance, utilities, repairs, and any other cost of living there.
- Transportation (15%) -- Car, gas, maintenance, and insurance.
- Debt Repayment (15%) -- Not including your house and car payments.
- Saving (10%) -- Self-explanatory.
- Living (25%) -- Everything else -- clothing, food, charitable donations, entertainment, gifts, travel, etc.
Step 5: Have a Trusted, Financially Successful Friend Review Your Cash Flow Plan and Make Suggestions
Find someone you know, trust, and respect who is doing well financially and ask them to look over your cash flow plan. Specifically ask for them to help you identify places where you may be spending more money than you need to.
When my wife and I used to do financial counseling, we would have couples bring us their budgets (we provided the forms in advance to make sure they covered everything.) Almost every time we ended the session with a laundry list of how they could save money -- based on our own personal experiences. For instance, one couple had two vehicles that were much older than ours and yet they paid twice what we did for car insurance. When we asked where they got their insurance, they said it was from a family friend, someone the wife's dad had always used, so that's who they used. We told them to quote it out. They came back the next time with a cost that saved them several hundred dollars a year for the same coverage! This is what an experienced mentor can do for you and your budget.
So find a mentor to help you identify cost savings. He or she will likely come up with a lot of suggestions you have never considered.
Step 6: Update the Budget
Take the ideas you've identified yourself as well as those your mentor has suggested (and you want to accept) and update your budget. Assuming you have a positive annual surplus and are saving what you want, your budget is now set for the time being. If you are falling short on either of these measures, repeat steps #4 and #5 until the budget is where you want it to be.
If your surplus is negative, low, or simply in need of being increased to super-charge your savings, the only two ways to improve it are to increase income and/or cut spending. We will be discussing ideas for how to do both of these in days to come, so stay tuned.
Step 7: Establish a Way to Consistently Track Your Spending
Now that you have your budget, you'll need to use it to manage your money on a daily basis. In addition, you'll want to record how you're doing so you can adjust as needed. There are three easy ways to track your spending to control and manage your finances as follows:
- Envelope System – This basic system is great for those with a tendency to overspend. Simply cash your paycheck and place the dollar bills in envelopes corresponding to your budget categories (such as housing, food, clothing, entertainment, etc.). Cash is removed as expenses occur.
For instance, if you budget $50 for entertainment, put $50 cash in your monthly “entertainment” envelope. As you entertain (attend movies, concerts, play sports), pay with money from this envelope. When the envelope is empty, no more spending! If you find yourself tempted to “rob” another envelope, re-evaluate your budget. Put receipts from your spending in each envelope to later analyze your spending patterns.
- Ledger System – This system requires more accountability and time, but will give you better spending information. Similar to a checking account, deposit your paycheck and use a ledger or a notebook (less than $5 at an office store) to record your spending. On separate pages, write the monthly budgeted amount for each category. Expenses are subtracted and deposits are added to this figure in a continual increase and decrease to the account.
Using the above example, “$50” is written on your entertainment page. If you spend $10 at the movies, write “movies -$10”, leaving a balance of $40. Do this with each expense. Next month, write “deposit +$50” and add it to the current balance. If you have a negative number, you need to re-assess your budget – are you spending too much in this area? Can you spend less in another area to compensate? If you can’t find a solution and you’re consistently in the red on several of your accounts, consider using the envelope system.
- Electronically – If you’re technologically minded and own a computer, tracking your spending electronically might just be your cup of tea. Quicken is a good financial program that not only tracks your spending but also helps with extras like recording your household inventory for insurance purposes. Or if you prefer a web-based option, Mint might be for you. Their versatility allows you to analyze your spending in a variety of ways, even providing a “net worth” graph as an incentive for saving and reducing debt. And though you still need to record your data regularly, this method can be less time consuming than the ledger system.
Any of these three methods will help you track your finances and manage your money. Choose one that works best for your temperament and lifestyle, and stick with it. The payoffs will be a greater understanding of your spending patterns, freedom from worry, and ultimately the realization of your financial goals.
And that's it! You now have a working budget and a system for knowing where your money goes. You're now able to manage your cash flow and have much better control of your money. Congratualtions!