Making a budget is one of the first things you learn in personal finance. That’s because a personal budget is a powerful forcing mechanism to help save money by getting you organized and focused.
An effective budget will help you understand where your money is going, so you can make sure it’s going to the things that are important. Over time, keeping track of your spending will help free up cash flow.
This extra cash flow can help you reach short-term financial goals, such as:
- Paying down credit card debt
- Setting up an emergency fund to be prepared for an unexpected situation
- Moving beyond living from paycheck to paycheck
At the same time, you can keep an eye on your long-term financial goals, such as investing for retirement or buying a house.
There are different ways to come up with a personalized budget. In this article, we’re going to utilize a simple financial planning tool called the zero-based budget.
What’s a zero-based budget?
Simply put, a zero-based budget is a proactive monthly budget that you create prior to the start of the month, where you assign a job to each dollar you have coming in until it equals zero.
Other budgeting techniques tend to function more as after-the-fact shaming tools. This might help you see what you did during the previous month. But then it’s too late to do anything about it.
The concept of the zero-based budgeting method has been around for years and is structured around this simple equation:
Monthly income – Monthly expenses = Cash flow
Besides simplicity, there are lots of good reasons that personal finance experts recommend this if you’re trying to create a new budget.
- A basic budget proactively highlights spending issues before they arise
- Setting budgeting goals forces you to be more organized to take control of your finances
- Over time, this helps you control your spending habits and reduce the additional stress brought on by juggling bills
Let’s take a look at how to create that budget.
Making your first budget
This will go way smoother with just a little bit of prep. Here’s what you’ll need:
- Paper and pencil
- Your last few pay statements or bank statements
- Any bills you’ve received for the upcoming month
- 30 minutes
- Whiteboard and dry erase marker (optional)
The reason for the paper and pencil is that you’ll need to make adjustments to your spending plan, and this is the best way to make those adjustments.
Once you have it all put together, you can put it any format you like. You can probably even find a budgeting app for your mobile device to help you.
Making a budget for the month
First, write the name of the upcoming month in the top right-hand corner of your paper, and “Income” at the top left.
Figure out what money is coming in next month.
Underneath that, list what you know you will get paid in the upcoming month, and the day you will get paid. Be sure to include things like child support or alimony payments. Make a note to check these against your pay stubs for accuracy.
Quick Note: How to Treat Irregular Income
For irregular sources of income like commission-based income, you should include what you typically receive on average. During the month, we will treat anything additional as an “extra” cash flow to be set aside. If unused, you can allocate it to a specific goal you’ve already established.
Figure out what money is going out.
Below your income, write “expenses.” Here, we will list your monthly expenses, using the following three categories.
This would include things like:
- Car payments
- School supplies
- Cell phone bill
This would include monthly payments for things like:
- Student loan payments
- Car loan payments
- Credit card
This would include things that are nice to have, but aren’t absolutely necessary. This would include:
- Meals and entertainment
- Gym membership
- Subscription services
Discretionary expenses can include the ‘extra’ part of a non-discretionary expense. For example, a cell phone is probably necessary in today’s day and age. But you don’t need all the bells and whistles, like 5G or unlimited bandwidth.
Identify your non-discretionary expenses.
List your mandatory living expenses.
Be honest with yourself here. If it’s not truly a must-have, we’ll still include in the discretionary income section. Or, if it’s a must-have, then only list the absolute minimum amount that for your household.
Next to each item, write the amount due (or average amount spent in previous months) and the due date where relevant.
Note: For items like groceries, where it’s not one set of fixed expenses for the month, put down your best guess of what you’re spending. This will be a living, breathing document that you will update all the time, so eventually, you will get dialed into how much you are actually spending.
Total Must-Have Expense = $3350
Your debt payments
Next, create your “Debt” category.
List each debt by name, payment amount, due date AND outstanding balance. This category is inclusive of credit cards, personal loans, car loans, medical loans, and other personal debt. In the case of a home mortgage, I recommend you include that as a “must-have.”
Total Debt Payments = $625
And your “nice to have” when making a budget
Now list your discretionary expenses, or “Nice to Haves,” in the same fashion as above.
Nice to haves are things you enjoy but could do without. This list is bigger than you think, since you may consider a lot of things to be must-haves that really aren’t.
For example: You need clothes, but odds are you already have some, so buying new clothes would not be a “Must Have” unless it’s something like a new winter coat for your kid or a suit for a job interview. Other common nice to haves include Netflix, gym memberships, cable, restaurants, movies, or travel.
