How to Create an Effective Budget

admin // November 21 // 0 Comments

If you read the headlines, you might not be sure what to believe. Many news blurbs indicate that saving and checking balances are at highs when compared to recent years. Others tell the story of the nearly half of American households that can’t cover a $400 emergency expense without borrowing money.[1]

No matter where you are on that spectrum, there is value in creating an effective budget. If you’re flush with cash, a budget can help you streamline further, freeing up more money to invest or save. If you’re building from a lower starting point, like nearly half of US households, an effective budget can help you identify areas for improvement and add an element of discipline that can get your finances on track for growth.

Why budgets often fail

Budgets are a bit like New Year’s resolutions. Many of us have some dusty exercise equipment in the garage or in the basement — or we know someone who does. Those New Year’s resolutions to finally get back into shape don’t always work out as well as we might hope. The reason budgets often fail is similar to the reason New Year’s resolutions often fail: we tend to set unrealistic goals. Positive results take time and going off-track can undo all the progress we’ve made, leaving us feeling like we’re running on the treadmill we bought a few years back and never really going anywhere.

If you approach your budget as a tool to build your future as opposed to a draconian exercise in unyielding discipline, it’s more likely to work for the long term. Budgets that are all business ignore the fact that we are human and we need to have some fun sometimes. They also recognize that too much fun leaves the bank account running on fumes. An effective budget needs to be balanced — but not just in the mathematical sense; it needs to provide some balance in our quality of life. Make an “ice cream” category in your budget if you want. Go ahead and have some fun. Just don’t make it too big.

A budget that can survive the test of time because it recognizes our human needs will be more effective in the long run. Budgets that are too strict or that never allow any flexibility are often doomed from the start.

Get the big picture view

The first step in creating an effective budget is to figure out how much you’re actually spending. You probably have a pretty good sense of how much money you spend in a month — or at least have a good idea of what the larger expenses are, including your housing costs, car loans, or commuting costs. What tends to be a bit more mysterious in many households are the smaller expenses and the occasional expenses.

You’ll need your bank statements and credit card statements to start building some totals. If you use cash frequently, you may have to start with some estimates — but start keeping track of your cash expenditures as well so you can adjust your budget later if you find your estimates were off by a significant amount.

Sort your expenditures into categories

Ideally, you’ll want a year’s worth of bank statements and credit card statements to begin categorizing expenses. The reason is simple; small samples of data — any kind of data — can be misleading. If you work with just a month’s worth of bank statements, quarterly expenses can be missed. If you work with just 2 or 3 months of bank statements, emergency spending or vacation spending may not be accurate. Make no mistake, this process will take some time but it isn’t difficult and you can probably listen to some Netflix reruns of your favorite show in the background to help make the process seem less like “work”.

The easiest way to build your budget is with a spreadsheet. Several free online options are available, like Google Sheets, Excel Online, or even LibreOffice if you prefer to use (free) software.

How fancy you want to get with date tracking is up to you but the simplest method is simply to record the expenses by category while making note of how long a period you’re tracking. It may not be relevant to know that an expense happened on “June 4th”. It is, however, relevant to know if the totals reflect a month, a quarter, or a year because we’ll need to break up those totals into monthly averages.

Let’s say you have a total of $5,000 for “auto expense” over the course of 12 months. This might include car payments, insurance, gas, and repairs (this is the one that sometimes gets missed). Simply divide your total by 12 to get a monthly average you’ll need for your budget.

Repeat the process for every category as you go. In the end, you’ll have a pretty accurate average monthly spending total for each category.

Identify frivolous purchases — and then choose

One of the primary advantages of going digital is the data that isn’t available with analog spending, i.e. cash spending. When you’re categorizing your expenses, you’re likely to find that you spent money regularly on eating out, coffee shops, subscription services, cigarettes, movies, or any of a number of other discretionary expenditures. You’re also likely to find that the total for these expenses is higher than you may have realized. Small indulgences have a way of adding up quickly.

By taking the time to look at the numbers, you’ll probably find some expenses that you can eliminate immediately. Maybe there’s a gym membership that you no longer use (but which you’re still paying for) or some online subscriptions for websites or services you rarely use.

You’ll also find some areas where it should be fairly easy to cut back on spending without denying yourself some of the things you enjoy. A $5 a day gourmet-coffee habit cost $1,300 per year, assuming you only stop for coffee Monday through Friday. Cutting back on coffee stops, for example, might put another $1,000+ a year back in your pocket — but you can still have your gourmet coffee once in a while.

The coffee expense is just an example. In most households, similar opportunities for savings can be found easily.

Plan for the unexpected

Life is full of surprises and many of those surprises cost money. If you used a full year of bank statements and credit card statements to plan your budget, many of life’s surprises will be well-documented. You’ll find examples of repair bills or other unexpected expenses. Add these up and come up with a monthly average for “emergencies”. Without this category in your budget, your budget is almost certain to break.

