Budgeting 101

Budgeting 101: A 10 Step Guide (With Tips to Get the Most Out of Your Spending)

Remember the last time you went to the grocery store hungry?

And without a list?

Besides snapping at your spouse because you were “hangry,” bet you spent twice what you normally would. And for the next week, you kept finding unusual stuff in the fridge and cupboards, wondering who bought that?

That’s what NOT having a budget does, but with ALL your money. Because being human, we are always hungry for more.

So, let’s dive into this whole budgeting thing.

But before we do, one quick point.

Maybe you found this article because you looked up budgeting. After all, it’s in the headline.

But what I really want to call this is a personal spending plan. It sounds so much more empowering. Like, when you have a big ole wad of cash and can spend it however you want. Which is what budgeting is.

Budgeting has negative connotations like it’s about harsh discipline for your money. I’ve seen articles stating that “budgeting is stupid,” but go on to write about…you guessed it, budgeting. They just call it something different because the word budget kicks up negative feelings in lots of people.

So, substitute “personal spending plan” for budgeting if you like that better. But really, it’s the same thing, with different packaging.

What’s a Budget?

A budget is nothing more than a financial plan for your money. It’s a way of being organized and thoughtful about what you spend your money on.

Before you begin, you need to understand what you are currently spending your money on. This step alone gives budgets half of their power because it brings awareness to our spending.

Then you compare how you are spending your money versus your values and goals. To get the most out of your spending, you want to align it with what is important to you in life.

Where things are off, you adjust them.

If money is a tool to build your life, your budget is your blueprint.

That’s the purpose of a budget.

Why Budget?

Okay, I’m not going to lie. Unless you’re a control freak like me, budgeting isn’t considered a fun activity. It’s right up there with exercising, with lots of benefits, but damn hard to do.

So first, we need to start with the “why” to keep you motivated. You’ll want to refer to these reasons when you think of quitting. Because, really, it is worth it. I promise. Try it for a few months. I think you’ll be impressed.

Here’s a list of benefits:

  • Budgeting promotes financial confidence by putting you in control. You know what you have and how much you can spend. Knowledge is power.
  • Budgeting can prevent or curb overspending in your areas of weakness—those things we keep buying even though we don’t need (or have the space for).
  • Budgeting can help you avoid overspending your way into debt.
  • Budgeting is a way to make sure that you spend your money in line with your values.
  • Budgeting helps you attain your goals or dreams like home improvements, vacations, or a new career’s educational costs.
  • Budgeting is a way out of the paycheck-to-paycheck treadmill.

But wait, there’s more!

Budgeting gives you the information you need to spend less than you earn—a critical skill for those pursuing financial independence. It is the key to attaining financial independence because it helps you channel your money to assets.

Your income doesn’t matter if you spend everything you make. You attain financial independence by funding savings and investing accounts.

How To Create A Budget In 10 Steps

1. Determine your monthly after-tax income.

If you have a salaried W2 job, this is easy. It’s your annual take-home pay divided by 12.

If you get paid hourly, take last year’s annual take-home pay and divide by 12.

If overtime is a large portion of your income, this can get tricky because it can’t always be relied on. Estimate on the low-end to be safe. For example, if your overtime varies from 2 to 10 hours a week, use the 2 hours of overtime paycheck to estimate.

If you have variable income, like freelance work, use either your previous year’s income divided by 12 or an estimate that seems reasonable to you.

If you aren’t salaried, underestimate your income so your plan will have a buffer built-in.

Now that you have your monthly take-home number, you know the actual cash amount you have to work with.

But we want to make sure that we count the deductions taken out of your paycheck. So look for the deductions that come out of your gross pay and add them back in. Then make sure you add the matching amount into your expense section.

budget 101 example

This way, you see the actual amount you earned.

Look for deductions for company insurance plans, like health, dental, or life. Also, add in any retirement plan deductions such as a 401(k).

