A budget method sets out how an individual, company, or organization plans to spend money over a period of time. Budgeting methods vary by needs, but a failure to budget is a quick path to long-lasting debt problems.
The process constitutes a critical part of your financial plan. Yet, nearly one in every three respondents of a 2019 survey admitted to not preparing a budget. Though not a majority, the proportion of those who live without a budget is sizable. It also speaks to some concerning statistics regarding overall financial awareness, even among those with well-paying jobs or income sources.
Here Are A Few Shocking Financial Statistics:
- Nearly 80 percent of individuals facing financial problems earned at least $40,000 per year or otherwise were not living below the poverty line.
- Approximately 37 percent of those with annual salaries of $50,000 or higher report living from paycheck to paycheck. Nine percent of those who struggle to meet monthly expenses earned at least $100,000 per year.
The Stakes In Not Using A Budgeting Method
As we explain below, the monthly budget process helps you identify where you spend or may have to spend money. If you don’t grasp the dollar amounts necessary to live, drive, or maintain a home, you might fall into bad spending habits that deplete your funds and leave you unable to address the essentials.
When those necessary items arise, you may gravitate to credit cards or using retirement funds or savings accounts to make ends meet.
Lower Credit Scores
The accumulation of debt brings more than added monthly spending obligations. As you become more reliant upon debt, you can drive down your credit score. Nearly 30 percent of the credit score used by mortgage companies, employers, landlords, and others comes from your “credit utilization rate.” This figure is the total balance of your credit cards divided by the credit limits (or borrowing limits) of your credit card accounts. Generally, strive to keep the credit utilization rate below 30 percent.
As you use credit cards with a high-interest rate, your monthly payments increase. This increases the risk you will incur late payments and perhaps default on credit cards or other obligations, such as student loans, mortgages, or car loans. Your payment history accounts for 35 percent of your credit score.
Missing payments places you in default on your loans or credit cards. Defaulting on a mortgage will subject you to foreclosure, and missing car payments lead to repossessions and deficiency judgments. Creditors, including card issuers or collection agencies, can institute or threaten lawsuits.
The specter of collection litigation may contribute to bankruptcies. As it relates to budgeting, an estimated 44 percent of study participants cited spending above means as a factor in filing bankruptcy. Unaffordable mortgages and foreclosures contributed to 45 percent of bankruptcy filing decisions. At nearly 78 percent, loss of income ranked as the highest contributor to bankruptcies.
When you budget, you probably will find yourself taking savings seriously. As mentioned above, the loss of income constitutes the biggest factor in bankruptcy filings. A healthy savings account and emergency savings can lessen the sting of a job loss or significant cut in pay and delay events such as foreclosures, repossessions, or bankruptcies. Plus, you can address unexpected financial emergencies without having to charge your credit card.
Through budgeting, you can plan for retirement or higher education savings by creating better financial habits.
As shown by statistics and studies, many Americans do not significantly include savings in their financial plan:
- By a 2017 report, at least three out of every ten Americans saved less than $500 for emergencies.
According to a survey, nearly seven out of ten have less than $1,000 in a savings account, with approximately 45 percent of the respondents having a zero balance.
- Forty-two percent do not save for retirement. Only about a tenth of Americans put aside the recommended 15 percent of income for retirement savings.
Future Marital Discord And Relationship Problems
Money issues can disrupt wedded bliss. Studies generally rank finances as either the leading or second leading cause of divorce and other marital conflicts. Seven out of every ten couples rank money as the top argument among spouses. Nearly 35 percent of couples attribute money and poor financial health to discord in the marriage.
Establishing and following a personal budget can lessen anxiety over paying bills and covering household expenses. When you craft a financial plan with your spouse, you also promote openness and communication. The personal accountability that comes with budgeting tends to discourage financial infidelity, which manifests itself in secret spending and hiding earnings.
