Many, many personal finance books and guides love to discuss the process of assembling a household budget, and for good reason: a household budget can be an extremely powerful tool for setting personal finance goals and achieving them while also providing a great “big picture” view of your spending.
These guides are great for the purposes of teaching you how to make a budget, but they miss out on the why. Why is a budget worth all of the work that you put into it? How do you create a budget? What good is the exercise of building a personal or household budget?
Why should you make a household budget?
Most of us have seen a budget in some form or another. It’s a listing of a bunch of different categories, along with the amount you intend to spend on each of those categories. In theory, every dollar you spend falls into one of those categories. At the bottom, the dollar amounts are totaled, and that total amount should add up to the money you bring home in a month (or ideally a little less, to give you some flexibility).
Great, it’s a table. What good does that do?
I like to think of a budget a little differently. Think of every single line in a budget as a short term goal, a 30-day challenge of sorts for you. That line is challenging you to spend that much money on that specific area.
So, let’s say I have a budget that looks like this:
That’s an extremely simple budget, but it gives you an idea of what I’m talking about.
You’ll notice an interesting pattern here. For most things, you’re stating the goal as spending a certain amount of money or less. However, for a few, you’re stating the goal as spending a certain amount of money or more. What’s the difference?
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In general, things that provide a long-term financial benefit if you go beyond that budget line should be thought of as a “or more” goal, whereas everything else should be thought of as a “or less” goal. It’s good for you long term to make an extra debt payment or an extra contribution to your Roth IRA, so those are “or more” goals. Everything else… you want to spend less on them, so they’re all “or less” goals.
Your budget, in other words, is nothing more than a list of goals for the month. If you’re successful at those goals, you’ll make good long term financial progress. You won’t accumulate more debt. You’ll pay off debt, instead. You’ll put money aside for your goals.
Tips for creating an effective budget
Think of a budget line as a SMART goal
For right now, let’s put aside goals that are fixed bills. You’re probably not changing the rent any time soon and that’s a fixed amount, so let’s not sweat that one for right now. Let’s instead focus on ones that you have at least some ability to influence, upwards or downwards.
For example, take that first one, the food goal: “I will spend $500 or less on food this month.”
This is actually a really good goal — it subscribes almost perfectly to the SMART framework for good goal setting. SMART is an acronym that refers to five traits that a good goal has:
- Specific: it tells you exactly what defines success for this goal, down to the dollar.
- Measurable: you can count up how much you’re spending on money to see whether you’re succeeding or not.
- Achievable: provided you’ve given some thought to the number, it’s definitely achievable.
- Relevant: doing this makes your budget as a whole succeed, and your budget as a whole succeeding means opening up your financial future.
- Time-bound: it lasts merely for the month that your budget is covering.
Vague goals, like “I want to spend less money,” don’t really hit any of those metrics, but “I will spend $500 or less on food this month” hist all five metrics.
Make sure your budget lines are achievable
Let’s look at that food goal again. You have a lot of control over that number. The more careful you are with your food spending, the lower that number goes. The less you think about what you’re spending, the higher it can creep up.
In other words, the lower you make that number, the more difficult the goal becomes to achieve and the more you have to focus to achieve it. Obviously, the lower you make that number, the easier it is to achieve the other goals in your budget, particularly the “more” goals that chart your financial future, but setting it unrealistically low begins to guarantee failure. It’s a balancing act.
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The best way to set a budget number in a flexible spending area like this is to make achieving that number be mildly challenging, but not require extensive changes to your life. If you have to throw all of your daily routines in life out the door to make that number, it probably won’t work for more than a month or two, and you’re just setting your budget up for failure. On the other hand, if you make that number so high that you don’t have to change much of anything to get there, what is even the point of creating a budget? The reason for doing this is to find more room for you to achieve financial goals, right? You have to find a good balance.
So, how do you find that balance?
The best place to start is with an honest reckoning of your current spending. You start by figuring up, to the best of your ability, how much you spent in that category each of the past several months. This likely involves getting out some bank statements and credit card statements so that you can start looking up numbers and adding them together. You’ll also have to decide what qualifies as spending in that category. If you go out to a restaurant or order takeout, is that “food” spending or “fun” spending? Maybe you have a “restaurant” category in your budget, but other options make sense.
What you’re really trying to do is figure out how much you spend right now so that you can set an achievable goal for yourself with regards to that budget line. In general, with flexible budget areas, it’s a good idea to aim for a goal of something like 20%–30% less than what you were spending in a typical month before you started making changes.
Let’s say you added up and you spent $650 on what you define as “food.” If you cut, say, 20% off of that, your goal is $520. $500 is a nice even round number, so that’s a good place to start. It effectively means that you’re spending $150 less on food this month so you can spend $150 more in other areas. The nice part about using this approach with flexible spending areas is that you typically have a lot of tools with which to cut that amount. By simply adopting some basic meal planning strategies, you can easily cut your food spending by that much without even breaking a sweat.
