Budgeting 101

Alden Wicker
Posted

Like any LearnVest reader, you’ve got one or two (or more!) financial goals. Maybe you need to pay off some debt, save for a house or take a break from your career, or maybe you just want to be more confident about your financial situation. As you’re about to discover, budgeting is the first step to reaching all of your financial goals.

Despite the importance of a budget, more than half of Americans don’t have one, and 22% say they don’t have a clear picture of what they spend on housing, food and entertainment.

What’s most surprising to us is that 78% of Americans say they do know what they are spending their money on, yet half don’t have budgets. Without a budget, your financial picture is at best muddy. At worst, you might find yourself overspending, racking up credit card debt and feeling confused and anxious about your situation. But a good budget gives you the confidence and a blueprint to live the life you want.

Budgeting in a Nutshell

A budget is a monthly financial plan that divides your income into categories. It uses your monthly income as a cap on your spending and then determines how you allocate your money to savings goals and expenses within that limit. It is the most crucial element of your personal finances, the key to living within your means and building your wealth.

In short, a budget is part of any financially with-it adult’s life plan. And it can and will change as you mature and see your wants, needs and goals shift.

Why Budgets Are Important

A budget will:

  1. Give you a clear picture of your financial situation so you can live within your means.
  2. Show you how much you can afford to spend—right down to the dollar—on everything from food ($200) to rent ($900) to a cocktail dress ($103).
  3. Keep you motivated and accountable on your way to reaching your financial goals.

We also love budgets because they give you a convenient framework in which to talk to yourself and others about what you can and can’t afford. “It’s way too expensive,” in response to your mom urging you to fly home for a second visit in this summer isn’t nearly as polite and effective as, “Another plane ticket just isn’t in my budget.” (Try it—you’ll see the difference.)

Term Sheet

Essential Expenses
n. The expenses you need in order to maintain the fundamentals of your life: shelter, food, heat, etc. They include your rent or mortgage, utilities like gas, electric and water, groceries and transportation. Essential Expenses should add up to no more than 50% of your total income after taxes.

Financial Priorities
n. Goals essential to a strong financial foundation, such as contributing toward your retirement; saving for emergencies and goals such as big trips or a down payment on a home; and paying off credit card payments, student loans, consumer loans and other debts. You should put your money toward financial priorities before you spend on your lifestyle choices. Your financial priorities should add up to at least 20% of your after-tax income.

Lifestyle Choices
n. The expenses you make with the day-to-day money you live on after your Essential Expenses and Financial Priorities are taken care of. They are often personal, voluntary and often fun choices about how you spend your discretionary income and includes cable, internet and phone plans, charitable giving, childcare, entertainment, gym fees, hobbies, pets, personal care, restaurants and bars, shopping and other miscellaneous expenses. Your lifestyle choices should add up to no more than 30% of your after-tax income.

How a Budget Prioritizes Your Money

Another benefit of a budget is that it helps you prioritize your spending. LearnVest recommends your budget follow the 50/20/30 rule. After your income comes in, this rule recommends that your money goes out in this order:

  • 50% of your budget should go to Essential Expenses. These are the expenses you always have to pay as a minimum to keep your life going, such as your housing, transportation, groceries and utilities.
  • Next, 20% should go to Financial Priorities. These are expenses that help you accomplish important financial tasks, such as paying off loans, building savings, saving for retirement and more; they generally include savings, debt repayment and financial contributions.
  • Lastly, 30% should go to Lifestyle Choices. This is what’s leftover, which is what you get to live on and enjoy now, on expenses such as dining out, shopping and other fun spending.

As you can see from these general guidelines, a budget is very personal. Your best friend the foodie might give herself a restaurant budget of $200 a month while setting a low limit of $30 on entertainment. Meanwhile, because you’re a music buff, you might set aside $150 for concerts every month and scrimp everywhere else. Similarly, the budget of someone paying back student loans and working in public service will be very different from someone who is debt-free and working in finance. But both can enjoy life and stay within budget, as long as they are realistic and know what they want out of their money.

How to Get a Budget to Work for You

1. Always, always have a realistic budget.
We tell you, step by step, how to build a budget here.

2. Stick to it.
We build monthly budgets, but that doesn’t mean you should only check in once a month. Depending on how tight your budget is, you should check in to see how you are doing every week, every day or maybe even before every purchase. Remember, there is a limited amount of money you can spend every month after your Essentials and Priorities are taken care of, so you want to be mindful of how much you’ve already spent as the month goes by. If you’re finding it hard to stick to your budget, then you should question whether it’s truly realistic. You may need to earn more or cut costs to make it work.

3. Revisit your budget.
Your budget will change as your wants and needs change, and also if you get a raise! At the end of each month, look at how you did and get realistic about your budget. If you are consistently going over your grocery budget, maybe you should cut back in other areas in order to increase it, or look for new ways to cut it.

This is not to say, however, that you should redo your entire budget on a daily basis. You’ll confuse yourself and never learn from month to month how well you’re sticking to your goals.

And when you get a raise, don’t just start spending more on dinner or get a nicer apartment. Also increase your savings, debt repayment and other priorities in order to keep your budget balanced and in line with the 50/20/30 rule.

RELATED: The One-Number Strategy: A New Approach to Budgeting

Remember …

A budget is the first and most important step to reaching your financial goals. By personalizing it to your life and following it, you’ll be in control of your finances and be prepared to take the next steps toward your richest life.

  • Pacer25jones

    So.. a question, as I begin to put this into practice.  Would a car loan go under Essential or Financial Priorities?  I can see it as both?

    • Sophia

      All debt, except a mortgage, would go under financial priorities.  Hope that helps!

  • fatgirl1983

    I don’t understand how childcare is considered a Lifestyle choice. I chose to have kids but childcare is a necessity in order for me to make a living.

  • CrankyFranky

    as an inveterate budgeter, I find this fascinating – I’ve been to classes where the speaker says ‘raise your hand if you’ve ever prepared a budget for your personal spending’ – typically I’m the only one to raise my hand.

    Yet I know it is the most powerful tool for identifying wasteful / unconscious spending habits which are the hole in your leaky boat, and once you’re aware of them, it’s typically very easy to say ‘I’d rather keep the money than buy that coffee/magazine/icecream/soft drink’

    I know I’m talking to myself here – 99% of people I ask about this tell me it’s ‘too boring’ – yet they will happily complain to me at length about how they haven’t got enough money.

    Spend less than you earn – if you don’t track your spending – guess what – it’s gone, you don’t know where and you don’t know why – how did that happen ? Hmm – maybe start by paying attention – I know most people hate maths – you can use a spreadsheet to add up automatically – find and plug the leaks and you can treat yourself with the money you save !

  • bettie

    I have just finished paying off over 12 thousand dollars in debit. now only have a few small bill to pay which can be done one or two amonth

  • KarenB

    I am having significant trouble with my budget. All of my fixed costs (rent, medical bills, school loans, etc) are making my essentials too high. Much higher than 50%. The good thing is that I am not THAT much over on my budget, but I am still over. I need help.