How to Create a Budget That Works

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Budgeting is an essential tool for gaining control of your finances — even in a normal economic environment. Amid the historic unemployment and financial hardship brought on by the COVID-19 pandemic, it’s more important than ever to have a plan for meeting your basic needs, paying off debt, and investing in your future.

And for those who already have a budget in place, now could be the time to reassess. What made sense before may no longer apply. For example, while paying down debt is a fundamental financial priority, conventional financial wisdom might not apply so much at the moment. For those without an emergency fund, author and financial educator Tiffany “The Budgetnista” Aliche recommends making only minimum payments in favor of building up savings. 

Others have found that shelter-in-place requirements have suddenly shifted their spending priorities — and even produced savings in the forms of foregone vacations, gym memberships, and other nonessential expenses. Now could be the time to lock in those savings and redirect that money to an emergency fund, investments, or debt payments. 

Whatever your financial situation, as you’re creating or reconsidering a budget you’ll want to follow these steps to make it your own. 

“The best type of a budget is when people have aligned their values with how they’re spending their money,” says Erin Lowry, author of “The Broke Millennial: Stop Scraping by and Get Your Financial Life Together.” Finding a style that fits your current stage of life and lines up with your goals is key to budgeting successfully in the long term, she said. “It’s not meant to be restrictive — it’s meant to be putting you in control.” 

How to Create a Budget

As with anything in life, there is no one-size-fits-all solution. The nuts and bolts of your budgeting strategy will depend on your goals, personality, and lifestyle. But following these core principles can set you up for success.

1. Know your income 

The first step to creating a budget is knowing how much you’re making — and because most of your biggest expenses are paid monthly, it’s common to measure your income per month. This is straightforward if you’re a salaried employee or have a regular paycheck. Keep in mind you should be focused on your take-home pay, or the amount of money you net after taxes and any pre-tax deductions like health insurance premiums or 401(k) contributions. 

If your income isn’t consistent, a weekly or biweekly budget might make more sense. This applies to business owners, freelancers, independent contractors, and anyone whose main income comes from tips or commissions.

2. Track your expenses

Once you know how much you have coming in, it’s time to get a handle on your spending. When you’re starting out, Lowry suggests you review bank and credit card statements from at least the past three to six months. “That can be such an eye-opening practice,” she says. “You thought you were spending $200 a month going out to eat with friends and going to happy hours, and really you were spending $450.”

A good way to categorize your spending is to divide it into two categories: fixed and variable expenses. Fixed costs, like health insurance, rent, or mortgage, don’t change month to month. You’ll also want to account for fixed irregular expenses you don’t pay each month. Real estate taxes, some insurance premiums, and vehicle registration are examples of bills that have a set cost, but are paid annually or quarterly. You can account for these expenses by dividing the annual cost by 12 and adding it to your monthly budget. 

Everything else is a variable expense, including gas, groceries, eating out, and special events. Variable expenses are harder to budget for, but looking at your past spending habits will give you a good idea of what to budget for each month.

3. Compare income and spending

Now it’s time to take a look at your earning and spending side by side. This can be the scariest step, but it’s the most important. You’ll want to end up making more than you spend, and knowing where you’re at is the first step to getting to where you want to be. Regardless of where you’re starting, you can make moves to get yourself headed in the right direction.

If your ratio of income to spending is off, the quickest way to turn it around is to decrease your variable expenses. Cutting down on travel or shopping can quickly add flexibility to your budget — but it’s not the most sustainable long-term solution. You’ll also want to consider ways to increase your income and decrease your fixed expenses. 

The most important changes you make will take the most time to adjust. Moving to a cheaper house or apartment can save you tons in maintenance and housing costs over the years. And the income you could earn from working on a side hustle, getting a promotion, or changing careers makes skipping that next latte seem inconsequential in comparison. But both can take months or years to complete, so patience is key.

4. Pick the right tool to automate your budget

Taking stock of your income and expenses is the first step in creating a successful budget. Once you have this foundation for your budget, you can figure out the right system or budgeting tool.