Let’s stop right here. We are only looking for a reasonable estimate. If you are all fired-up and want to be super accurate, excellent. But if your head is already swimming, just come up with what you think is a reasonable but conservative estimate.

2. Figure out what your current expenses are.

To create an accurate budget, you need to know your actual expenses, not what you think they are. This step alone can reduce your spending without much effort.

Thirty days of expense information is the bare minimum to get started, but the ideal would be one full year. Why? To catch those tricky, budget-trashing one-timers. The lump-sum insurance payments. The holiday spending sprees. The property tax bill. Having a whole year of your expenses should catch all of these.

The last thing I want to do is give you an excuse to put this down and do it later, which means never. So here are some less-than-ideal ways to get the job done.

So, sorry, no binge-watching your favorite show just yet. But that would be a great reward once you do the next step!

For now, we’re going old-school. Get out a pad of paper or fire up a spreadsheet. If you have a budgeting app that you already use, no problem, use that. But if you don’t, please skip finding an app for now. That’s a rabbit hole for another day.

Pull out your credit card and banking statements. These will have transactions for the big stuff.

You’ll miss out on anything you bought with cash, and you won’t be able to get into much detail, but the goal right now isn’t perfect accuracy. It’s getting started! For example, you’ll see that you spend $86 at Target, but you won’t know if it’s clothes, cat food, or cough syrup. But it’s better to begin a budget with 10 categories and plop that Target amount under “Household” then to do nothing!

3. Break your expenses into categories and estimate their average monthly amounts.

Use enough category detail to be meaningful, but not so much that this becomes intolerable. How detailed you go is up to you.  I recommend high-level categories to start and only add in more detail later.

It could be as simple as this:

10 Category budget example

Here’s where having a full year of expenses to review is best, so you can catch lump sum payments.

There are three types of expenses:

  • Fixed expenses
    By fixed, this means the amount doesn’t vary in the short term or month to month. Some examples are rent, mortgage payments, health care premiums, car payments, or student loans. All of your minimum debt payments go here. In the short term, you don’t have much control over these expenses. But these are easy to plug into your budget because they are a fixed amount each month.
  • Variable expenses
    These are the expenses that vary widely from month to month. These are things like groceries, entertainment, dining out, gas, or clothes. You have a lot more control over these expenses. Either use a yearly average or an estimate since these bounce around a bit every month.
  • Annual or irregular expenses
    These expenses don’t fit into either category above. They are the easiest to miss because they are either yearly or highly variable year to year. Examples are insurance premiums, medical co-pays, big vacations, veterinarian costs, gifts, holidays, vehicle registrations, property tax, and home or car maintenance. These are the types of expenses that can destroy your budget if you forget to add them in. They are the reason why you need an emergency fund. Like when you take a trip to the ER with your high-deductible insurance, and you go home happy that you’ll be okay, but now you have a $1,200 medical bill to pay.

4. Calculate your monthly after-tax income minus expenses, which is either…drum roll…

  • A negative number: You are spending more than you earn. This means if you continue down this path, you’ll either go deeper into debt or eat into your savings. You already know this, but there are two choices. Either figure out how to cut expenses or how to earn more money. Take a deep breath, congratulate yourself for being brave enough to look at your numbers, and move on to step 5. Focus on what you can cut from your budget.
  • A positive number:
    Phew! But we aren’t done yet. Onto step 5.

5. Look at your spending categories through the lens of needs versus wants.

Here’s where you need to be honest with yourself.

I can’t tell you what your needs versus wants are. I can only give you a framework.

Needs tend to be all those things that take care of us physically or provide security. This includes shelter (rent or mortgages), utilities, food, transportation, and insurance.

You can’t escape needs. But you do have more control over them in the long-term. For example, if you have a giant mortgage, you can either refinance or sell your house.

Although you may or may not “need” what you’ve already purchased, you do need to make loan payments.

Wants are optional. Some examples are eating out, gifts, travel, and entertainment.