The deception may become unraveled when a spouse discovers unfamiliar purchases or bills on a bank account statement, a checking account with a zero or negative balance or collection, eviction, or foreclosure notices which suddenly fill the mailbox.
The Essentials Of A Proper Budgeting Method
Below, we will discuss various alternative budgets. Whatever your budgeting strategy, a few general budget categories and principles should guide your approach.
Mandatory Expenses In Your Monthly Budget
Normally, any budget plan includes a category for necessary expenses — items for which you must pay each month. In this spending category, you will find expenses imposed by law and contractual obligations for debt repayment. Mandatory expenses also include essentials for living. Below are typically mandatory or essential, budgeted categories in your budget:
- Mortgage payment
- Vehicle loan payment
- Student loan payment
- Credit card debt payments
- Homeowners and Vehicle Insurance
- Vehicle registration fees
- Child support
- Power, water, and other utility bills
A Budgeting Method With Discretionary Expenses
You may consider discretionary expenses to be “wants” as opposed to needs. That is, you do not have to spend on these items to live or satisfy your debt or government-imposed financial obligations. Within the discretionary set lie items such as:
- Cable, satellite, or streaming television services
- Personal care from a salon, barber, or beautician
- Movies, plays, concerts
- Magazine subscriptions
- Video games
Those items that generally are mandatory have discretionary elements. While you must have food to survive, it does not have to come from a restaurant. Many types of foods, especially pricier ones, do not qualify as essentials. You can hardly go without clothes, but name brands and designer outfits and separates are not mandatory expenses.
Budget Targets For Fixed Expenses
Your budget consists of many expenses for which you can prepare ahead of time. The fixed expected costs do not change when they become due. Some of these, such as student loan payments, mortgage, insurance premiums, and vehicle loan payments, are also mandatory.
The bills for cable, satellite, streaming services, and magazine subscriptions typically have fixed payments as well.
Variable, or irregular expenses, in your budget likely will fluctuate. Your electricity and water bills depend upon how much of these utilities you use each month. Especially extremes in temperatures or prolonged periods of hot or cold weather cause higher than anticipated heating or air conditioning use.
Transportation expenses also vary by month. The culprits of differing and perhaps unpredictable figures include gas prices. Political turmoil in oil-producing regions, economic conditions, natural disasters that disrupt oil refineries, and seasonal changes in oil consumption can drive the cost of gas upward or downward.
You likely increase spending on gifts during the Christmas and Holiday seasons, while your budget in summer months might take into account spending money on lodging, airfare, increased driving, meals, and vacation spending.
In many, but not all cases, variable expenses bring room for your discretion — even if the budget category is mandatory. Navigating the highs and lows of gas prices may mean less driving. You might limit the spending money for vacations, gifts, and other wants. Even with necessities such as food and utilities, less consumption might lower the total costs.
Times Of The Year
We’ve already touched upon seasonal costs such as holiday gifts or summer vacations. Your budgeting strategy should take into consideration those obligations that rear themselves periodically. Insurance premiums may come due every six months or one year. Figure into your budget, inspection and registration fees, and property taxes you pay once every year.
Planning For The Future
A sound financial plan should include long term savings.
Your savings goal or goals may consist of:
- College for yourself or children
- Future home purchases
Use Calculators To Estimate Future Expenses
What you will need to pay for college or a home depends on the school or kind of home you seek. Sites such as College Board provide online college cost calculators to gauge the price tag of particular institutions to which you aspire. These and other calculators afford a glimpse of how big you need to build the nest egg for higher education and the amount of money you need to set aside monthly for college.
In particular, use 529 College Savings Plan calculators for the amount you need to set aside monthly. These plans allow you to save money tax-free, so long as the money goes to eligible college expenses.
Use Cash To Your Advantage
In buying a home, you likely do not need to save for the entire purchase price. Being able to make a down payment is the primary savings goal as a home buyer. Under the U.S. Department of Housing and Urban Development, programs allow you a mortgage with down payments as small as 3.5 percent of the purchase.
