Do you want to control your finances? Are you scared of spending money?
According to statistics, 65% of Americans don’t know how much they’ve spent last month. And half of the Americans don’t do any budgeting while the other half do some kind of but not a proper one.
Money is so powerful if you don’t know how to manage it then it will manage you until you die.
One of the tools that help you keep track of your income and expenses is budgeting. If you know what it is and how you can make it then excellent. But if don’t then worry about it.
In this article, you’re going to learn how to create a personal budget to effectively control and manage your money. I will go through while providing you with comprehensive information about what is budgeting? How do they benefit? And how to create one for yourself to stay on track?
Here is the breakdown of what you’re going to learn:
What is the budget?
Before diving into how to create a personal budget, first, let’s understand the concept of a budget.
Definition of budget:
In simple words, a budget is an estimation of your income and spendings for a specific period of time. You find in advance how much you will earn and spend for a particular future time period like a month, quarter, or year.
Budgets can be used by individuals, groups, organizations, and the government for sure.
They can be surplus, deficit, and balanced. It all depends on the amount of income and expenses.
Budgeting helps you find out how your earning and spending pattern will be in the future. So you can prioritize your expenses and focus more on income to meet your needs.
Let’s explore why they’re so important.
Why are budgets important?
Budgets are important both from a business and individual perspective. It has a prominent position as a financial tool when it comes to financing and money matters.
Here are some of the reasons why budgeting is so crucial:
- It allows you to have a plan for spending on different expenses. Without budgets you can’t find out where to spend first and where later.
- Help you get clear on what is more important regarding spending. So you can easily prioritize different expenses. For example, health and medicare, food, house, bills, child school expenses etc.
- You can get out of debt fast while utilizing budgets. They tell you which expenses are useless and so to cut them out to pay your debt.
- Budgets give you the real picture of your financial condition. This helps you easily control spending to make some saving.
- It helps you achieve your financial goals fast because you get an opportunity to analyze the data and try to find ways to achieve the end objective.
- Proper budgeting can save you money and prepare you for meeting any unwanted and emergency needs.
- Help you find ways to make more money if you’re not meeting your existing expenses with current income.
According to Business Insider, 61% of US adults don’t keep track of their finances. Therefore, budgeting helps you make your finances organized and have control over them.
Budgets reflect a real picture of your financial condition and tell you where you’re and how you can make it better. That’s why don’t hesitate to utilize them if you want financial prosperity.
What are the types of budgets?
Budgets fall in different categories with respect to amount, time, and usage. Here is a brief introduction to 12 types of budgets:
1. Surplus budget
If your expenses are less than your income and you become able to save a certain amount of money after spending. It is called a surplus budget.
2. Deficit budget
When your estimated income is less than the expenses you need to spend your income. In that situation, the budget is called a deficit. Here either you need to cut out some expenses or raise your income level to meet the requirement.
3. Balanced budget
In case the amount of expected income gets equal to what you planned to spend then it is called a balanced budget. This budget is mostly used in government and public sectors.
4. Flexible budget
When the budget for a specific time frame changes in accordance with the actual revenue level, it is called a flexible budget. A more reliable option than a static budget.
5. Static budget
This budget doesn’t change with the volume of actual revenue or activity. It remains as it is for the whole period of time after getting approved.
6. Master Budget
Master budgets are usually used in businesses and large firms. They’re a comprehensive financial plan that includes much lower level and small budgets like overhead, sales, material, and production budget, etc.
7. Functional budgets
These budgets take into account the estimation of different functional activities of the company or firm. The three main types include cash budget, sales budget, and production budget.
8. Participative budget
When a business or company gives permission to its lowest level management to prepare the budgets. It is called a participative budget. Usually, top-level management gives this responsibility while trusting lower-level management to give them a sense of ownership.
9. Annual budget
It is a budget used by companies and the government for estimating the revenue and expenses for a whole financial year. It is based on a time period of 12 months.
10. Rolling budget
It is a budget that is continuously adjusted and updated for each next month or period comes. A more accurate estimation as compared with the fixed budget.
11. Imposed budget
It is a fixed amount of budget prepared by top-level management and then imposed on lower-level management. It usually follows the mission and objectives of the company or organization.
