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.
A budget is the answer. Here’s how to set one up.
Follow 5 steps to creating 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 have other types of income — perhaps you make money from side gigs — 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.
- Automate your savings. Automate as much as possible so the 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’re held accountable for choices that blow the budget.
- Revisit your budget as needed. Your income, expenses and priorities will change over time. Adjust your budget accordingly, but always have one.
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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.
Try a simple budgeting plan
We recommend the popular 50/30/20 budget. In it, 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.
Allow up to 50% of your income for 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 you need 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.
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’ll 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.
Leave 30% of your income for 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’re 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 shouldn’t be so austere that you can never buy anything just for fun.
Every budget needs both wiggle room and some money you are entitled to spend as you wish.
Every budget needs both wiggle room — maybe you forgot about an expense or one was bigger than you anticipated — and some money you’re 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, you’ll be less likely to stick with your budget — and a good budget is one you’ll stick with.
Commit 20% of your income to 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.
You can’t 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.
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.
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.
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.