As to retirement, your current and anticipated future financial situation may guide what you need to budget each month for savings. Depending on the expert or financial advisor, you may need to save aside 80 percent to 90 percent of your yearly pre-retirement income, a million dollars, or 12 times your pre-retirement pay. A commonly-invoked rule of thumb calls for you to save 15 percent of your income for retirement. Online retirement calculators can help you decide the amount to save for various purposes.
When you budget for retirement, list the expected sources of income. Besides what you might set aside in a retirement account, look at your 401(k) plan and what you might fetch monthly from Social Security. When you create an account through the Social Security Administration, you can calculate your anticipated monthly retirement benefits at either age 62 or age 70.
As a rule of thumb, your emergency fund should contain enough to meet three to six months of living expenses. This becomes important if you lose your job or become unable to work.
The Budgeting Methods – Your Definitive Guide For All Types Of Budgets
The Traditional Budget: Income Less Expenses (Basic Budgeting Method)
The traditional way is a budgeting technique rooted in the business and corporate world. For those of you with the time, orientation to details, and analytics, a traditional budget method can serve your personal financial management.
Unlike most systems, the traditional budget system calls upon you to use a prior period’s (either year or month) income and expense figures in planning the next month or year. You subtract the expenses from your take-home income, or dollars you place in the checking account or a savings account from which you can withdraw easily.
Choose Your Budgeting Style
You will find an Excel application, Google Sheets, printable budget template, or budgeting app program beneficial to use traditional budgeting. You list your take-home pay and other income you received in the period. If you’re basing the budget on a year, find your W-2 form and subtract the taxes withheld for the state, federal, FICA (Medicare), and Social Security from the gross income. You might consider the Social Security gross salary and wages. As an easier approach, use your final pay stub for the calendar year or total the paystubs in the particular previous month.
Create on your Excel spreadsheet a list of expenditures you commonly spend on each month. You might have debt payments such as mortgage, car, student loan debt, and credit cards. Other categories of expenses include transportation, food, clothing, utilities, entertainment, television, and other media and insurance.
Track Your Expenses
Your ability to track expenses by type is important to the usefulness of the traditional budgeting technique. Check with your bank for options to get spending reports. Several apps also accomplish this goal. On a daily or regular basis, you might wish to record and label your Excel spreadsheet expenses.
With this type of budget, you can easily see what you brought in with the traditional way, what you spent, and what you have left. This approach prompts you to examine where you may need or wish to trim spending — especially if you’re running at or close to deficits each month or lack the funds to save or accomplish other financial goals. For example, you might see opportunities to lower food expenses by:
- Using store-label or generic brand groceries rather than national name brands
- Cooking more and eating out less
- Opting for water instead of sodas at the restaurant
With eating out in particular, a family of four might lower the restaurant bill by at least eight dollars by not ordering sodas. At many restaurants, sodas run north of $2.00.
Change Your Shopping Habits
Certain shopping habits might promote less driving and, thus, lower gas bills. Consider online ordering, especially if you can avoid shipping and handling charges. Take inventory of your grocery stock and plan meals so that you reduce the number of times you need a grocery store run. Grocery store trips to buy one or two items for a meal takes gas. If you need to supply something in your home, consider going while you are already out of the home, perhaps after work or while performing another errand.
Speaking of groceries, take note of what already occupies your cupboard and refrigerator. Keep note if you are constantly replacing food or other items that have spoiled.
The use of your historical data leads can support your efforts at incremental budgeting. This approach calls for usually a modest upward adjustment in spending. If you retained data over several periods, you might compute the average increase in categories over a particular period. Incremental budgeting may help you recognize economic conditions that can increase your costs of particular items.
The disadvantages of this approach lie chiefly in the lack of analysis of spending habits and priorities. If your income is not stable, you find yourself not addressing more fundamental issues in your financial condition.