The Achilles heel(s) of budgets

Emergencies often top the list when analyzing where budgets go wrong, which is why it’s so important to plan for the unexpected by including emergencies in your budget. Frivolous spending is another area in which good budgets can go bad. You’ll want to stay as close as possible to the amount you budgeted for discretionary spending, including entertainment, eating out, trips to the mall, or purchases from your favorite online vendor.

Flawed math can also break a budget. Missed expenses will change your average monthly spending estimates and leave you wondering why your budget doesn’t work. If you find that your budget doesn’t seem to be adding up right, it’s worth the time investment to check your work. Perhaps something was missed or maybe an emergency expense put you off your pace.

Debt can be another budget-buster. If an unplanned expense forces you to use credit, your monthly debt payments will increase. Be sure you account for this increase elsewhere to avoid breaking your budget. You may have to cut back on another expense in the short-term to keep your budget balanced.

Cancel unneeded subscriptions or memberships

In most households, you’re likely to find some automatic subscriptions or automatic membership renewals that are billed monthly, quarterly, or even annually. Look at these pragmatically and decide what you really need and if these subscriptions are memberships still hold value to you. There might be a few hundred dollars each year (or more) leaking out of your budget when you total these items.

Set realistic spending goals for each category

Effective budgeting is based on reality. You’ll identify areas where you can reduce your spending but setting an unrealistically low number for any of your spending categories is just asking for trouble.

As a starting point, reduce your discretionary spending and set goals for other spending categories based on your actual spending history. Over time, it’s likely that you’ll find less expensive solutions to some of your “fixed” expenses as well, such as balance transfers to save on interest expense, switching to a bank with fewer fees, or revisiting your insurance policies, possibly even switching to another insurance company.

Consider adding a small amount of “padding” to each of your budget categories. It’s nearly impossible to balance a budget to the penny. If you’re going to budget more than your average spending for a given category, try to focus this extra money on areas that have a history of increases, like insurance or your gas budget.

Identify how much spare money you have

Much of the focus when budgeting is on spending but income plays a role as well. If your after-tax income is $4,000 a month and your budget — even after making cuts — is $4,500 a month, you have an unsustainable situation. Eitheryour credit balances will increase or your savings will dwindle by $500 a month. For most households, no major lifestyle changes are required to balance a budget but if you’re running at a deficit, something has to change. Maybe less expensive housing is in order, or a less expensive car, or maybe you need to look into ways to earn more money.

If you do have some spare money — and it’s likely that you do after making some cuts to frivolous spending — then it’s time to put that money someplace safe.

Let’s say your budget has a $200 average monthly surplus. You can set up an automatic transfer to send $200 every month to a separate savings account. In the short-term, it’s important not to put this extra money into investments or anything else you might have to sell to access your money. Your budget is built using averages, which means a high expense may be just as likely as a low expense in categories like “emergencies”. Over time, your averages should prove to be closer to your spreadsheet estimates but if you have a larger-than-average emergency expense, you’ll want easy access to the money you put aside in savings.

The goal of having a separate savings account isn’t to make the money inaccessible; it’s simply a way to make you think twice before spending your savings.

Adjust your budget as needed

In the history of budgeting, it’s likely that nobody has ever built a perfect budget. Expenses can (and will) change, which will require some adjustments to your budget. When was the last time your insurance bill went down? When was the last time your rent went down, or the cost of a car? Inflation has a way of putting pressure on budgets slowly, causing them to break if you don’t make adjustments along the way.

Hopefully, as inflation is increasing your average monthly expenses in some categories, your income is also rising at the same rate or higher. If you do find your earnings increasing faster than your expenses, this is the perfect opportunity to invest in your future. It may be tempting to increase your spending as your income increases but if you were able to survive (and even thrive) on lower spending in the past, there’s often no reason to increase your spending. Save it or invest it.

Using an app for budgeting

If you use a smartphone or a tablet, a number of useful apps can help you track your spending, with most even offering to “categorize your spending for you. These apps can be useful tools although some have a tendency to miscategorize expenditures. This can create a bit of extra work. A spreadsheet and a notepad, even a digital notepad, can be just as effective and have the advantage of taking a hands-on approach to recording expenses. If you do it yourself, you become abundantly aware of how much you’re spending and it may help you think twice before spending money on something you don’t need.

No matter what method you use to track your budget and spending, the principles of effective budgeting remain the same:

  • Use realistic estimates for each category
  • Spend less than you earn
  • Save the surplus
  • Invest after you’ve saved enough to fund emergencies

And don’t forget to budget a little bit for fun or new experiences. An effective budget — meaning a budget that you can keep — provides an occasional “reward” for a job well done.

  1. https://www.washingtonpost.com/news/wonk/wp/2016/05/25/the-shocking-number-of-americans-who-cant-cover-a-400-expense/?noredirect=on&utm_term=.a4a49fd055cb

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