12. Zero based budget
A budget that you need to make from scratch and not base it on any previous period budget. Here you justify the expenses before adding them to the budget.
Now comes the important part…
How to create a personal budget?
I’ve listed a 7 step budgeting process on how to create a personal finance budget in the right way. Most people find this step so overwhelming but honestly making a budget isn’t that horrible. It’s so simple if you follow the steps.
So let’s dive in.
1. Prepare your documents
Before sitting on a chair and starting making your budget you need the financial documents defining your income and expenses. They include all the documents of income sources and expenses including variable and fixed.
Some common documents that you need include:
- Cash Flow statement
- Bank statement
- Income statement
- Food expense details
- Insurance documents
- Utility bills
- Salary statement
- Mortgage documents and receipts
- Credit card bills
- 1099s, w-2s and paystubs
- List of all the other expenses
- List of all the different incomes
All these details are important to find out total expenses and income. Help you get real-time accurate information to make a budget.
2. Calculate your total income
Now comes the important part. Where you need to calculate all the income and revenue you earn at the end of each month.
But for calculating the accurate amount you need to list down all the income streams. Some common ones include:
- Salary and wage if you’re doing a job
- Dividend if you’ve investment in any company shares
- Business income if you’re running one
- Interest payments if you’ve savings accounts or bonds or t-bills
- Earned income but not yet received
- Unearned income but received
- Any rent payments if you rented out house, apartment or machinery
- Stimulus checks received from government like in COVID19
- Tax returns given by the government
- Payment transferred to you as a bonus, allowance, or gift
- And another source if know
How to calculate income?
A simple formula you can use to find out gross total income:
Total income = salary/wage + interest received + dividend + extra payments received + rent received + any other misc income
Using this formula you get the total amount of income earned during a specific period of time.
3. Calculate your total expenses
Let’s list down all the expenses you incur personally. They don’t include any business expenses because they are deducted from business income statements.
Here you list down all the household and personal expenses. So let’s take a look at some of them:
- Food expenses for each month including groceries, outside launch, fruits, and other
- Fuel and repairing expenses for the vehicle you’ve
- Utility expenses including electricity, gas, water, cable, and garbage
- House maintenance like new paint and cleaning
- Rent paid if you’re living in a rented house or apartment
- Mortgage and loan payments taken for buying a house or for personal needs as a consumer
- Picnic, vacations, and other entertainment expenses you incur each month
- Children expenses including school and tuition fees
- Other expenses incurred on giving gifts, parties and more
- Retirement saving, insurance. And other 401k deductions
These expenses fall into two categories. One is called fixed expenses like rent, mortgage, interest, real estate tax, insurance, and lease payments. While the other ones are variable expenses the change in amount each month like food, utility bills, and entertainment.
How to calculate total expense?
After listing down all the expenses use the formula below to calculate the total expenses. You need to add up all the expenses.
Total expenses = Fixed expenses + Variable expenses
If you feel it is difficult to identify variable and fixed expenses then simply add all of them.
4. Deduct expenses from income
In this step, you need to find out net income by simply deducting your expenses from your total income.
Here is the formula:
Net income = total income minus total expenses
For example, if your total income for a specific month is $8000 and total expenses are $6900, then here you go. The net income is $1100.
Why is finding net income important? Because you will have to intercept your financial performance. You get an idea of whether you’re earning enough or not.
Remember this net income is not liable for taxes because if you’re doing a job then the government deducts tax in advance. It is the net income remaining after deducting expenses from disposable income.
5. Interpret results and take necessary action
When you’re done with finding the net income now is the time to interpret your results. There are three possibilities:
- First, the net income is positive as in the above example ( $1100) then it means you’re earning enough. Your monthly budget is in surplus where there is money left for saving.
- Second, if net income is in negative figures and expenses exceed then your budget is deficit. In this case either you need to cut out some expenses like entertainment, wine, or parties. Or you need to work extra and find a source of income to settle down those expenses.
- In the third situation it is possible that your expenses and income match and balance each other. It is called balanced budget.