Zero Based Budgeting Method: AKA Zero-Sum Budget
The zero-based budgeting technique promotes discipline and careful tracking of your spending. In this approach, you give every single dollar that you bring home a task. Since you account for every dollar of income, you should not have any money left over in your budget at the end of the month.
Here, you don’t simply rely upon expense categories. Using a general budget category, such as food, might guide your zero-based budget. However, you would identify specific categories for food spending with this method and then allocate money to it.
Below is an example of a zero-based budgeting system for a particular month:
Total Monthly Income: $3,000.00
- Rent – $700.00
- Electrical – $100.00
- Water – $50.00
- Cable and Internet – $175.00
- Wireless/Cell Phone – $200.00
- Grocery Shopping – $400.00
- Dine out – $75.00
- Car Payment – $200.00
- Gasoline – $200.00
- Car Insurance – $150.00
- My Credit Card 1 – $75.00
- My Credit Card 2 – $100.00
- Doctor’s Visit – $25.00
- Church Offering – $100.00
- Deposit to Savings Account – $450.00
(=)Total Expenses $3,000.00
You have all of your $3,000 in take-home pay allocated to various expenses and items in this example.
The zero-based method might not involve as much detail and time, as you think. Remember that you have many fixed expenses such as mortgage or rent, student loan payments, car payments, wireless phone bills, and cable bills. You can plug in certain one-time or normally non-recurring expenditures in your zero-based budgeting, such as an insurance premium, a medical appointment copay, scheduled oil change, and oil change.
With this budgeting strategy, you have to examine priorities in light of mandatory expenses that do not arise monthly. The one-time mandatory or essential items may take funds from discretionary ones for that month. In other words, you may have to forego some restaurant trips or vacation to pay insurance.
Proportional Budgeting Systems
In a proportional budget, you devote a certain amount of your income each month to specific categories. Unlike the zero-based method, you focus less on specific items. Instead, general areas of expenses guide the budgeting process.
The 50 30 20 Budget Method
Many proportional approaches allocate fifty-cents of every single dollar to the mandatory expenses. You use 20 percent of your after-tax income for items such as retirement or educational savings, a fund to handle car or home repairs, a sudden job loss, and other emergencies. In other words, the 50/20/30 method calls for you to treat 20 percent of your take-home pay as generally untouchable except for emergencies and paying extra on your debts. The remaining 30 percent goes to your wants.
Suppose you have a monthly after-tax income of $3,000. In the 50/20/30 budget, you distribute your money as follows:
- (50%) Essentials: $1,500
- (20%) Savings, Retirement, Emergency-Fund: $600
- (30%) Discretionary: $900
The 50/20/30 method carries the advantage of making you think about savings and emergency funds. When you budget for especially emergencies, you more likely than not will resist the temptation to incur credit card debt for repairs, meet unexpected expenses, or handle a drop of income.
However, this approach calls for you to make perhaps unrealistic assumptions about your financial condition. If you have a low income, the pitfall of the 50/30/20 method of budgeting lies in the fact that your essential expenses likely climb above the 50 percent called for in this technique. That means you likely must reduce much of your discretionary spending, and your ability to build a nest-egg for emergencies or other future goals is limited. Those with greater means might yield to the temptation to overspend on luxuries.
The 60/40 Budgeting Style
The one-time MSN Money Editor-in-Chief Richard Jenkins developed another proportional budget. In the 60/40 approach, you spend 60 percent of your net income on committed expenses. This categorization of spending includes mandatory expenses and non-essentials to which you commit.
By treating them as committed, your discretionary items in effect become somewhat “mandatory.” Of course, if you see some of the committed expenses busting the budget, you can eliminate them or find lower-cost alternatives.
With the remaining 40 percent, you allocate savings and money that might not have any utility beyond “fun.” You distribute these funds in 10 percent increments among perhaps three 401(k) or retirement plans, including a tax-free one. In developing his budgeting plan, Jenkins expressed a strong preference for saving well above the recommended five percent of income.
With enough income and an ability to shave expenses from your committed expense, you might reach significant savings goals and future spending power in a small number of years.
