This post is part of the textbook personal finance series which covers basic personal finance skills by going through an actual textbook, chapter-by-chapter. Check out the intro post for more information.
In the last two sections, we looked at discovering your net worth and creating a cash flow statement. Both of these steps help you assess your financial situation—the big picture and the day-to-day. From figuring out where you are now, the textbook moves into concrete plans for the future: budgeting.
I’ve written about budgeting before. I’ve talked about how it’s different on an irregular income and how I findnot budgeting more frightening. But because it’s the next step in the book and the next logical step in what we’ve been reading. Plus, I’ll be working from the book’s approach, which is a little different from mine.
The textbook lays out seven main steps to building and keeping successful budgets.
Step 1. Set Financial Goals
I like that the book starts here. Rather than thinking of your budget as a tool to rein in your spending the book encourages you to think of it as a way to achieve your financial (and other) goals. Sure, it covers things you’d have to pay for anyway, like rent, but what you spend and where you spend it has an effect on how you live now and how you’ll live in the future. Your budget is what gets you to the future you want.
Step 2. Estimate Income
If you have your cash flow statement on hand, it should be easy to estimate your monthly income. Remember that this may change at times if you’re paid biweekly (in which case you should have several months with three pay periods instead of two).
If you’re a freelance or someone with a highly irregular income, start with a low estimate based on the least you’ve earned in a month in the last six months.
Step 3. Budget an Emergency Fund and Savings
I’d forgotten that the book prioritized the emergency fund and savings, paying yourself first. It suggests having three to six months of living expenses on hand. Set a date when you want to have finished saving your emergency fund as well as a goal for the fund. Then divide the amount by the number of months to go until you want to have that saved. Add it to your budget.
If you already have an emergency fund, take this opportunity to budget for other financial goals.
Why put this first? Otherwise it may get lost in the other expenses and despite having a budget you may end up living paycheck to paycheck.
Step 4. Budget Fixed Expenses
Again, if you have your cash flow statement, it’ll be easy to write down your fixed expenses. Otherwise, look over your last few months of bank statements and get the numbers for things like rent/mortgage, any regular loan repayments, insurance payments, etc. You may want to split an annual insurance payment into monthly portions and put them aside for the end of the year.
Step 5. Budget Variable Expenses
Now that you’ve budgeted for your future and set down your fixed expenses, the rest of your income goes into variable expenses. It’s harder to budget for variable expenses at first, but each month you learn more and more about your spending habits.
Step 6. Record Spending Amounts
A budget doesn’t do you much good unless you record your income and expenses. The free [download#13#nohits] I created has a section for this up front. At the end of the month, find out what kind of variance you had. If you had a surplus, that’s great—put it toward a goal. If you had a deficit, look for places where you can cut back next month. It may be necessary to revise your spending or, if your income has dropped, to revise your financial goals (or find more income).
Step 7. Review Spending and Saving Patterns
You’ll get the most out of a budget if you review not just at the end of every month but if you look over a few months of budgeting every quarter of so. Are you still on progress? Areas where you’re consistently falling short? Or are you doing just what you expected to?
A good spending plan is well-planned (not just thrown together), realistic (based on your current income and needs), flexible (we budget a bit to a car fund each month just in case), and clearly-communicated to all spenders in the household.
I used this chapter to create my first real budget back in college. If you want a budget spreadsheet that grew out of that original budget, check out my free, downloadable [download#13#nohits].