Building a budget makes good financial sense. It keeps you from spending more than you make, and it helps you achieve financial goals like creating an emergency fund or saving for retirement. Moreover, everyone should understand the five basic building blocks of a budget whether you use pen and paper, a spreadsheet or the latest budgeting app to create yours.
1. Your Monthly Income
Your monthly income is the first building block of your budget. Your gross income is how much you earn before your employer deducts for income taxes and your contributions to its sponsored health insurance and retirement savings plans. Net income is what you take home after those deductions. You can’t know how much you have to spend or save in a month until you know both of these numbers.
If you’re a salaried employee, look at your most recent paystub to determine your gross and net pay for one pay period and calculate your monthly total. For non-salaried workers whose hours vary each pay period, average your gross and net pay using paystubs for the last four to six months.
As a freelancer or gig worker, average out your earnings over the past year to determine your monthly gross income. You’ll have to include self-employment tax and your out-of-pocket health insurance premiums as monthly expenses, which are the next budget building block.
2. Your Average Monthly Expenses
- Create a list of spending categories. Here are the most common ones, the first nine of which are necessary expenses:
- Housing (mortgage or rent payment)
- Auto, student and personal loan payments along with credit card minimums
- Homeowners, auto and other insurance premiums
- Transportation (fuel or public transit fares)
- Utilities (electric, natural gas and water)
- Television (cable, satellite or streaming services)
- Clothing and personal grooming
- Memberships and subscriptions
- Add up all the transactions in each category.
- Divide them by three to get the average amount spent per category in one month.
- Total up the category averages to determine your typical monthly expenses.
If your spending varied significantly within those three months, then go further back to get a more precise average.
3. The Difference Between Your Income and Expenses
This third building block is crucial. Subtract your total average monthly expenses from your monthly net income. If the sum is positive, you’re living within your means. That’s good news, but it doesn’t mean you’re done yet. If the sum shows a negative number, you’re overextending yourself, meaning you also have more work to do.
4. Your Financial Goals
For this fourth building block, step away from the work you’ve done so far to make a list of your financial goals and prioritize them by importance. Here are some typical goals:
- Building an emergency fund
- Establishing a college fund for your kids
- Paying down credit card debt
- Starting your own business
- Saving for a down payment for a home
- Saving up for a vacation
- Paying off student loans
- Saving for retirement
For each goal, determine where they currently stand. For example, experts recommend an emergency fund capable of covering three to six months’ worth of expenses. If yours could only cover one month of expenses, then you know how much more you need to achieve this goal.
5. An Appropriate Budget Rule
Once you identify everything you need or want to spend money on or save for, it’s time to apply the fifth building block: a budget rule. This is a framework for determining how much of your gross income you want to allocate to your needs, wants and financial goals. The most common budget rule is the 50/30/20 rule in which 50% goes to needs (including taxes), 30% to wants and 20% to goals.
To find the most appropriate budget rule for you, go back to your necessary expenses. Let’s say they currently take up 80% of your gross income. That’s your budget rule starting point unless you can find ways to reduce the cost of your needs, such as finding a cheaper apartment or adopting habits that lower your auto insurance or reduce your grocery bill.
Next, test different scenarios for how to allocate the remaining 20%, such as 10% to wants and 10% to financial goals, including any contributions to an employer-sponsored savings plan. If that split doesn’t do enough to help you reach your goals or isn’t enough to cover what you’re currently spending on wants, then you need to find ways to reduce or eliminate some wants, such as:
- Canceling your gym membership and working out at home
- Taking your lunch to work rather than buying it
- Reducing the number of your streaming services or subscriptions
Finalizing, Tracking and Reviewing Your Budget
Now, you’re ready to put all the building blocks together in a final budget. You can document it in a notebook, using a spreadsheet template from Microsoft or Google, or by taking advantage of a budgeting app like Mint, PocketGuard or Wally. Choose the method that you find easiest to use because regularly tracking your actual monthly expenses will help you stick to your budget.
Editor’s note: Quorum is not affiliated with any of the companies mentioned in this article and derives no benefit from these businesses for placement in this article.
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