But some of these wants also satisfy needs. Here’s where the budgeting process falls apart for most people. You drastically cut expenses for your “wants” to nothing. Then, within a month or two, you realize you hate your budget. That’s probably because you cut things that have a lot of meaning for you.

Maybe you get a lot of joy out of going out to eat with friends (pre-COVID-19). This meets a deep need for social connection. If you cut out going out to eat, that need will be unmet, and there’s a danger you’ll dump your whole budget.

Look for these “want as need” areas. Give them priority if you have the extra money. Or better yet, look for ways to meet these needs without money or by spending less. Can you go to less expensive restaurants with your friends? Invite them over for dinner, and rotate hosting? Or get together to go hiking, walking, or some other activity that doesn’t require money?

In general, non-physical “want/needs” can be met in ways not involving spending money.

Again, budgeting gets a bad rap because here’s where I’m supposed to tell you that needs are okay, but cut your wants to the bone. Nope. Instead, get creative. And if something is important to you, find something else to cut, or find a way to earn more income.

Is there a way to earn some side income while doing what you enjoy? For example, if woodworking is a passion, could you sell your creations on Etsy?

Would volunteering help reduce the cost of your hobby? For instance, if your club offers discounted dues for volunteers, could you “donate” your time?

6. Look at your spending categories and match them against your values.

Are you spending your money in a way that meets your values?

Here’s an easy way to cut things from your life without pain. Look for areas of spending that you really don’t care about. Be ruthless. Expenses like memberships that you no longer use are a perfect example.

It’s so much better to use that money to fund your goals and your dreams!

Balance and moderation are two big themes you’ll see in this blog. Don’t chase pennies. Yes, frugality is part of achieving financial independence. And if you ignore the small stuff, it does add up. Go back to our grocery store scenario. All those little purchases in your cart sure add up at the register, right?

However, focus on the big stuff first. For U.S. household budgets in 2019, the two largest expenses were housing and transportation, at roughly 50% of total expenses.

Think of how absurd it would be to spend time reading frugal blogs about reusing vacuum cleaner bags while living in a 6,000 square foot house.  Or to drive to the grocery store in a $90,000 car after spending hours cutting coupons.

Keeping these two categories at a reasonable level in your budget will give you so many other options for your money.

If something looks frivolous to other people, but you are spending in line with your values (and you’ll still have money for saving and investing), guess what?

Keep it in your budget.

This is your budget, and no one else gets to judge you.

So now, you’ve adjusted your budget, and your income should exceed your expenses.

If not, please read on for motivation to make this happen in the future. Even small steps forward provide forward momentum and make changes for the better.

7. Add life-changing categories to your budget.

These are the categories that make all this budgeting stuff worth it.

For each of these categories, there is one rule. If they are going to happen, you need to pay yourself first. Make them a priority!

For every dollar you don’t spend, for every expense that you can cut, you generate savings that you can channel to a goal that improves your life.

* Pay Down Debt *

When you pay off your debt, it frees up more money for everything else. It’s one less payment you need to make. It’s a two-for-one strategy. You save money on interest and free up cash flow.

You could use the debt avalanche method, which means that you pay off the highest interest rate loans first.

So if you owed $5,000 at 18% on a credit card and had $3,000 left on a car loan at 4.5%, this method would have you pay down the credit card first.

This could be considered the rational approach because higher interest rate loans cost more.

However, consider the debt snowball method, especially if you have lots of smaller loan balances. This method has you paying off the lowest balance loans first.

Mathematically, the debt snowball may not make sense. But emotionally, and really, we are all emotional creatures, it can be a better approach. Because for each loan you pay off, you feel a bit more confident. Plus, for each loan you pay off, you can now use that loan payment to pay down the next loan balance on the list.

Which method you pick depends on you. Personally, I would tackle credit card debt first because I hate paying interest, and credit cards typically have the highest interest rates. Plus, if you don’t pay off your credit card balance, then every new expense you charge is charged interest immediately!

