Having a budget creates freedom
Budgeting is often viewed in a negative light. It is usually associated with restriction. You may have heard financial "gurus" say that you can't have a morning cup of coffee from Starbucks as it will tank the rest of your finances.
However, budgeting is a great thing when done right. It will lower your financial stress and give you freedom to spend your money on the things you want. A budget is simply a spending plan based on your income and your expenses over a period of time.
Budgeting on a monthly basis is typically recommended as most bills need to be paid on a monthly basis. Having a budget can seem like more of a hassle than a benefit when you set one up. After all, you are telling yourself that you can only spend a certain amount of money on certain things.
However, having a budget gives you a reality check. The reality is this. Everyone has limited resources. It does not matter if you make $50,000 per year, $500,000 per year, or $5 million per year. All of these incomes are still limited.
If you make $5 million per year and spend every last dollar you have, you may be in a worse position than the person who makes $50,000 per year, but has a budget that helps them save and invest a portion of their income.
What a balanced budget looks like
The entire goal of having a budget is to create balance in your financial life. You are trying to balance your current needs and wants, with your future needs and wants. There are many budgeting methods that aim to accomplish this, but in general you want your monthly after tax income to go to one of three places.
1) Part of your money goes towards safety measures
When you create a budget, you want to send some of your money towards financial safety nets. You would not go rock climbing on a 200 foot tall cliff without a safety harness. The same principle can be applied to your finances.
A financial safety net will consist of two things. First, you need to have an emergency fund. An emergency fund is a cash reserve that you can access to pay for unexpected expenses. For example, your car might break down, you might lose your job, you might get injured and have unexpected medical expenses, etc.
If you don't
create an emergency fund, you might have to break your entire budget to pay for unexpected expenses when they inevitably arise. You should have 3 to 6 months worth of expenses in your emergency fund, but try to at least have $1,000 when you get started.
The second part of a financial safety net is having strong insurance policies. This can include
car insurance,
home or
renters insurance,
life insurance, disability insurance, and health insurance. Each of these policies is designed to mitigate risk in a particular area of life.
For example, say that you rent an apartment and do not have a renters policy. If a fire broke out in the apartment, you would be on the hook to replace all of your personal belongings as your landlord does not cover your personal property. This can cost thousands of dollars, which will break your budget.
2) Part of your money goes towards your future
If you want to create a balanced budget, you also need to send part of your money towards your future. Remember, having a budget is all about balance. If you spend every last dollar that you make today, you will not have any dollars for your future.
Budgeting is not always fun, but if you set up your budget so that you will be in a better place in the future than you are today, you can find the motivation to stick to your budget. The money that goes towards your future is money that you are going to invest.
An easy way to start investing can be to open up a
Roth IRA and hold high quality investment funds, such as
index funds, inside of the Roth IRA. Building wealth for your future takes time, so it is important to always have a portion of your budget that is designed to help you save and invest for your future.
3) Part of your money goes towards other expenses and lifestyle
Once you allocate part of your budget towards financial safety nets and part of your budget towards investing for your future, the money that is left in the middle will go towards your other expenses and your lifestyle.
This portion of your budget is where you can balance your needs and your wants. You are going to need a place to live, you are going to need food, you are going to need transportation, but you will also have wants such as taking an annual vacation, going to concerts and sporting events, and whatever else you want.
Here is the good news. You can spend all of the money that is left in the middle of your budget. Once you have safety nets in place, you know you will not go backwards financially. Once you have a portion of your budget designed to save for your future, you know you are going somewhere better.
This gives you the freedom to spend all of the money left in your budget. You will need to track all of your needs such as housing, food, transportation, and more. Once you know what your necessities will cost every month, you can use the rest of your budget to fund a lifestyle that you enjoy.
This means that when you budget, you can find the money to spend on your wants in addition to your needs. You may find that you have an extra $500 per month that can go towards your wants. This can pay for new clothes, a morning cup of Starbucks coffee, an annual vacation, and much more.
Common budgeting methods
There are endless ways to create a budget. What you want to do is find a method that works for you so that you will stick to it over time. With that being said, there are a couple of common budgeting methods that you could use. Keep in mind you do not have to use these. They are only examples of what you could do.
