Personal Finance Step 4 – Set Up A Budget

Did you already set up a budget you track and stick to? If not that is ok. I’ll help you build a simple budget to get you started on the path to financial independence. you update each month to track how you are spending your money?

If you do that is perfect and you are on your way to understanding your finances. If you don’t have a budget that is fine too since we’ll be working below to build one. I honestly don’t expect every person outside of the finance or accounting profession to have a budget they keep up with. Everyone needs to set up a budget but so few people have one they manage to despite the advantages.

You Need A Budget and To Track It

You know this or you wouldn’t be reading a blog like mine. Everyone needs to set up a budget and track it. Initially it might need to be very specific and tracked weekly to stay on the path. Eventually you might be able to keep the categories loose and track it quarterly. Find what works best for you.

Wait… I want to start at the beginning.
Link to the previous step – Step 3: Income Statement

Quick Note

The guidelines below on how to set up a budget is what worked for me and designed for simplicity in construction, tracking, and updating.  This may or may not work for your situation but is worth a shot.  If your personal situation is dire financially, there might be other programs available on the internet better in tune with your needs. 

Dave Ramsay’s seven baby steps is a very popular system for getting out of debt and returning your finances to a more manageable situation.  While I don’t personally agree with the entirety of the program, the initial steps employed to rapidly reduce debt are worth exploring if that is your primary goal at first.

Eww, a budget ?

Budgeting, in common use, has seemed to take on a negative connotation for some reason. Mention your budget for some category of spending to your friends and family and you’ll get at least one negative reaction in some degree.  Part of the misconception stems from viewing budgets as restricting your fun or a life of deprivation when a well-made budget can have allowances for all of the frivolities of life.  The fact that a vacation, new toy, or splurge was included in the budget hardly diminishes the enjoyment of the experience.

Similar to telling people you are on a diet, I think people wrongly assume that if you are on a budget there must be something financially wrong in your life to warrant such an action when, in reality, it is simply a healthy way to take control of your financial life.  The average person is unlikely to get to their goal weight without a proper plan, so planning your path to financial independence should be viewed as no different. 

A budget is not a diet

Budgeting, to me, isn’t an exercise in deprivation that tells me where I can and cannot spend my money.  It is a tool for me to easily and quickly see where my money is going so that I can make sure it is going to the places that provide us with the most value every month.  A budget isn’t used to tell  you that you can’t go out to eat this month or that you can’t buy that new board game you really want.  It provides guardrails and accountability to your spending so that you can stay on track and know your money is working for you. 

If you’ve ever looked at your bank account at the end of the month and see the same balance even though you know you got paid a couple times and honestly can’t recall where it all went then a budget is for you.  It isn’t deprivation.  It is empowering to know exactly where your money went each month and lets you sleep well at night knowing you’ll have enough to meet your basic needs and achieve your goals in life.

We still agree?

I’ll assume that if you are still reading this far down you agree with the need to set up a budget and compiled your historical transactions into an income statement in the previous steps along this path.  So let’s build our first monthly budget to see where we are starting this journey.

First Step: how much do you spend on average?

Trying to set up a budget from scratch for a person’s life we aren’t familiar with would be difficult. I’ve done one for family in the past this way, but that isn’t what we are doing here.  We already know what you spend on average for various categories thanks to the work we did in previous steps.  We already know how your personal income statement should look so the first step is filling out your income statement budget with the prior 3 to 6 month average spending and income. Go ahead and exclude any known one-time expenses that might be skewing the averages (like a car repair or annual dues).

Now do the math

Now that we filled out our budget with the average income and expenses, do the math and see if you have money left over at the end of the month.  Do you? If so that is a good start, but don’t celebrate yet.  Is your net income negative at the end of the month using these numbers? We need to start looking at the expense lines and adjust our budget. 

Start with the items near the end of the priority listing we used for sorting and start adjusting them down within reason until your net income is positive.  Order of budget cutting: non-essential spending, essential spending, then bills.  Finally see some clearance in your cash flow with the changes?  Perfect, move on to the next step.

Income – Expenses positive now?

Once we set up a budget to have a positive net amount at the end of the month we will have some extra cash to save. Ask yourself if that amount of savings at the end of the month is enough for your long or short term goals? Having five extra dollars at the end of the month is an achievement if that previously was not the case but it’ll take a very long time to build an emergency fund let alone a retirement nest egg at that pace. 

You may not be able to immediately pump up the savings rate though and that is ok. Just keeping that goal in mind goes a long way to slowly building it up over time.  Small improvements make a big difference.  Is the amount left over enough for your plans?  Good, keep this process moving.  Are you still a little short? Maybe review the budgeted expenses one more time to see if there are any further adjustments that can be made.

What if my number still isn’t right?

If you need ideas on how to cut expenses and live a more frugal lifestyle without feeling deprived, a quick google search will find dozens and dozens of blogs more than willing to guide you through some of the better suggestions.  The solution may not be as stark as only eating rice, beans, and ramen in the dark reading books borrowed from the library. Conversely, the solution might be to earn extra income through overtime or a side-hustle but I think this should be a last resort compared to the expense reduction.  It is harder to achieve for most people and generally not good advice to attempt to out-earn your bad spending habits if you still have expenses that could reasonably be reduced.

Reality check on the new budget

Stop right here and look at your revised monthly budget compared to your historical average spending in those categories. Do the new amounts even make sense?  Are they reasonable changes? Just because you have been spending a certain amount on average each month for a category doesn’t mean that you should continue doing so.  Make sure you set up a budget that makes sense.