The important thing is to pick a method that works for your personality and begin.

Whether or not mortgages or student loans should be paid off early is up to you. You may be better off funding the other categories instead, especially if you have low-interest rate loans.

But I’ll leave you with the idea that even with interest rates at historic lows, there can be a psychological cost of having debt. Only you can decide if this is true for you.

* Protect Yourself with Emergency Savings *

As we’ve seen during the COVID-19 crisis, this is essential to your peace of mind. Without emergency savings, it can throw off your entire budget when an unexpected expense comes up. Spoiler alert: you can count on random, unplannable expenses!

Build your emergency fund up to the point where you can sleep at night, knowing that you have money in the bank if you need it. The amount could be anywhere from 3 months to a full year of living expenses.

* Provide Fuel for Your Savings Goals *

Once you’ve set up your financial savings goals, you’ll want to channel money towards them as if you were making payments. This is a fantastic way to afford major purchases without going into debt. It’s also a way to fund significant expenses like home down payments.

I’ve used this trick for years. Once we pay off a car, my husband and I pretend to make car payments, but to ourselves. It feels wonderful to escape car loans. Yes, I know interest rates are low, but the psychological benefits are worth it for us.

* Plump Up Your Long-term Investment Accounts *

I saved this one for last, but it is the most important goal to fund. This is your financial independence fund, aka retirement savings. This is where your long-term investments get funded. Every dollar you put here gets you closer to the goal of eventually having your money work for you.

If you have a company plan like a 401(k), and your company matches a portion of your savings, make sure to contribute enough to get the match. Free money for your future, what’s better than that?

8. If you have a partner, set up a meeting and go through your budget together

Obviously, if you’re single, you can skip this step. Even if you and your partner each have separate financial accounts, you may still want to discuss a budget for your future together.

If your partner doesn’t have lots of interest in finances, try building a budget first on your own. Then meet with your partner to fine-tune it. Maybe you should avoid using the words “budget meeting.” Instead, say, “Hey, let’s plan our spending for next year.” I find that a frosty beverage helps too!

There will be differences. What you consider a want could be a partner’s need. One way to take care of this is to have “no questions asked” personal money for each of you.

Ensure that you take care of each other’s needs in your budget because otherwise, you set it up to fail. Build a plan you both agree to follow.

9. Pinky swear promise to yourself and make a pledge.

What if every time you got a raise or increased your income, you added in a portion of that money to your life-changing categories?

Boom. Instant lifestyle creep avoidance. Lifestyle creep is where for every pay raise, you tend to spend more. You get a fancy new job, so you want a fancy new house to match. However, that fancy house requires a fancy mortgage payment. Now your lifestyle is “improved,” or is it?

As always, it’s your choice.

Maybe that house is worth it to you. Having a big, beautiful home is essential to you, and you can still fund your other goals. Excellent. This isn’t about judging; it’s about making sure that the decisions you make are your conscious decisions. That you understand the trade-off you are making.

Also, decide in advance how much “found” or unexpected money will go to these categories. Half? If you plan for this in advance, it will be easier to follow. We tend to use mental accounting and discount the value of unexpected money. Instead, treat all money the same.

Yes, go ahead and use a portion of unexpected money for fun. But carefully consider the trade-offs of short-term fun versus the long-term pleasure of growing a fat financial portfolio.

By adding both income increases and unexpected money to your savings categories, you’ll be building assets. Assets that one day will support you financially.

However, do keep this in balance. Add a category to your budget like “Frivolous Fun.” Yes, you want to fund those critical categories, but don’t train yourself to fear spending money on fun.

Believe it or not, there are dangers to frugality. It’s important to enjoy a portion of your earnings in the present while you save for your future.

10. Update and review your plan regularly.

Building the plan is the first half of the battle. Simply creating a budget can lead to all sorts of discoveries and changes based on those discoveries. But this isn’t a one-and-done thing.

