How to Build a Budget 101
Perhaps the single most important thing anyone can do to improve their financial well-being is to start and keep a budget. What makes that so important? Wouldn’t opening an emergency fund or a retirement fund be more effective? While those things are also very important, without a budget they wouldn’t have nearly as much impact.
In a previous post we defined the purpose of a budget: “to track your spending so you can make educated financial decisions which will ultimately lead to saving money and building wealth”. One thing we can derive from this definition is that a budget is the foundation on which we construct our financial well-being. It is necessary for an emergency fund or retirement fund to be fixed on that foundation in order for them to stand. You see, when you create a budget you are learning every detail about your income and expenses. That knowledge is key to maximizing the power of every dollar you make.
Okay okay we get it, a budget is important. So… how the heck do I actually make one of these things? Good news! That’s the goal of this post! Hopefully, I can inspire you and give you the tools to start your own budget.
Step 1: Determining Monthly Income
The starting place for your budget is to figure out how much money you are actually making each month. There are a few ways to do this:
Check your bank statements for the past few months
Look for patterns in your deposits and figure out the average income per month over that period. Use this number to predict how much income you will make next month. This will be for people who make varying amounts through commission based roles or freelance contractors and the like.
Salaried? Do Some Math
Start with your base salary then, using the tax bracket table below, take that percentage from your salary to get your total after tax income and then divide by 12 months. This will give you an idea of what to expect your monthly income to be.
Let’s take an annual salary of $45k as an example:
- Base Salary:$45,000
- After Tax:$45,000 X (1 – .25) = $33,750
- Monthly Income:$33,750 / 12 months = $2,812.50
In that example you can expect to make approx. $2,810 next month. I suggest rounding down so that you don’t run the risk of budgeting for more income than you receive.
Also, something to figure out is when your company distributes your paychecks. The most common schedules are twice a month (ex. 15th and 30th of each month) and bi-weekly (every other week). If you have a bi-weekly schedule then don’t be surprised if your monthly income appears to be less than what you budgeted. Since there are 26 pay periods in the year versus 24 in a “twice a month” schedule. There will be two months in which you will receive three paychecks so try to account for those months.
Hourly? Do Some More Math
Find out what your hourly rate is and how many hours you tend to work in a month. Then multiply that number by 12 months to determine your annual income. Once you have that number you can follow the same steps as the salaried folks. Find your tax rate in the income tax bracket table above then deduct that amount to find your after tax income. Divide that number by 12 months and you will have your monthly income.
Here’s an example of $18/hr at 40 hours a week:
- Hourly Rate:$18/hr at 40 hours a week
- Annual Income:$18 X 40 hours X 52 weeks = $37,440
- After Tax:$37,440 X (1 – .15) = $31,824
- Monthly Income:$31,824 / 12 months = $2,652
For this example we can estimate that next month we will make around $2,650. This information will be greatly useful when we start dividing up our budget.
Step 2: Split Expenses Into Fixed or Variable Expenses
The next step is to break down your expenses into the most important categories. Doing this will illuminate which expenses you need to cover month to month and which you need to decrease or can afford to increase. Let’s first look at what I mean by a fixed expense vs a variable expense.
A fixed expense is anything that is absolutely necessary and recurring. Try to calculate all of your fixed expenses first since these are unlikely to change. Some examples of fixed expenses are: mortgage payment, utility bills, car insurance, etc.
After you allocate all of your fixed expenses you can begin to calculate your variable expenses. These are expenditures that are not as high of a priority and can easily change from month to month. Some variable expenses could be: grocery shopping, entertainment, eating out etc.
Try to make a list of all the things you spend your money on that fit under either Fixed or Variable. Go through your bank account statements and distribute your transactions between the two groups.
Step 3: Divide Your Budget Into Main Categories
At this point you probably have a much better understanding of where your money is actually going. Now you should try to further categorize each of these expenses. I personally use these categories for my own budget:
- Charitable Gifts
As you are allocating your expenses into the different categories you should be deducting them from your monthly income. The goal of a budget is to get your total monthly expenses to be as close to your total monthly income as possible. If you were successful and your remaining income is minimal or zero then you have officially made a “balanced budget”. Beware of a negative balance because you are spending more than you are making! If that is the case take a look at your variable expenses and see what changes you can make to get out of the red.
Here is an example of what a balanced budget might look like, let’s take the monthly income at $2,650 from the hourly rate example above (A budget is very specific to your situation so yours will vary):
Monthly Cash-Flow Plan
This is the budget in it’s most basic form and a great starting point for anyone ready to take control of their money. There is still a lot more we can do to improve this budget so check out the following post, How to Build a Budget 102!