Zero-Based Budgeting Explained

Budgeting, Personal Finance
Zero-Based Budgeting Explained

The zero-based budgeting method encourages you to use every penny of your monthly income — but that doesn’t mean blowing it on a shopping spree. Rather, you allocate your money to expenses, savings and debt payments. The goal is that your income minus your expenditures equals zero by the end of the month. Here’s how it works.

How to build your zero-based budget

The idea behind the zero-based budget, sometimes called the zero-sum budget, is to give every cent a purpose. Let’s say you make $3,000 per month. Your budget might look like this:

 

You can repeat expense categories and amounts every month or mix it up. If you come in under budget in a certain category at the end of the month, add the remaining amount to next month’s budget or move it to another category, such as your emergency fund. It’s the same concept as the envelope system, which involves distributing money for different expense categories into envelopes.

Build your zero-based budget with an app — such as You Need a Budget or Goodbudget — or a spreadsheet or pen and paper.

What you need to get started

Before implementing this budget, take a few steps to ensure you’re realistically planning your spending:

  • Know your income. Total your paycheck, benefits and other sources of monthly income to find out how much money you have to work with.
  • Track your expenses for a few months. Knowing what you typically spend — and on what — creates a framework you can use going forward. You’ll spot areas in which you can cut back and in which you want to allocate more.
  • Name your categories. Identify all of your priorities and expenses, including your needs and wants, debt repayment, emergency fund and other savings goals. Want a vacation? Create a “travel fund” category. Saving for a new car? Make that another.

How much should you allocate to each category? NerdWallet recommends the 50/30/20 rule. With this approach, 50% of your income goes to needs, 30% to wants, and 20% toward debt repayment and savings.

The pros

The zero-based budget keeps you aware of how much money flows in and out. This can prevent you from spending what you don’t have.

“If you haven’t tracked where your money is going or if you feel like you don’t have control of your money or spending, then I think that this is a really good method,” says Catherine Hawley, a certified financial planner in Monterey, California.

This system is also customizable, which can be especially useful if you’re new to managing your money.

The cons

Following a zero-based budget eats up quite a bit of time. To hold yourself accountable, you’ll have to closely and consistently monitor your spending. And that’s not the only challenge you may experience.

“I think one thing that can be problematic with it is that there are a lot of variable expenses,” Hawley says. “If you don’t account for your irregular expenses, the zero budget is going to potentially not leave you with enough money on average.”

These variable expenses might include holiday purchases, traveling to a friend’s wedding or replacing a broken phone.

But there’s a way to solve this: Set aside money specifically for these costs. Create a savings fund, separate from your emergency fund and other savings goal funds, and contribute to it each month.

The zero-based budgeting method might also pose a problem if you have an irregular or unpredictable income; say, if you’re a freelancer or an hourly worker whose schedule fluctuates. If you don’t always know how much money you’ll have to allocate, consider using the previous month’s income for the current month’s budget. Note that you’ll need to save up a month’s worth of income as a buffer first.

Ready to begin?

Now that you know what the zero-based budgeting system is all about, you’re ready to give it a shot. If it doesn’t work for you, try another budgeting method. And if your financial situation is complex, you might benefit from speaking to a financial planner.

Lauren Schwahn is a staff writer at NerdWallet, a personal finance website. Email: lschwahn@nerdwallet.com. Twitter: @lauren_schwahn.