The budgeting process is not just a personal finance exercise. It’s also a self-discovery and goal prioritization journey. I think this is one of the reasons why it can seem daunting and why it’s annoying (who wants to know how much one spent on wine last month?). However, budgeting is critical to building financial success. Unless we know what we planned to do, we won’t be able to assess our progress and correct course if necessary.
Here are some simple steps of a monthly budgeting process.
- Know your take-home income
- Identify spendings and group them into buckets
- Prioritize goals and determine the plan for this month
- Monitor progress
- Review, assess, and adjust
Know your take-home income
The first thing to do is know how much you are taking home each month. Your take-home income is your pre-tax pay minus deductions such as income taxes, health insurance premiums, social security taxes, etc. Take-home income represents the money that enters your bank account regularly that you get to decide how to spend.
You can get this number in several ways.
- Reviewing your paystubs
- Looking at your bank accounts for the amount that enters your bank account regularly
- Using a calculator to estimate it (https://www.adp.com/resources/tools/calculators.aspx)
- Asking your company’s HR department.
Some other notes:
- If your monthly take-home income varies depending on the circumstances, I suggest going with a conservative amount that you have relatively high confidence in achieving consistently.
- If you are paid biweekly (i.e., a 26-week schedule), I suggest annualizing the take-home amount and determining the average monthly rate. This means multiplying the biweekly take-home amount from your last paystub by 26 and dividing that by 12 to arrive at the average monthly income.
Identify spendings and group them into buckets
The next step is to analyze all your expenses and understand where your money has been going. You can do so by 1) reviewing expenses in bank accounts and 2) utilizing a free budget tracking tool.
Make sure to go through all transactions, bucket expenses, as shown in the chart below, and note the average monthly spending. The table below is for illustrative purposes only.
The chart above has some features:
- Fixed expenses. These are known, recurring, fixed payments. For example, rent.
- Variable expenses. These are anything other than fixed costs that are typically discretionary.
- Necessities. These are your mandatory expenses usually related to safety and survival.
- Wants. These are expenses you don’t need.
All of us have different definitions of wants and needs. The chart helps you put expenses in perspective, and it enables you to prioritize what makes it into your budget. This framework is also a way to help drive savings. There may be things in the “wants” buckets that can be eliminated immediately.
Some other notes:
- Most bankers offer customers a way to download transactions in Excel. This capability can help you analyze expenses.
- Mint is a tool that can help aggregate transaction data across multiple banks. Mint also allows users to download the aggregated transactions list for up to 3 years. It’s a powerful tool to keep an eye on expenses.
Prioritize goals and determine the plan for this month
With the first two steps, you have a good understanding of your starting point and your past habits. Now we turn to piece the plan together with your goals.
To do so, we need to take a look at goals (near-term and long-term), retirement, and existing debts, and we need to determine what matters most. Is the most critical milestone to pay off those high-interest credit card debt? Or is it to save toward purchasing a house? Are they equally important right now? This part is the step you determine how much you want to put into these buckets.
From there, you can determine what remains for discretionary spending. Your starting point is your take-home income, reduce the amount by the necessities you identified in step 2, and then reduce the remaining amount by your goals. The result is what’s left for discretionary spending.
That’s your budget. That’s your financial plan.
The takeaway here is that we are putting your goals right behind your necessities and ahead of any wants.
Some sound conventional wisdom and tips:
- The simplified 50/30/20 budget framework can help here. This framework suggests that 50% of take-home income should cover necessities, 30% should be for wants, and 20% for savings. This could be a good benchmark for comparing your spending habits. However, keep in mind that it’s just a framework. You may have different goals, such as saving more.
- If rent or mortgage makes up more than 30% of your take-home income, consider downsizing and finding a cheaper option.
- Things do add up. Canceling a couple of small subscriptions could speed up your progress towards your goals.
- If you have trouble gaining control over spending, try “the envelope system.” I have found this method to be particularly effective for managing variable expenses.
Monitor progress
Now that you have a plan, you have to monitor your actual performance against it. You need a system to track your expenses. There are numerous tools out there. Some of the most popular ones are listed below.
- Mint
- Personal Capital
- YNAB (You Need A Budget)
- Excel / Google Sheets
Find one that works for you. The objective is to know where your money is going.
Review, assess, and adjust
The budgeting process is iterative. The budget is not a “set it and forget about it” concept.
We plan. We monitor. We review. We adjust. This cycle is how we improve. As you get better at all of these steps, the budget will get more precise and sophisticated.
During the review process, we measure ourselves against our plan. Did we achieve our goals? Why or why not? What can we do better? What expense added no value? Where can I find more savings? We should ask these questions every month and make any changes necessary to accelerate our progress towards our goal.
Some other things to keep in mind:
- The first couple of months after setting a budget is critical. This is when you are starting to build a habit in keeping to a budget. Consider blocking an hour every week to review expenses against budget.
- If you did well against budget and have some excess income, don’t spend it and get in the habit of saving those “extras.” Doing so helps you achieve your goals faster, but it also helps build a mentality and habit against lifestyle creep.
Building the discipline to track against a budget is not easy. It takes time, effort, and a full commitment. It’s hard, but it’ll be worth it. We wish you the best of luck on this journey and hope you discover the freedom that comes with it.
Disclaimer: The contents of this website is an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.