Create your own categories
One big issue that many people have with budgeting is organizing all of their spendings into a series of categories. Many books solve this problem by offering a huge list of potential budget categories, literally, a one-size-fits-all approach to budgeting.
When it comes to budgeting categories, you want to have categories that make sense to you. You shouldn’t ever have to think about virtually all of your expenses go — it should just be obvious to you so that when you’re checking your budget to make sure you’re staying on track, it’s really clear where each expense goes and the process is fast and clean.
Obviously, a huge list of categories isn’t going to really match up with what’s intuitive for you. Some of them will be completely irrelevant to your life. Some of them are more specific than what feels sensible for you. Maybe you don’t think “wine” needs its own line item in your budget and the rare occasion when you do buy a bottle makes sense to include in “food.” Others might be too broad for what you want to consider — “hobbies and entertainment” could include streaming services, movie tickets, board game purchases, collectibles and so much more.
The solution to this in the past is to just go through bank statements and make up your own categories. Just group things together in ways that make sense to you, figure out what you’re spending in that particular group, set a goal, and there’s a budget line item for you. The problem with that approach is that it can feel really overwhelming and it also requires a fair amount of creativity. For some, it’s just not a good solution.
Another approach is simply to find a good long list of budget categories from your favorite personal finance book. Here’s a list to use if you don’t have one. Then, go through your expenses one by one and try to match them up with a category from that long list. Just assign it to what feels right to you. If there isn’t a category on that list that feels right to you, that’s when you make up a category. This lets you come up with a budget that clicks with you. Some people want a smaller number of really broad categories, while others might want a bigger number of more narrow categories.
Just go through a few months’ worths of expenses in this way, adding them to categories intuitively and starting new categories when you don’t already have one that feels right. The key is to make sure you’re not missing any expenses. Check your bank statements and your credit card statements and go through them item by item, just to make sure you’re not missing anything, and assign all of those expenses individually.
Use the “pay yourself first” philosophy
One popular nugget of financial advice that often pops up on talk radio or print ads is the idea of “pay yourself first.” As I’ve discussed before, “pay yourself first” simply means that you immediately remove your fixed bills and the money you’re putting aside for your financial future right off the bat from your income, leaving you with just your flexible spending.
So, in the budget above…
… rent, utilities, debts, and the Roth IRA contribution would fall under paying yourself first. You cover those bills first, before anything else. You can effectively eliminate them from the budget in that case, leaving you with something like this:
That’s really your budget, at least in terms of what you have to work with. Those are the areas in this example budget in which your own action can easily lower your expenses this month.
(Obviously, you can take action to reduce your expenses in other categories going forward, particularly things like utilities and insurance, but those changes don’t usually have an immediate effect. They affect future budgets.)
So, in terms of truly practical SMART goals for the month, you really just have three:
- I will spend $500 or less on food this month.
- I will spend $100 or less on gas this month.
- I will spend $200 or less on fun things this month.
The other lines in your budget really aren’t actionable goals if you’re fully subscribed to the idea of paying yourself first. Those things could actually be fully automated with online bill pay and automatic transfers.
Build flexibility into your budget
There are always going to be things you miss in this process, plus there are going to be unexpected events that you didn’t foresee or plan for. It happens to everyone because we can’t possibly see the future. That’s why it’s good to have some flexibility in your budget and to not beat yourself up too bad if you fail to meet some of your goals in a given month.
Flexibility is an amount of money you can slide into another category due to a small emergency or opportunity or other unexpected events. You don’t want the 29th of a month to roll around and have an old friend suggest that you guys meet up for dinner only for you to say you can’t because it’s not in your budget. Similarly, you don’t want to have to tap into your emergency fund or throw your budget in the trash because you forgot to account for some maintenance on your car. That’s what flexibility is for — it’s money that you can pull on when truly unexpected events happen.
Too long, didn’t read?
Budgeting is like training wheels on a bike. When you put training wheels on a bike, your big goal is to actually learn how to ride the bike on your own without the wheels. The wheels just give you the support you need while you’re learning, and before long you don’t need them at all.
When you make the decision to improve your financial life, it’s not all that different than learning how to ride a bike. At first, it feels hard and there’s a lot of adjusting and falling down and struggling, and that’s what the training wheels are for. They’re a tool for creating lots of little goals for yourself, and successfully completing those goals over and over builds new habits and routines and behaviors in your life. Just as training wheels are there to help you learn the new mechanisms of riding a bicycle, budgets are there to help you learn the new mechanisms of financially successful living.
As you start to learn and master those new habits and routines and behaviors, you can eventually take the budgetary “training wheels” off, either by revising your budget for new goals or by simply trusting in your own new habits and routines. In either case, you’re well along the road to your financial goals.
Originally posted at https://www.thesimpledollar.com/financial-wellness/how-to-create-best-budget-for-you