Most would recognize a budget as an elementary concept, yet so few people know how to build and follow one. Understanding the dollars arriving in your bank account and leaving your bank account is the fundamental concept to financial planning and every decision you make hinges on the ability to manage this effectively. Follow these steps and be on your way to a better financial future.
1) Identify your Monthly Income
You may be saying “I already know what I make” but I’m telling you this step is of the utmost importance. You may think you make a few thousand a month but upon looking at your pay stub (or 1099 income if you’re not W2), that number may be less based on the deductions or taxes you’re paying.
It usually works best to use some sort of document to track this (most prefer a basic excel worksheet) and you can place net income at the top. Net income is what actually gets to your bank account after all your deductions are taken out. While it’s out of scope for this blog post, you may want to consider changing your withholding to adjust your net income depending on your tax situation—talk to a tax professional or financial adviser to determine the right choice for you.
Make sure you put the exact amount for the month so if you get paid twice per month, add up your net income from both paychecks (or multiple by 2) to get your net monthly income. Make sure you put all your income sources so if you make more than just your full-time W2 income, include that as well.
2) Identify your Monthly Required (Non-discretionary) Expenses
These expenses absolutely have to be paid every month. Examples include rent, utilities, student loans, and basic groceries. Make sure to account for required expenses that may not be monthly, for example oil changes or insurance premiums. For those expenses, just make sure you average them over the period of time they cover, so for example if it’s $420 for car insurance every 6 months, you’ll type $70 for your monthly expense.
You’ll want to total all of these monthly expenses to see the absolute minimum you need to spend every month to safely live. Here is an example of what you’ll see so far:
As we can see, the total here is $1,735 per month and the net income is $3,474, which brings us to the next step…
3) Analyze your Net Income minus your Total Non-discretionary Expenses
This is one of the most important (and absent) practices that people should do; understand the money you are bringing in versus what you need to spend. You may see that your required expenses are more than your net income and if this is the case, you should really focus on areas you can improve spending. Can you move to a cheaper apartment, find a roommate to help supplement the rent, or refinance a high-interest loan? Having required living expenses above your income level is dangerous and would need to be remediated as soon as possible.
Hopefully, you’re not in that situation and similar to the example I provided, you have an excess of income compared to required expenses. Let’s take a look at our example:
In this situation, we can see that there is an excess of $1,739 per month which tells us what additional dollars there are to allocate to different areas of your life.
4) Understand your Goals and Values
This task is one of the most difficult and subjective since every single person has different goals and objectives. Some of the common goals include saving for retirement so by looking at the excess income we have, for this person maybe we could decide to increase his or her 401k contribution or start an IRA/Roth IRA to start putting money away for that.
Another person could be interested in buying a home so maybe it makes sense to allocate a few hundred dollars towards a down payment for the next year and have it go to a separate savings account.
Finally, some people value enjoying/living their life today and as long as it’s financially feasible, it may make sense to dedicate a few hundred dollars to entertainment or dining out.
All of these decisions need to be made on an individual basis so at this step is the perfect opportunity for you to work with a financial adviser or do some soul searching to determine what matters in your life and put your money towards those values.
5) Set a Monthly Amount and Track it!
After determining what excess dollars you have and deciding where to allocate those, make sure you update your spreadsheet (or online tool) to include those discretionary expenses so you can be sure you’ve accounted for all of your expenses. This budget or cash flow projection is intended to be followed so setting it up is just as important as doing a monthly check in to ensure you’re staying on track and not overspending. Some of the following tools are popular in the marketplace if you’re not already working with a financial adviser:
· You Need A Budget (www.youneedabudget.com)
· Mint (www.mint.com)
· Your own personal bank (many banks now have alerts and/or budgeting tools built in the platform you already use for your banking)
While budgeting and cash flow management doesn’t seem overly enthralling, it is absolutely the core element to a financial plan that works for you and allows you to achieve your dreams. Good luck!