For the majority of us, we can’t just buy whatever we want. Be that a new TV, a vacation or something more expensive like a Car. For these purchases, we tend to create a plan to follow so that we can buy them. This is considered a budget.
The word “budget” tends to make people cringe, but it’s an important tool for our financial wellbeing. If you find yourself living paycheck to paycheck a budget can help to improve your financial situation.
What is a personal budget?
A personal budget is a financial plan where you track your expenses and plan how you’ll spend and save your income over a defined period of time. Most commonly, budgets are planned one month at a time.
Your budget will show you an estimate of how much money you bring in each month and where that money goes. You can then use this info to help reach the financial goals that you set.
Why do I need a personal budget?
Even if you don’t have a specific financial goal, having a personal budget will improve your financial wellness. It will help keep you on top of your spending habits, help you stay out of debt among other financial positives such as prepare for emergencies or retirement.
When you build a budget, you expose yourself to your spending habits. Over time, you may start to notice things or areas where you’re spending money that may not need. For example, do you really need an unlimited data plan for your phone if you only use 2GB per month?
A personal budget can also help you stay out of debt. At the time of writing this, Nerdwallet’s 2020 credit card debt survey states that the average American has over $7000 in credit card debt. A key part of avoiding credit card debt is by living within your means. This means knowing your financials intimately and spending only what you have.
It also helps you be prepared for emergencies. A key part of financial health is having an emergency fund. To build an emergency fund, you need to plan to put money away for this purpose. One of the most alarming personal finance statistics is that less than 40% of Americans could cover a $1000 emergency expense. The easiest wait to avoid this is to budget for it and start building an emergency fund that is between 3-12 months of your living expenses. So if you spend $1500 a month, your emergency fund should be $4500-18,000.
Types of Personal Budgets
There are a bunch of different budgeting methods. A few of the types are the line-item budget, a proportional budget, the ‘pay yourself first budget’, and the ‘envelope budget’.
At the end of the day though, the budget you choose will depend on your specific circumstance. If you live somewhere with a high cost of living you may not be able to save the same percentage of your income as someone living in an area with a lower cost of living.
This list is nowhere close to exhaustive. To find the best budget for yourself, you may need to do a little research. Keep in mind, you can also mix and match the types below. What’s important is that you figure out what works for you and use it to reach whatever your goal may be.
Line-item budget
The line-item budget is probably what comes to mind when you think of a personal budget. Simply put, you itemize all of your income and expenses and track them line by line.
To get started, record your income and expenses (or expense categories) throughout the month. It can be as simple as using pen and paper or you can get fancy with an Excel spreadsheet. Take a look at this Google sheet I’ve made for inspiration.
One downfall to this type of budget is that it does not take savings into account. So you’ll need to be proactive and make a separate line item for it.
The main benefit of this method is that it is quite easy to get started and compare expenses month to month. This is important because you’ll be able to easily see where you’re wasting money and adjust.
Proportional budget
With a proportional budget, you divide your monthly income into categories. The main categories tend to be: needs, wants, and savings. You can then break them down further depending on your goals and circumstances.
The most common proportion suggested tends to be the 50/30/20 rule. Where 50% of your income is allocated to needs, 30% to wants, and 20% to savings.
This is an excellent starting point, but depending on your circumstances or goals this may not be possible. Additionally, there is the 70/20/10 rule which is a good choice if you live in a high cost of living area, have an average income, or a family. With this method, 70% of your income would be put toward your living expenses, 20% to savings, and 10% debt — if you have no debt, then toward wants.
In the middle of the two, there is the 60/40 method. Here you’d spend 60% on expenses, 10% on retirement savings, 10% on long-term savings, 10% on short-term savings/debt repayment, and 10% toward wants.
Pay yourself first budget
The pay yourself first budget is my favorite because it’s the simplest. This is because you allocate a set amount to your financial goal, whatever that may be and the rest doesn’t matter.
For example, my goal is to save 40% of my take-home pay. So I automatically deposit a portion of this 40% into my retirement account and a portion into my investment account and live on the remaining 60% of my income.
The key here is to set attainable goals so that you don’t find yourself taking on credit card debt to achieve them. This method is difficult for those that have trouble prioritizing saving.
Envelope budget
The envelope budget is more hands-on than previously mentioned budget types. This is because it involves using only cash. The idea is that you’ll spend less if you physically see your money.
It works like this. First, you make a list of your monthly expenses and an approximate amount of money each requires. Then you write the time of each expense and its expected expense amount on an envelope. Once you’ve got your envelopes set up, head to the bank and withdraw that amount of cash and distribute it among them.
If you run out of cash in an envelope during the month, you’ll need to tap into another category to cover it. As a last resort, you can take out additional cash from the bank.
How to stick to a personal budget?
After you’ve been budgeting for a while, you realize that the easiest part was picking the budget type while the most difficult part is sticking to it. A couple of things that you can do from the start to increase the odds that you’ll stick to your budget is to first, be realistic, and second, account for irregular expenses.
Be realistic with your budget
When you start planning your budget, it is important to be realistic. If you want to save 50% of your income, you need to take into account your salary and living expenses. Or other things such as are you willing to live with roommates?
Be conservative — don’t try and over-extend your ability to save because you may just end up with more debt than if you didn’t budget at all.
Account for irregular expenses
The second most important thing to take into account are irregular expenses such as registering a car or higher heating/cooling costs due to the season. These are expenses that happen infrequently and are often overlooked.
This is especially important if you’re accounting for every dollar because you’ll have to tap into your savings to cover these expenses.
The best way to solve this problem is to create a separate savings category. Brainstorm all of the irregular expenses you can think of, and add 20% more. Then divide this by 12 and pay that much each month into your irregular expenses category. Then, when these expenses come up, you’ll have money to cover them.