If you don’t currently have a budget, I strongly recommend that you create one immediately. A budget can be simple or complex. At its most basic, it just reflects the income you are earning and what you spend money on (your expenses).
And with a new year on the horizon, now’s the perfect time to start doing your homework so you’ll be able to hit the ground running when the calendar flips.
The most important reason to get on a budget is this: If you don’t have any idea of what’s coming in and what’s going out, there is no room for maximizing what’s left over—the building blocks of your long-term wealth.
Let’s start with the ABCs of budgeting. Many people like to begin with the 50/30/20 rule. Simply, this rule says, “Allocate your monthly after-tax income into three categories: 50% for needs, 30% for wants, and 20% for savings and debt repayment.”
Needs = essentials such as a mortgage, utilities, and minimum debt payments.
Wants = discretionary spending on things like entertainment, clothes, gifts, and eating out.
Savings = financial goals, including an emergency fund, retirement, or getting rid of debt by paying more than the minimum payments.
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5 Easy Steps to Create a Budget
1. Calculate your net income.
Most of us have a steady paycheck. But 7.4% of us are independent contractors (like me), working on commission or by the job, so our income varies month to month. If that is your situation, you can just take the last two years of your income, divide it by 24, and you’ll have your average monthly earnings.
2. List your monthly expenses.
This may be an eye-opener for you. It’s really easy to stop by Starbucks and spend $5-$6 a day on coffee or buy those tempting items you see while waiting in line at the store. But when you begin to track every penny you spend, I guarantee that you will be amazed at how much money you are wasting!
Find out just what you are buying. The best way to figure this out is to keep a record of all your expenses for a minimum of one month. Write it all down: $5 at Starbucks, $10 at the grocery store for impulse buys (that’s why you need to make a grocery list before you go shopping!), $24.99 for Netflix, $80 for your hair cut and style, $40 for that scarf you didn’t need, utilities, auto and health insurance, gas, auto repair, HVAC tune-up, childcare, gym memberships, dining out, entertainment, and loan and mortgage payments—yes, write it all down—no matter how small!
3. Note which expenses are fixed and which are variable.
Fixed expenses are just like they sound: You have to pay them. These are bills like rent/mortgage, utilities, transportation, insurance, food, and car loans. Variable expenses are items that you may not need, like your daily Starbucks run, eating out three times a week, the gym membership that you don’t use, the multiple streaming services you have accumulated, or those regular shopping sprees to make you feel better. In other words, these are the expenses that you have the opportunity to reduce or eliminate completely, which can be the source of your new savings/investing initiative.
4. Determine your average monthly costs for each expense.
Your fixed expenses should be about the same each month, but things like groceries and utilities may vary. So, if you have the patience, look at your checking account and see how much you’ve spent on these items in the last year, and average them out. Then put that number into your budget. Some months you’ll be ahead and some you won’t.
5. Make adjustments as needed.
If you’re spending more than you are earning, you’ll need to take a hard look at your expenses and find some that you can reduce or eliminate completely. You want to make sure you have some of your earnings left after your monthly expenses.
You don’t have to make creating a budget a nightmare of spreadsheets. There are plenty of budgeting apps that you can use on your phone. Forbes just rated these apps as the best for budgeting:
Nerdwallet also offers this spreadsheet as a way to get started.
Once you’ve come this far and now have a strong sense of your financial status, there are two more steps to take in completing your budget process:
Prepare for the unexpected.
You know it will happen! It seems that every month, there is some unexpected expense. Last month, my dryer, my computer (only 1 ½ years old!) and my vacuum cleaner broke—all in one week! Thank goodness I had my emergency fund handy. And that’s what you need to first fund with your extra money (after regular expenses are allocated). According to a recent survey from Bankrate.com, less than half (46%) of Americans have enough emergency savings to cover three months of expenses. Just 30% of people have some emergency savings but not enough to cover three months’ expenses, and 24% have no emergency savings at all.
Historically, experts have advised that you have three to six months’ worth of living expenses in your rainy-day fund. But our experience with COVID-19 has unfortunately shown us that our emergency funds should probably cover at least one year’s expenses.
Dedicate a portion of your extra monthly funds to investing.
When I worked for big corporations, I enrolled in their 401(k) plan as soon as possible. And every time I received a raise, I allocated half of the extra to my retirement savings. That’s an easy way to automate saving for retirement, but it’s not your only option. You can start contributing to an IRA or, if you’re saving for something other than retirement, you can begin funding an individual brokerage account and start investing in stocks.
Once you’ve got your monthly expenses under control and can focus on saving for the future, you can start prioritizing investing to meet your long-term financial goals, and if you need some help there, consider joining the Cabot Money Club for stock picks, ETF insights, and more.
This post has been excerpted from a recent issue of Cabot Money Club Magazine, to read the full article and for access to past articles, join Cabot Money Club today.
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