You want to compare your actual spending to your budgeted spending each month. Flag categories where you’ve overspent, so you can either slow down spending or spend less in a different category to offset it.

Make sure your life-changing savings categories are fully funded and that you don’t exceed your income.

The monthly numbers can be useful, but it’s the yearly results that are important. If you go over your budget for one month, you could cut back the next month.

Focus on the big picture. So maybe there was a big sale, and you bought a bunch of clothes, trashing that budget category in September. But if you don’t buy much for the rest of the year, you’ll come in at budget, so it’s not a problem.

Adjust your budget numbers when you realize that you are consistently off. Every year, I underestimate what we’ll spend on food. But I love to eat, and I try to buy organic as much as possible. Maybe this year, I’ll finally give in and increase that category!

This sounds like a lot of work, and it is. But here’s the cool part.

Eventually, this will become automatic. We spend almost the same core amount every year (excluding large purchases like home improvements and vehicles). Alarm bells go off in our heads when we start to spend too much. Then we automatically adjust spending in other categories.

The critical part of a budget is to use it to spend consciously. It can help you find the money to fund those life-changing savings categories.

Tools for Budgeting

For the first time around, do this on paper. Later on, budgeting apps can be helpful. I personally use a combination of Quicken and a spreadsheet because I happen to be a control freak.

A popular budgeting formula is the 50-30-20 formula. This is a formula for spending where you spend 50% on your needs, 30% on your wants, and then use 20% for savings and debt repayment. If you need a starting place, this can be a useful guideline.

Zero-based budgeting is a method where you give every dollar a job. It’s the approach used by the budgeting app YNAB (You Need A Budget). If you want to learn more, read the book You Need a Budget by Jesse Mecham, the founder of YNAB. It’s an excellent introduction to zero-based budgeting and the philosophy behind his app.

However, zero-based budgeting can be more challenging for freelancers and others with variable incomes.

The envelope system works for some people. This is where you physically portion your money out by categories. You put cash into an envelope for your categories. When the money is gone, you’re done spending in that category. The purpose is to tame problem categories where you always overspend.

The pros are that you spend less with cash than you do with credit cards. However, the con of handling cash is that it is easy to lose or have stolen. Plus germs.

Personally, I’d only use this if I was having issues keeping spending in check for a variable fun expense like eating out. But if this sounds interesting to you, by all means, use it.

Common Mistakes and Obstacles

Here are some of the primary mistakes people make and the obstacles they encounter.

  • Focusing on the small stuff and ignoring the big categories like housing and transportation. Avoid expensive houses or luxury vehicles, and you’ll free up plenty of money for the little things.
  • Failing to have an emergency fund, and then declaring that budgets are useless when the first unexpected expense hits. That’s why we have emergency funds!
  • Making significant budget cuts immediately. Instead, go slowly. Small changes added in over time have far higher odds of working.
  • Creating a strict, no fun budget. You need a little money for stupid stuff or splurges. Build a sustainable budget that reflects the lifestyle you want to live.
  • Having unrealistic expectations. A budget is a blueprint, but you still need to do the work to hit your goals. Building your budget is only the first half of the battle. The second part is using it.
  • Ignoring the budget after it’s built. Budgets only provide value through use. They need to be reviewed to gain insight into your spending habits.
  • Feeling like you “failed” when you overspend. Nope, that’s part of the process. I’ve spent according to a budget for over 25 years. I frequently overspend, either in a category or in a month. But over the year, we usually come in under budget. It’s part of the process to be off. Success comes when you catch it and adjust it to get back on course.

The biggest mistake of all? Reading this article, and then not taking some sort of action. I’m sorry, but reading about it doesn’t count. I know, I love to read, and converting new knowledge into action is tough. But without action, nothing happens.

Don’t overcomplicate this. You can use only 10 spending categories, and your new budget would still be valuable.

Think of how it will feel to have the financial confidence of having a plan. Focus on how wonderful it will be to hit your goals. A budget can make that a reality.

Now, get started!