In our previous installment we discussed tracking your finances to get an accurate picture of your cash flow, expenses, income and investments. This gives us a great starting point for our next step: Budgeting.
Creating a Budget
Most people assume you create a budget based on what your goal is for each category. While you can certainly try this, you’re likely to be setting yourself up for failure. The best place to start is to actually use last month’s expenses are your initial budget. This is the most accurate and realistic budget to use – it’s based on reality, not your ideal!
The point of a budget when you are beginning is to track your actual spending and get a picture of your cash flow. It’s also to get a good long term view of it. People often forget to add in expenses that don’t happen monthly or happen irregularly. If you have a less frequent bill (say Auto Repairs), go ahead and add a new budget category for it and break down the amount by how often the bill/expense tends to happen. Over time your budget will become more accurate. Obviously this is difficult for expenses that are “unexpected” like a repair, but becomes much easier for something like an annual or semi-annual car insurance payment. If they’re large lump sums typically you can opt to have them broken up for you so you don’t need to allocate some monthly amount that doesn’t get paid until 6 or 12 months have passed. My insurance company offers quarterly, semi-annual and annual payment options. Clearly, a quarterly payment would make for less temptation to steal those accumulating savings for the bill – though be aware they tend to charge some small fee/higher rate for this privilege.
So what should you include in your budget? Well the point here is to track spending in the major portions of your monthly expenses, but not so broad as to be useless in getting details. In practical terms, anything that regularly makes up more than a percent of your monthly expenses, but ideally less than 15-20%. I’ll give an example of when to break the category down further or not to worry about tracking it too deeply, but first let’s list some typical categories you might use:
- Food > Dining Out
- Food > Groceries
- Home > Mortgage/Rent
- Home > Home Improvement
- Home > Lawn & Garden
- Home > Insurance
- Gifts & Donations > Donations
- Gifts & Donations > Gifts
- Auto > Gas
- Auto > Maintenance
- Auto > Insurance
- Shopping > Clothing
- Shopping > Electronics
- Shopping > Entertainment
- Utilities > Gas
- Utilities > Electric
- Utilities > Phone
- Utilities > Internet
- Utilities > Water
- Pets > Food
- Pets > Veterinary
- Health > Prescriptions
- Health > Doctor
- Health > Dentist
Now, as mentioned, you only want to really track categories that make up a roughly 1-15% portion of your expenses. So if you don’t have a lot of expenses going towards something like Prescriptions or Electronics you can avoid creating a budget for it and let it fall into a “Miscellaneous/Everything Else” category. If you do see a category getting to be too large a portion of your expense you may want to break it down further to get a better handle on the breakdown. For example, I find it very useful to have separate budgets for Dining Out and Groceries, rather than just tracking the Food category as a whole.
What to Use
While we’ve discussed general categories you could track, what level of detail we’re aiming for and how to begin – we haven’t discussed the actual tool you’ll use to budget.
I was raised in a household that used the time-honored “envelope” budgeting system. You get an envelope, write the budget category on it in sharpie and then at the beginning of the month you fill it with cash to match the budget amount. This is a great beginner system and make it very easy to see when you’re going to run low. Often people who have runaway spending use this and then hold themselves to the exact amount in the envelope until the end of the month. You can also “cheat” and take some from an under-budget category to cover temporary shortfalls. Whatever is left at the end of the month gets put into a savings account and we start over.
This old-school approach is very simple and effective, but does require you have a good amount of cash on hand. It also means you’ll have to track your transactions manually since it’s all getting paid in cash.
You Need a Budget
There is a highly touted software solution called You Need a Budget. I haven’t used it personally, but many speak highly of it. It takes much of the same principles from above assigning budget amounts and tracking it, but does so by pulling down transactions from your banks and credit cards.
Since I already use Mint, I use their budgeting feature. They allow you to set up budgets assigned to categories, and they track your expenses and income automatically so it make things pretty simple. Budgets can be fixed (same amount every month) for regular bills so that they reset each month; or you can have a “rollover” budget where the extra savings or spending rolls over to the next month for variable bills like Utilities or Shopping.
It can take a long time to get an accurate budget. If you perpetually go over or under budget on a category, adjust the budget – this isn’t “cheating”, it’s creating a more accurate budget and picture of your cash flow. You’ll get a good picture of categories where you’ve constantly overspending over time anyhow, which will be a good indicator for you to look deeper into that category’s transactions and see if the budget was unrealistic, or you’ve been making some unwise discretionary buys. The important thing is to get a good snapshot of your monthly expenses, you can analyze the spending history to get details on whether you’re doing a good job of reducing spending or starting to get too free spending. I like to view my budgets as a guideline for normal spending – so that if we tend to go over repeatedly or suddenly it’s a good indicator that I need to look deeper at my finances and see what’s going on.
- Don’t let ATM withdrawals, personal checks, or use of cash to taint your budget!
- When you withdraw from an ATM, split the transactions off as you use the cash to pay for things.
- Track transactions manually when you pay in cash.
- Properly categorize your check transactions when they are listed.