We are all guilty of setting some spending habits on auto-pilot and never revisiting them in the future when they are no longer necessary.  Quick examples include a gym membership not getting enough use, a streaming service you hardly watch, dining out more frequently than needed, and buying a lot of clothing relegated to the back of your closet. 

Perhaps you still need those things or plan on increasing their usage rates to justify the expense, the point is that it is important to periodically evaluate our spending habits to make sure they still align with our ultimate goal of becoming financially independent.

Avoid over-cutting expenses in your budget

Checking on revised budget amounts that still seem too high is one thing, but a mistake people often make when they set up a budget is cutting an expense too much. Often the cuts are either too much, too soon, or not reflective of the underlying drivers of that expense.

If you normally spend $2,000 a month on food and decide to cut that down to $600 a month because you are going to stop dining out as often as you used to, that is a good idea in theory. What if you don’t know how to cook or don’t have the proper cooking equipment? Cooking is a skill that I highly recommend to everyone but you might want to plan in some time to ramp down that expense as you get more comfortable cooking at home more often. 

Also, you need to be realistic in your cuts. If you’ve never had a month where you spent less than $300 on gasoline, it may not be reasonable to cut that budget to $50 after this exercise.  Cuts that dramatic can be difficult to maintain, especially on driver-based items like transportation expenses.  Are you planning on driving less in the future? No? Then how would your gas expense go down so dramatically?  It is fine to aspire to make such changes, you just need a plan to change the underlying drivers of those expenses to deploy those changes.

Google it

Do a Google search for what other people are spending on that category each month and find a handful of examples to compare your spending levels.  Some external context might be very helpful in determining the reasonableness of your budget.

Rinse and repeat

If the new budget goals look fine that is good news, keep moving along. If you still aren’t where you want to be when you set up a budget and leftover savings at the end of the month, keep looping through the review, adjust, calculate, review cycle until you find a place that works for you.  Don’t worry about getting it correct on the first try. This is a living document you’ll be making periodic adjustments to for the rest of your life in all likelihood.  It is not just ok, but expected, to make gradual changes over the first couple months if those adjustments make the new budget reality more palatable and ultimately more successful.

It is important that you have support for the changes you are implementing or you are just setting yourself up for failure.  Picking unreasonable short term spending goals and failing is a sure fire way to discourage yourself on this journey before you even leave the station.

Add ‘Savings’ as an expense to your budget

Once you determine how much you should have left over each month after all of your expenses clear, make that a budget line.  Make paying yourself (saving) as much of a priority as your bills. It is a lot harder to spend frivolously if you trick yourself into thinking you don’t have any money left over at the end of the month because you already transferred that to your savings account like paying a bill.

Don’t skip reviewing your current expenses

I can’t emphasize enough how important it is to not skip the step where you build what is functionally your current income statement on your quest to jump right to your ideal budget. You can’t set up a budget without the context. Knowing exactly where your money is currently coming from and going to is critical context to understand your current situation.  The current situation provides a set starting place for your financial journey where we can more readily see any improvements made after today. 

People need immediate, measurable, visible wins to stay motivated usually.  Too many early losses and many people will give up prematurely and often blame external issues or the environment (which can be a factor sometimes) without questioning if their plan might share the blame.  Imagine if you started a new weight loss plan and only gained weight for the first couple weeks.  I’m not sure how many people would stick to that plan even if they knew many people were very successful in the long run.

Stick to it, stick to it, stick to it

Finally, stick to the budget.  Also, stick to the budget.  It is important to stick to the new, reasonable budget as much as possible for at least a couple months to see how actual spending compares.  If a one-time expense hits and derails the budget, mark it as an anomaly and keep sticking to the remainder of the budget.  Abandoning the budget just because you go over one month is no way to achieve financial freedom.  If you need to, make small changes up or down to your budget lines to reach a workable equilibrium between saving and living your life. 

A crucial assumption in sticking to your budget is keeping track of your income and expenses versus your budget during this time period.  If you don’t measure a thing, it cannot be improved.  Track your budget variance whether it is “good” or “bad” every month. Consistently going over a budget is just as important to know and understand as consistently coming in under your budget on a line so you can make the appropriate adjustments.

Can’t someone do this for me?

The mechanics of how to track your budget is something that will probably be covered in more detail in another article, but since we built all of this in Excel or Google Sheets initially, it might be best to continue updating it there for the time being.  Online financial aggregators like Mint, Personal Capital, and YouNeedABudget do a good job as well but have their own pros and cons. 

Excel and Google Sheets are not particularly complicated to understand (for this use case at least) and offer the most customization for those starting out in the process. The granular view will hopefully become less necessary over time as you progress down the path to financial independence.

I highly recommend doing at least your first basic budget by hand in Excel or Google Sheets. Building it yourself from the pieces will really help you understand how it works. Understanding the framework will make what those aggregators provide all the more valuable to you. I personally use a combination of Mint and Personal Capital to track my spending and net worth today. I still have a budget I track in Excel each month as well.

Good work

Successful businesses and people have budgets. You need a budget. Once your life gets used to operating within a budget and you have more clearance in your monthly savings rate you might be able to further relax your strict adherence to the budget.  For now, stick to the budget.

TL;DR

You need to set up a budget and you need to stick to it. Start with what you currently spend and work your way backward, cutting expenses, until you meet your savings goals. Write it down, track it each month, and adjust as necessary.

Link to the next step – A Small Emergency Fund