Having an effective budget prevents you from going into debt and makes it easier to pay for unexpected costs or spontaneous purchases. From a long-term perspective, proper budgeting helps you achieve big savings goals such as buying a car or home or paying for a child’s college tuition.
While some people find budgeting tiresome, the truth is it actually gives you freedom. Once an expense has been budgeted for, any guilt associated with that expense disappears. And if you’re really successful at saving money, you’ll have more freedom in the long run to achieve your big financial goals.
If you approach making a budget step-by-step, it doesn't need to be overwhelming. Here are our 10 essential steps to planning an effective budget to save money:
1. Calculate your monthly income
The first step to budgeting is to calculate your household’s monthly post-tax income (also known as ‘take-home pay’). Take-home pay consists of gross income minus deductions. To begin, gather your pay checks and financial statements so that you've got all the documents you need to work with.
Your gross income consists of:
- Income earned from work (monthly salary, plus tips and overtime if applicable)
- Investments, such as dividends and interest
Deductions may include:
- Federal, state and local income taxes
- Medicare and social security taxes
- Insurance payments
- Retirement contributions
- Some medical and dental expenses
- Legal obligations, such as child support or wage garnishments
The recent geopolitical situation caused havoc with people’s income, so you’ll need to regularly revisit this if your financial picture has changed. Has your income been cut? Have you or any other member of your household been furloughed? Have bonuses been cancelled this year? If the answer to any of these questions is yes, then your income will obviously be affected.
2. List your fixed monthly expenses
The next step is to note down your fixed expenses. Fixed expenses cost the same (or almost the same) each month, making them fairly easy to budget for.
Typical fixed monthly expenses for households include:
- Mortgage/rent payments
- Real estate taxes
- Car payments
- Insurance premiums
- Utility bills, such as cell phone, electricity, and water (while these may vary from month to month, they can be considered fixed costs if they are fairly predictable)
Don’t forget to factor in fixed quarterly, semi-annual, or annual expenses such as:
- Property taxes
- Insurance (if you pay annually)
- Scheduled vehicle maintenance
- Gym membership (if you pay once or twice per year)
3. Know your variable expenses
Variable expenses include anything that isn’t a fixed cost. Most of us are conscious about grocery costs, but it can be easy to lose track of other expenses – especially if you have lots of them.
Common variable expenses include:
- Gas / public transportation
- Clothing and shoes
- Entertainment and dining out
4. Divide your expenses into needs and wants
The next step is to prioritize your spending, which you can do by dividing expenses into needs and wants. (You can have more categories if you’d like, but the simpler the better).
Your needs are all your essential items. These include:
- Basic groceries
- Electricity and water
- Mortgage / rent payments
- Other debt payments (e.g. car)
- Cell and internet (these are essential if you or members of your household use the internet for work / studies)
- Insurance payments
- Gas / public transport expenses for getting to work / essential appointments
Your wants are everything else – anything you can live without. These include:
- Morning coffee
- Gym membership
- Gas / public transport expenses for getting to non-essential things.
If something good has come from the past couple of months, it’s the opportunity to spend less on wants (and even some needs). Working from home means spending less on gas, while lockdowns and closures naturally lead to eating out less often. On the flipside, you might find yourself spending more on home entertainment options, such as Netflix.
When preparing budgeting, think carefully about which wants you can discard.
5. Set savings goals
Now that you have a handle on your income and expenses, it’s time to set some savings goals. Statements like ‘I'd like to save more money' are too vague to be useful. It's good to have both short-term and long-term savings goals. That way, you can feel a sense of achievement when you reach the short-term goals but also ensure you're able to finance life's major milestones – such as buying a house.
Short-term goals can include:
- Taking a vacation
- Paying off debt
- Making home improvements or repairs
Long-term goals can include:
- Buying a house
- Paying for a child’s college tuition
- Putting aside money for retirement
6. Create savings rules
The key to achieving your savings goals is to set realistic savings rules. For most people, saving half of your take-home pay just isn’t realistic. After all, you have needs and wants to pay for.
Here are a few popular savings rules of thumb to consider:
- 50/30/20 rule. Allocate 50% of take-home pay to needs (e.g. mortgage/rent, loan repayments, food, electricity); 30% to wants (e.g. entertainment, social outings); and 20% to savings.
- 50/15/5 rule. Allocate 50% of post-tax income to needs, 15% of pre-tax income (including employer contributions) to retirement, 5% of take-home pay into short-term savings for emergency expenses, and the remainder to whatever you want.
- Savings first. When you get paid, put a fixed percentage of your salary into savings before worrying about other expenses. By prioritizing savings, you improve the likelihood of reaching long-term savings goals and give yourself an incentive to be more disciplined with the money that’s left over for expenses.
7. Open a savings or investment account
If you don’t already have a savings or investment account, then it’s time to open one. Average yields on savings accounts are very low right now due to the Fed’s decision to reduce its benchmark rate to near-zero back in March 2020. However, a savings account remains the safest bet if you are just starting out investing small amounts of money, plus you can access the funds in the event of an emergency. A certificate of deposit also gives you a guaranteed rate, although you’ll need to lock your money away for a fixed amount of time (e.g. 3 months, 3 years).
The more you put into your savings account, the more interest you earn. And, thanks to the miracle that is compound interest (interest on interest), your earnings will increase every month and year.
Let’s say you put $5,000 in a new savings account and set up a direct deposit of $200 per month. At annual interest of 0.8% (the highest market rates available in September 2020), you would earn:
- $48.97 in year one
- $68.63 in year two
- $88.45 in year three, and so on…
8. Create your budget
Now you’re ready to put your budget down on paper (or on screen). You can use an online (or offline) spreadsheet or money-saving app to get budget templates that make this step faster and easier.
Thanks to the work you’ve done up till now, writing your budget should be simple. You’ll just record how much is spent on your needs each month, decide how much to allocate to your wants, and choose how much to save. You’ll need to allow space to note down how much you actually spent in each category, as well as how much you intend to spend.
If your budget adds up to more than your available monthly income, then you’ll need to review it. You might need to cut down some of your wants or find ways to spend less on your needs, or you might have to reduce the amount that you save each month.
9. Leave space for unforeseen expenses
A savings account can help you in the event of an emergency, but you don’t want to be dipping into it every time a small expense comes up unexpectedly. The truth about budgeting is that you can’t foresee every expense. Sometimes things come up that you didn’t plan for, like contributing $5 to a colleague’s leaving gift or buying flowers for a loved one.
When preparing your budget, you can account for small, unexpected expenses by putting aside a small amount (e.g. $50) under “miscellaneous”.
10. Review your budget regularly
Making a budget isn’t something you can just set and forget. Life doesn’t stand still, and neither do your finances. It’s best to review your budget every year or even half-year. In that time, you could get a raise or find yourself furloughed from work, inherit a large sum or suddenly have to pay an unexpected bill. There are many ways your financial situation could change and when that happens, your budget needs to reflect these changes.
Use Your Budget Wisely
Now that you’ve mastered the art of budgeting, you’re halfway to your savings goals. The real challenge isn’t making the budget, but sticking to it in the long term. Once you have a budget, you can get started on meeting your savings goals.