The first situation is amazing because you become able to save something for future needs like emergency funds. You can also invest that money to earn large profits.
But in both the second and third situations you aren’t saving anything. Which means your financial performance is bad. In this situation, you need to find ways to cope with that. Either do freelancing, work part-time, or do any side business or cut out extra expenses to make your budget surplus.
In the fifth step, you do an additional thing, where you decide on the remaining positive balance. Here you need to assign a job to the remaining dollars after deducting expenses from your after-tax income.
There are several ways to use these dollars. You can spend it on emergency funds, savings account like high yield saving account. Another best way is to invest it somewhere to get a steady passive income.
But whatever you decide don’t leave them unused. Because money is ideal and doesn’t work if you don’t put it to work for you.
6. Make continuous updates
You prepared your budget for a month and all the income and expenses are known to you. And you have determined your financial condition and decided on the necessary actions steps to take onwards.
From here you need to constantly update your budget. The reason is many factors affect your budget. Some common ones include:
- Size of your family
- Inflation and rising prices
- Income of family members
- Your and your family financial goals
- Economic, natural, and social situations
- Employment position and status
- Taxes imposed on you
- Government policies
As time passes you should take care of all the elements in your budget. It is possible that you need to exclude and include any expense or income source.
For example, in the first month if your loan payments are completed the next month you should update the budget by excluding loan expenses. Likewise, if you started a part-time job or business then include the new income source in the next month’s budget.
The same applies to macroeconomic factors. If inflation and prices rise your expenses go up so make sure to adjust the budget accordingly.
This helps you stay organized and have a more accurate estimation.
You’ve covered the six steps for how to create a personal budget. Now let’s move on to some personal budgeting methods.
Related Post: 20 Budget Templates To Confidently Track Your Money
What are the different types of budgeting methods?
Here are 10 different methods of budgeting that you can use to your benefit. Some are most used and popular while others aren’t that common. In the end, I’ll share which ones you should use to your benefit.
So let’s dive into it
1. Zero-based budgeting method
In this budgeting method, you zero out all your income. This means you assign a job to each penny or dollar of your income. First, you calculate the grand total of all disposable income. Then you total all the expenses and subtract them from total income.
If the remaining balance is positive, as in the example $624, then you assign jobs to this remaining amount. For example, you can see the example $200 goes to emergency fund while $324 to high yield saving account.
2. Traditional budgeting method
Here you simply add all the expenses and deduct them from total income. After finding the difference you analyze that where you can cut back on expenses and save more money.
It is a time-consuming method because you need to calculate each expense separately. But a good method if you’re keen on details. It’s also not very useful for people with big goals and dreams. But excellent for achieving your professional and financial goals.
3. 70/20/10 rule for budgeting
This method is based on three monetary uses. First is your regular and necessary spendings, second is savings and investment, and third is debt payments and charity.
Using the above rule you spend:
- 70% of after-tax income on monthly expenses,
- 20% on saving or investment, and
- 10% for paying debt or giving to charity
In the 20% section, you can divide the amount between saving and investment. And same can be done with 10% remaining for debt and charity payment.
It is a very effective rule if you manage needs and wants in the first 70%.
Here is the practical example:
Let say you earn $5,000 each month. According to this rule, you spend $3500 on needs (plus wants), $1,000 on saving or investment, and $500 on debt payment or charity.
4. 50/30/20 rule for budgeting
Works the same way as 70/20/10 but with a little tweak. Using the 50/30/20 rule you’re required to spend 50% of your after-tax income on necessary expenses (needs), 30% on important wants, and 20% on saving and debt payment.
If you analyze this method, you spend 80% of your income on needs and wants. As compared with 70% in the previous rule. While you speed 20% on saving or debt payment or both. There is no charity donation. But if you have a margin then you can spend something out of the remaining 20% on charity.
That rule is very simple and most used. Senator Elizabeth Warren make it famous by mentioning it in his book called “All Your Worth: The Ultimate Lifetime Money Plan”.
5. Spending first budget
Here you first spend money on important expenses. This means you prioritize your expenses from most important to least important. For example, food, rent, utility bills, traveling, and debt payment, etc. And cut back on those expenses that are least important if you get into deficit.