Proportional Budgets For Would-Be Homeowners
Banks and other mortgage lenders use a variety of percentage or proportional budgeting in loan underwriting. If you’re planning to buy a home, your monthly debt payments should not exceed 43 percent of gross (pretax) monthly income. In calculating this debt-to-income ratio, you include car loans, student loans, credit card debt, and the anticipated monthly mortgage payment in debt. If, for instance, you have a monthly gross income of $6,000, your debt payments should stay at or below $2,580 per month.
Also, consider the cost of maintaining your home. Some financial or home experts suggest budgeting one percent of your home’s price for maintenance, as we discussed above. Other advisors include maintenance costs with mortgage payments to recommend that your housing costs do not exceed one-fourth of your income.
Reverse Budgeting: AKA Pay Yourself First Budget
A budgeting technique, such as a proportional budget, stresses the value of saving money. Reverse budgeting takes that a step further by making saving the top priority. Most budgets have you start with mandatory expenses such as debt payments, food, and utilities. When you put the budget in reverse, you first decide how much to save and then treat the remainder of your income as available for expenditures.
With its focus upon savings, reverse budgeting users should have in mind short-term and even long-term savings goals. If you’re planning to buy a home or car or save a certain amount for college or retirement, start the process with an estimation of the cost of the particular benchmark. You may also use online savings calendars or consult with financial advisors to determine how much a savings account or investment fund will have based upon how much you contribute monthly.
Envelope Budget AKA Cash Envelope Method
Many budgeting techniques focus on determining how much to spend on particular categories depending on your financial goals. With the cash envelope system, you’re mentally forcing yourself into a planned spending limit.
Specifically, you label envelopes according to spending categories. Your take-home play goes into particular envelopes based on what you have budgeted for the categories in its purest form. To that end, you might use some of the methods we’ve discussed, especially a proportional budget method, to decide how to allocate the money.
As you want or need to pay for something, you take money out of the envelope for that category and pay for the items with cash. A trip to the gas station means you draw from the transportation or gas envelope. When you buy groceries, take the envelope labeled food or groceries. Once you have emptied the envelope, you no longer spend on that category. With discipline and commitment, you resist the urge to borrow from another category.
The Cash Envelope System Works
The cash envelope system allows you to see how you spend your money specifically. To see that you have run out of money for a particular category, say food, becomes a stark reminder to choose less expensive menus or grocery brands. Having nothing left in the gas envelope may spark a change in driving habits.
Additionally, you’re more likely to avoid the complications that come with the seeming convenience of a debit card. As you are swiping or inserting the debit card, you might lose track of what you have left in the bank account unless you meticulously record transactions as they happen.
Even writing down your purchases and withdrawals consistently or instantaneously do not mean freedom from math errors. When you fail to record transactions accurately, you run the risk of overdrafts and attendant rejection of purchases, overdraft loans, and fees or bounced checks that can land you in legal jeopardy.
Using the cash envelope method for all of your monthly expenses might prove impractical because the main drawback is the time and organization it takes to retrieve cash from the bank on a monthly basis. This is especially the case when your creditors are out-of-town.
Plus, you might defeat the purpose of budgeting if you use gas to drive cash payments to the offices of your water, electric, cable, and waste collection providers. You might use the envelope for transportation, food, clothing, haircuts, and other goods or services offered in-store to solve that dilemma.
The Advantages Of Budgeting Will Change Your Financial Life
The budgeting method that works best for you is a personal preference and depends on your financial situation, financial goal, goals, and ability to be detail-oriented. Whatever you use to create your budget, the exercise of budgeting should enhance your financial literacy, help you find approaches to debt repayment and other financial goals, and afford you discipline and structure in your spending habits.
A successful budget involves total buy-in and a belief that you can achieve financial independence and finally fix your debt payoff problems. Chose one of these simple budgeting methods to take control of your financial future and reducing your overall money stress.