In its simplest form, budgeting is a third-grade math problem.
If I have take-home pay of, say, $2,000 a month, how can I pay for housing, food, insurance, health care, debt repayment and fun without running out of money? That’s a lot to cover with a limited amount, and this is a zero-sum game.
You cannot thrive for long by spending more than you take in.
How do you decide what’s important and where to spend most of your money? If your expenses outpace your income, what can you do? How can you cope with unexpected major expenses?
For all these questions, a budget is the answer. Here’s how to set one up:
How to create a budget
- Figure out your after-tax income. If you get a regular paycheck, the amount you receive is probably it, but if you have automatic deductions for a 401(k), savings, and health and life insurance, add those back in to give yourself a true picture of your savings and expenditures. If you receive other types of income, subtract anything that reduces it, such as taxes and business expenses.
- Choose a budgeting plan. Any budget must cover all of your needs, some of your wants and — this is key — savings for emergencies and the future.
- Track your progress. Record your spending or use online budgeting and savings tools.
- Set yourself up for success. Automate as much as possible so money you’ve allocated for a specific purpose gets there with minimal effort on your part. An accountability partner or online support group can help, so that you are held accountable for choices that blow the budget. And leave a little room in your budget for fun, too.
- Revisit your budget and tweak it as needed. Your income, expenses and priorities will change over time. Adjust your budget accordingly, but always have one.
A budget is a plan for every dollar you have. It’s not magic, but it represents more financial freedom and a life with much less stress.
A good starting budget
We recommend the popular 50/30/20 budget.
Bankruptcy expert Sen. Elizabeth Warren co-wrote “All Your Worth” with her daughter Amelia Warren Tyagi. In it, they recommend a budget where you spend roughly 50% of your after-tax dollars on necessities, no more than 30% on wants, and at least 20% on savings and debt repayment.
We like the simplicity of this plan. Over the long term, someone who follows these guidelines will have manageable debt, room to indulge occasionally, and savings to pay irregular or unexpected expenses and retire comfortably.
Those proportions may be wildly out of whack until you get your finances on track. “It’s not unusual for people to be spending 70% or more on must-haves, which explains why it’s so hard for them to save and pay down debt. There just isn’t room,” says Liz Weston, NerdWallet columnist.
50% of your income: needs
Your needs — about 50% of your after-tax income — should include:
- Basic utilities.
- Minimum loan payments (anything beyond the minimum goes into the savings and debt repayment category).
- Child care or other expenses needed so you can work.
If your absolute essentials overshoot the 50% mark, you may need to dip into the “wants” portion of your budget for a while. It’s not the end of the world, but you will have to adjust your spending.
Even if your necessities fall under the 50% cap, revisiting these fixed expenses occasionally is smart. You may find a better cell phone plan, an opportunity to refinance your mortgage or less expensive car insurance. That leaves you more to work with elsewhere.
20% of your income: savings and debt repayment
Use 20% of your after-tax income to put something away for the unexpected, save for the future and pay off debt. Make sure you think of the bigger financial picture; that may mean two-stepping between savings and debt repayment to accomplish your most pressing goals.
Priority No. 1 is a starter emergency fund. Many experts recommend you try to build up several months of bare-bones living expenses. We suggest you start with at least $500 — enough to cover small emergencies and repairs — and build from there.
You cannot get out of debt without a way to avoid more debt every time something unexpected happens. And you’ll sleep better knowing you have a financial cushion.
Priority No. 2 is getting the employer match on your 401(k). Get the easy money first. For most people, that means tax-sheltered accounts such as a 401(k). If your employer offers a match, contribute at least enough to grab the maximum. It’s free money.
Why do we make capturing an employer match a higher priority than debts? Because you won’t get another chance this big at free money, tax breaks and compound interest. Ultimately, you have a better shot at building wealth by getting in the habit of regular long-term savings.
Priority No. 3 is toxic debt. Once you’ve snagged a match on a 401(k), if available, go after the toxic debt in your life — high-interest credit card debt, personal and payday loans, title loans and rent-to-own payments. All carry interest rates so high that you end up repaying two or three times what you borrowed.
- Your unsecured debt (credit cards, medical bills, personal loans) can’t be repaid within five years, even with drastic spending cuts.
- Your unpaid unsecured debt, in total, equals half or more of your gross income.
Priority No. 4 is, again, saving for retirement. Once you’ve knocked off any toxic debt, the next task is to get yourself on track for retirement. Aim to save 15% of your gross income (that includes your company match if there is one). If you’re young, consider funding a Roth IRA after you capture the company match; once you hit the contribution limit on the IRA, return to your 401(k) and maximize your contribution there.
Priority No. 5 is, again, your emergency fund. Regular contributions can help you build up three to six months’ worth of expenses. You shouldn’t expect steady progress, because emergencies happen, but at least you’ll be able to manage them.
Priority No. 6 is debt repayment. These are payments beyond the minimum required to pay off your remaining debt.
If you’ve already paid off your most toxic debt, what’s left is probably lower-rate, often tax-deductible debt (such as your mortgage). You should tackle these only after you’ve gotten your other financial ducks in a row.
Any wiggle room you have here comes from the money available for wants or from saving on your necessities, not your emergency fund and retirement savings.
Priority No. 7 is you. Congratulations! You’re in a great position — a really great position — if you’ve built an emergency fund, paid off toxic debt and are socking away 15% toward a retirement nest egg. You’ve built a habit of saving that gives you immense financial flexibility. Don’t give up now.
If you’ve reached this happy point, consider saving for irregular expenses that aren’t emergencies, such as a new roof or your next car. Those expenses will come no matter what, and it’s better to save for them than borrow.
30% of your income: wants
Separating wants from needs can be difficult. In general, though, needs are essential for you to live and work. Typical wants include dinners out, gifts, travel and entertainment.
It’s not always easy to decide. Is a gym membership a want or a need? How about organic groceries? Decisions vary from person to person.
If you are eager to get out of debt as fast as you can, you may decide your wants can wait until you have some savings or your debts are under control. But your budget should not be so austere that you can never buy anything just for fun. Every budget needs both wiggle room (you forgot about an expense, or one was bigger than you anticipated) and some money you are entitled to spend as you wish.
Your budget is a tool to help you, not a straitjacket to keep you from enjoying life, ever. If there’s no money for fun, it’s more likely you won’t stick with your budget — and a good budget is one you’ll stick with.
Image via iStock.