If something still remains then you put it into savings or emergency fund. It is a commonly used method for spending your income. It is also called priority-based budgeting.
6. Envelope budgeting method
This system for personal budgeting is amazing. Because it helps you avoid overspending.
You keep an envelope for each expense category with his name on it. After that, you review your expenses and put cash accordingly. For example, if your food costs $400 a month from previous estimates then you put $400 in the envelope. And start spending for the whole month.
When the cash-in envelope gets to zero you stop spending further amount on that particular expense. So this is how the envelope budgeting method works.
7. Pay yourself first budgeting
It works oppositely to the spending first budgeting method. What you do here is total out your after-tax income and then first deduct the total savings needed from it. For example, your after-tax income each month is $5,000 and you need the following savings to be deducted:
- Roth IRA $200
- Car payment $200
- Insurance payment $150
- Emergency fund $200
- High yield saving account $250
All these saving categories total out to $1,000 a month. So deduct it from the total income which gives you $4,000. Now you can freely spend this $4,000 on your expenses including fixed and variable. So this is how the pay yourself first budgeting method works. It is also called the savings first budget.
Other budgeting methods include:
- The no budget
- Anti budget
- Budget ceiling
But these are not as common as the above ones so it’s enough to mention their names here.
What are some budgeting tips?
Here are some important budgeting tips that help you stay on track:
- Pay off your debt fast to save more
- Keep your budget updated each month
- Start from a zero based budget when making
- Use a spreadsheet or budgeting template to save time
- Avoid using credit cards instead pay with cash
- Don’t overspend instead cut out useless expenses
Using these simple budgeting tips you can control your spending and save more.
What are budgeting mistakes to avoid?
Along with learning how to create a personal budget you should be aware of budgeting mistakes. So you make an accurate budget.
Let’s have a look at them:
- Entering the wrong figures
- Forget any of the expense or income while accounting
- Not updating it frequently
- Not including emergency fund to meet sudden needs
Avoid these mistakes and your budget will be more effective as time passes.
What are some personal budgeting tools?
Budgeting tools fall into different categories. Some of them include applications that you can use on a laptop or mobile. Others are dedicated software that makes budgeting a breeze. You can also use spreadsheet templates if you don’t want to learn software or apps.
Here are some famous budgeting tools that you can use easily:
- Personal capital
- Intuit Mint
- Personal capital
- Good budget
- Every dollar
- Gnu cash
- Google spreadsheet
Some of them are paid and others are free. You can find more software by simply searching on google. There are tons and tons of options available. These tools help you make budgets easy and save you time. Also, you can organize your items by monthly history.
What are some downsides of budgeting?
Budgeting is a good tool to take control of your finances. But at the same time, there are some disadvantages you need to be aware of.
- Lack of accuracy: They’re made on the basis of assumptions, estimations, and expectations while considering the current financial conditions and data. In case the current financial situation varies significantly in the future then budgeted assumptions may prove wrong. In that situation you need to either update the budget or make it from scratch.
- Lack of flexibility: Sometimes you stick to budgeted numbers and don’t overspend where needed. That can result in not fulfilling certain important needs.
- Adjustment: You need to constantly adjust and update the budget for correct and accurate information to predict future financial needs. Not continuously updating will make your budget less useful.
- Time consuming: Sure the online tools and software make budgeting easy and time saving. But still gathering documents and entering values and then updating them takes lots of time. So to some extent it takes time and effort to properly set up.
Considering these downsides budgets are a bit ugly but the upsides always beat the downsides. That’s why to consider investing time and effort to make your budget. Ultimately they will benefit in the long run.
Let’s summarize the whole discussion of how to create a personal budget.
Budgeting is an easy tool to keep track of your finances. It doesn’t matter whether you use the simple spreadsheet template or any online software application.
If you use the above 6 steps then it will be easy for you to create a budget that tells you to manage finances.
Here is the 6 step budgeting process summary:
- Gather the financial documents and information
- Calculate your total income
- Find out your total expenses
- Calculate your total net income
- Interpret the results and decide on action steps
- Update your budget continuously
If you’ve any budgeting tips in mind then tell me in the comments.
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