You can set up a smoothly functioning system without any complicated budgeting app. Aliche believes automation is key to a successful budget, but she doesn’t use any of the popular apps. She keeps it simple using direct deposit to separate the money coming in into accounts for spending, paying bills, and saving. She pays her bills with her bank’s auto-pay feature and keeps track of it all with an Excel spreadsheet (Google Sheets works too).

If your income is more unpredictable, Lowry recommends using a zero-based budget, and says the app You Need a Budget is the best fit for this strategy. Under zero-based budgeting, you’ll base your current month’s spending on your previous month’s income, and every dollar is accounted for, with nothing left over at the end of the month. The money you don’t put toward expenses is used to pay down debt, invest, or use during months when you don’t earn as much. This encourages you to save during “feast” times and gives you a cushion during “famine” times.

There is no shortage of budgeting apps and services to choose from, ranging in price from free to $12+ a month. Regardless of the price, the best tool is going to be the one that actually helps you get the job done. You may find the user interface or that ads plastered on the free apps ruin the experience for you. And paying for a sleek budgeting app could be an unnecessary extra expense since you can download budget templates for Excel or Google Sheets for free. Remember, the specific tool you use is less important than developing a budgeting habit that fits your lifestyle.

Pro Tip

Keep it simple to start budgeting! By committing a small amount of each paycheck to savings, you can create the habit on which to build.

How to Use a Budget

A budget shouldn’t just help you get by — it should help you get somewhere. And that means you’ll need to set goals and revisit your budget regularly to adjust your course.

Set goals

Effective goals give you a reason to spend less than you make and align your money with your values. Goals are your priorities. If you don’t have an emergency fund or retirement savings, or you’re carrying high-interest debt, those should be high on your list. 

Emergency fund

You’ll need to balance paying off debt with saving for an emergency fund; how much you need to set aside is a matter of debate among the experts. Lowry suggests that, at a bare minimum, you should set aside one month’s worth of living expenses (ideally more) while you’re paying off debt. Aliche recommends building up reserves to cover six months of basic expenses in the current economic climate, because when unexpected expenses hit, “no savings with no debt equals debt.” Find a number that you’re comfortable with and make that the target.

Paying off debt

There are lots of different tactics to effectively pay off debt. One strategy is to focus on the debt with the highest interest rate, while only paying the minimum on all the others. This is known as the debt avalanche method, and will help you pay off debt more quickly by paying less interest. However, trying to climb your tallest mountain of debt first can be disheartening. If that’s the case, you can build momentum using the snowball method, in which you tackle your smallest debt first. Once that’s paid off, take what you were paying toward that bill and immediately put it to work on your next biggest debt. The inspiration that comes from racking up small wins can turn your financial outlook around in ways that aren’t captured in the numbers.

Long-term goals like retirement

You’ll also want to set aside funds for bigger purchases and long-term goals, like a house, your children’s education, or retirement. If your employer matches contributions to your 401(k), you should do everything possible to contribute up to the match. Think of it this way: If your job will match 50% of your 401(k) contributions up to 5%, do you have any other investment opportunity that will instantly earn a 50% return? Probably nothing that’s legal, so take it. For anyone without an employer sponsored retirement plan, you can open up an IRA at a discount brokerage like Vanguard, and aim to max out your contributions each year ($6,000 for 2020).

Whatever your goals are, build them into your budget and set aside those funds first. Think of your goals as fixed expenses that come right off the top. Start small. Don’t go too hard or too fast out of the gate. Planning too much sacrifice can set you up for failure in the long term. 

“Over-sacrificing is really detrimental to budgets, because you can’t keep that up,” says Aliche. She believes in starting with a small amount of savings from every paycheck. It’s not about the amount of money you’re saving; it’s about creating the right habit.

Revisit and refine

Plan to regularly check in on your budget, especially when you’re just starting out. Don’t expect to get everything perfect in the first attempt. Be flexible and make adjustments as your circumstances change. Keep the tools and strategies that are working for you and toss out the ones that aren’t. And it’s OK to not get it 100% right at the start, as long as you’re headed in the right direction.

Early on, checking in on your budget plan once a week is a good way to keep on track. Then, once you’ve got your system refined, monthly check-ins to watch your debt shrink and your savings grow can be a great way to keep making healthy financial decisions day to day.