1) The 50/30/20 method
The 50/30/20 budgeting method says that you should budget by allocating a certain percentage of your income towards a certain area. It says that 50% of your after tax income should go towards needs, 30% towards wants, and 20% towards saving and investing.
Your needs can include things like housing, food, transportation, and insurance. Your wants can include things like entertainment, events, vacations, new clothing or furniture, electronics and more. Your savings and investments can include things like investing for retirement, saving for a home, and building an emergency fund.
For some individuals, the 50/30/20 budgeting method works well. This method does a good job at creating a balanced budget, which is the goal. However, the problem with this method is that it does not do a good job at helping you evaluate your specific circumstances.
For example, you may live in an area with increased housing costs. For this reason, you have to allocate 60% of your budget towards your needs as opposed to 50%. You may have also waited to start saving for your retirement until you were 40 years old.
For this reason, you may need to allocate 30% of your budget towards savings in order to save enough to retire when you want to. The 50/30/20 rule is a good general outline for most people, but keep in mind it is not a strict rule. You can use this method as a starting place for your budget, and then adjust it to meet your individual needs.
2) Zero based budgeting method
The zero based budgeting method is a concept in which every single dollar you earn gets a job. The idea is to budget for every single dollar you have and spend all of your money each month. For example, say that you make $5,000 of after tax income per month.
A zero based budgeting model says that you should assign every single one of those dollars a job so that at the end of each month you have spent the $5,000. For example, you want to list out every single expense that you have.
This can include housing, insurance, food, entertainment, savings, investments, bad
debt, transportation, gas and more. You want to look at how much each of these costs and list it down. If you still have money left over after doing all of this, you can assign those dollars jobs such as saving for a vacation.
The zero based budgeting method does a good job at helping you assign a job to every dollar you earn so that you are not wasting any of your money. The downside to this method is that it can be quite cumbersome to track your spending down to the last dollar.
If you have irregular income, such as a commission based job, it can be hard to use this method as you do not know what your income is going to be each month. For some individuals, a zero based budgeting method works, but again you do not have to use it if you believe it won't work for you.
Additional budgeting tips
1) Use budgeting tools
The good news about budgeting today is that there are many different online budgeting tools that you can use to help you track and manage your budget. Most of these online budgeting tools work the same. The tools allow you to connect your bank account and credit cards to help track your spending.
Some of these budgeting tools follow a specific framework, such as the zero based budgeting method, while others allow you to customize your budget. Budgeting apps can help provide a visual representation of how you spend your money so that you can create a better budget.
Online budgeting tools are not perfect as they may not provide every feature you need and can cost money, but they are often worthwhile for many individuals who struggle to create or stick to a budget. Some popular budgeting tools include
YNAB (you need a budget), and
PocketGuard.
2) Automate your budget
If you have fixed expenses, you can automate those expenses to help you stick with your budget. A fixed expense is any expense that will be the same every month. This might include a car payment, phone payment, rent or mortgage, and more.
If you can set up fixed payments to be automatically withdrawn from your bank account, it is one less thing that you have to worry about when you are budgeting. The downside to doing this is that you have to ensure that you have enough cash in your bank account to cover these fixed expenses when they are automatically withdrawn each month.
If you have a variable expense, it may not be the best idea to automate. A variable expense is any expense that can change from month to month. This might include utilities, food, clothing, and more. If you are not sure what an expense is going to be, you probably do not want to automate paying for it as it can create a cash flow problem.
3) Review and adjust your budget over time
Creating a budget is not a one time thing. As your life changes, so will your budget. Your income and expenses will likely go up and down throughout your life. Maybe you are getting married, moving to a new location, having a kid, getting a promotion, etc.
The point here is simply to adjust your budget as your life changes. Preparation is the key to a good budget and having a strong financial plan. It is important to review your budget for both the short and the long term.
You can review your budget each month to make sure you are prepared for the expenses that month will bring. You can also review your budget any time you have a major life change to ensure you are prepared for the financial changes that the life change will bring.
The bottom line
The bottom line is that you need to have a budget. Budgeting is not always fun and can even seem restrictive at times, but following a budget will actually create more freedom in your life. When you know where your money is going, you do not have to feel guilty when you spend money on the things you want since you have budgeted for them.
When you create a budget, your money should go to one of three areas - your safety net, your future, and your other expenses and lifestyle. There are many different budgeting methods you can follow, but it is important to pick one that you will stick to over time.
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