In 21st century America, the idea of budgeting seems almost passé. After all, with practically unlimited credit available on a seemingly never-ending supply of credit cards, why bother with the discipline of budgeting?
Well, there are plenty of reasons. For starters, budgeting is the first step in the process of building financial discipline in your life. Your success in every other aspect of personal financial management — from saving and investing to retirement planning to buying a home and making responsible everyday purchases — will hinge on your ability to create, and stick to, a basic household budget.
A Simple Concept
Like many things, the process of creating and following a budget is not as hard as people often think it is going to be. The concept of budgeting is actually very simple: Your goal is to plan your spending around how much money actually comes into your household every month. In other words, try to match your expenses with your income.
Unfortunately, many Americans do just the opposite: They essentially buy whatever they want and then hope they make enough money to pay for it. If they don’t, they just pay for things they cannot afford with a credit card or installment loan. However, this can be a very dangerous practice over time, as the interest on credit card purchases starts adding up if card balances are not paid in full each month. Eventually, people can end up paying more money in interest than they paid for the items they originally bought in the first place.
Creating a simple household budget can be summarized in three steps:
- Figure how much money comes in every month. Tally up all of your sources of income so you know exactly what you have to spend each month. For most people, the primary source of income is their salary, but be sure to include any bonuses or commissions you might receive at work. Alimony or child support, government payments and income from a side job or freelance business should also be included to arrive at your monthly net income (or income after taxes).
- Identify all of your monthly expenses. This is a little more involved. For most people, expenses can be divided into two main types: essential (and usually recurring) expenses and non-essential (or discretionary) expenses. Essentials are your basic living expenses that stay mostly the same every month: your home mortgage or rent payment, utilities, groceries, transportation (car payment and gasoline) and insurance. Keep in mind that your housing costs could go up if you have an adjustable-rate mortgage.
Non-essentials would include almost everything else: entertainment (including eating out), vacations, TVs, stereos, computers, cell phones, clothes, cable, etc. Of course, you need to have clothing, and some would argue that cell phones and cable TV are essential in today’s society. The point here is to identify these expenses and work them into your monthly budget, whether you consider them essential or not.
- Subtract number two from number one. When you subtract your expenses from your income, you should end up with a positive number. If you do, congratulations! You have passed the first basic money management test: You are spending less money than you earn. You next step is to decide what to do with your excess monthly income.
If you do not end up with a positive number, then you have some work to do. Specifically, you need to determine where you can cut your expenses to bring them into line with your income. Start with non-essential expenses: Can you reduce your entertainment costs by eating out less or not going to concerts and movies as often? Can you cut back on your vacations, or go somewhere that is less expensive? Can you pull the plug on your cable TV (which is getting easier as online options increase) or opt for a less-expensive cell phone plan?
If these steps do not bring your income and expenses in line, you will need to consider more drastic measures like moving into a less expensive home or buying a cheaper car. Ouch! Of course, another option is to increase your income, perhaps by taking on a second part-time job or starting a side or freelance business. If you have a non-working partner, perhaps he or she could take on some part-time work to balance the family budget.
Sticking To It
Once your budget is in place, your next challenge is sticking to the plan. This is simply a matter of financial discipline: You must decide that budgeting is an important enough financial priority that you’re going to do whatever it takes to stick to your budget and get your personal financial house in order. If you have never budgeted before, this will require a change in your financial mindset. However, it is a change that will pay dividends for you and your family for the rest of your life — if you take budgeting seriously and make it a real priority.
Next article: What to do with excess monthly income.