Putting it all together
If you’ve been following along, you should now have a prioritized and organized list of all your income and expenses for the month, like the sample budget pictured below.
Understanding your cash flow
Note: This part is pretty easy math, but having a calculator nearby when you are making a budget won’t hurt.
- First step: Add up all your income and write it down as “Total Monthly Income.”
- Second: Add up all your expenses by each of the three groups, write them down, and then add up those three totals. Write this down as “Total Monthly Expenses.”
- Third: Subtract your “Total Monthly Expenses” from your “Total Monthly Income.” Take that number, positive or negative, and write it down as “Total Monthly Cash Flow.”
Want To Learn More About Cash Flow?
For a few more examples check out this post on how to calculate and manage cash flow which also includes 7 tips for increasing cash flow.
Shouldn’t it equal zero?
Yes!! That is what makes this number so important. Assuming that you have a positive number for your cash flow…all of the available cash flow is allocated against one of the following items depending on what phase you are in on your path to financial independence.
- Pay down debt
- Build up your emergency savings
- Invest in your future
Stop! Now review and refine
Take a deep breath…and another look. Now that you have the full picture in front of you, you may not be happy with how you’ve classified some things.
At this point, everyone’s budget will ultimately fall into one of two categories; positive cash flow and negative cash flow.
Regardless of which category yours falls in, the strategies behind the tool won’t change, just how forcefully you apply them.
In either case, you need to take a critical look at your income and expenses to identify where the highest points of leverage are so you can create some more margin/breathing room within it.
Where can you move the needle?
Do you need all the nice to haves?
These are your quickest points of leverage since you have already identified them as expendable. Cut deep and stop spending money where it’s not critical.
Every dollar saved in this category is a dollar directly into your cash flow and another step towards financial freedom. Think about these as your gas pedal. Hit it!
Are you sure it’s a must-have?
When you are focused on making a budget, you will have to challenge your assumptions on what is a must-have. If childcare costs exceed income, one of the parents may be better off staying at home.
If your house payment is more then 25% of your take-home pay, you will struggle if you don’t lower it. Groceries are typically a huge part of this spending category, so take a closer look on lowering that amount.
Can you increase your income? Even for a short time?
If your income is too low, making adjustments to your expenses is only going to provide you incremental results.
Can you do anything to increase your income, even if it’s for a short time? Second Job? Overtime? Sell stuff on eBay or have a yard sale?
Hit the debt, hard!
Paying interest on the debt is painful. The higher your interest rates are, the more money you’re throwing away in compound interest.
The truth is, the only sure-fire way to get rid of pain is to get rid of the debt. You can focus on paying it off, or try to restructure it so you’re paying a lower interest rate.
Bankruptcy is not always an option
You’ll need to think long and hard before considering bankruptcy. There are multiple difference “chapters” you’ll need to consider, which different implications on what is covered.
In many cases things like government-backed student loans, taxes, alimony, are not covered. If those are places where you carry the most debt, you may not end up any further ahead.
Making your budget PRO tip: Put your budget where you can see it!
Once you’re satisfied with your plan, you’ll need to put it someplace visible, where you’ll see it every single day. I put mine on a whiteboard above my desk.
As you go through the month, you now have a view of what money is coming in and when, where that money needs to go, when it needs to go, and how it’s prioritized in case you need to make tradeoffs to cover unexpected expenses.
Towards the end of every month, you’ll need to redo this budget to reflect the upcoming month’s paydays and expenses. Remember, making a budget is a proactive tool, not a report!
If you’re struggling to stick with your budget, try using something like the cash envelope system, where you put your budgeted cash into categorized envelopes used for tracking spending.
Wrapping up with making your budget
Let me go ahead and break it to you–making a budget isn’t easy! You’re going to mess this up in the beginning.
But that’s alright, as long as you learn from it and move on. Just don’t get frustrated and give up. Clearly identify what’s motivating you to start making a budget to begin with and start by making small changes.
You’re developing a brand new muscle, so it will take time for it to gain strength. Give it the reps it needs to get there. Even though you know how to make a budget, keeping at it takes determination.
If you do stick with it, in a few months you will have a predictable way to manage your finances. This creates the right foundation to enable you to tackle even bigger goals, like getting out of debt and investing for the future.
In the comments below, please share any tips or tricks you learned to about making a budget and learning to stick to your budget!