Here is a step-by-step guide on how to make a budget!
Hello, my dear readers! The budget talk is all the rage nowadays. Many of us know the importance of having a budget, which is a key component of a financial plan. Perhaps you want to create a budget to improve your spending behaviours, or maybe you want to save more money to pay down your credit card debt.
However, not all of us know how exactly we can build a budget from scratch. Don’t stress! I have a step-by-step guide on how to make a budget. I use these steps myself on my own budgeting journey, so I hope that they can help you as well. Let’s begin!
Step 1: Find a monthly spending tracking template
If you want to know how to build a budget, you need to first understand your existing spending behaviours. A monthly spending tracking template serves as the first step towards creating a personal budget.
At this point, the template doesn’t have to be perfect. As long as you have the structure (e.g., columns and rows) down, you are good to go. You can always modify it as you move along.
If you are interested, you can get a copy of the spending tracker that I personally use for free here. It is a simple Microsoft Excel spreadsheet-based tool. What I like about my spending tracker is that it not only covers major categories of expenses, such as housing, transportation, utilities and entertainment, but also provides flexibility for new ones. You can easily modify it to suit your needs after you understand your spending habits in Step 2.
Step 2: Track your expenses
After you find a template you like, it is time to get down to work – track your expenses!
Although you may have a general idea on how you spend your money (e.g., how much rent you have to pay on a monthly basis), you may not necessarily remember precisely how you spend all your money. This is especially true when it comes to discretionary expenses. After all, how many times do you surprise yourself when you receive the credit card statement?
If you want to understand your spending behaviours, you need to track your expenses. EVERY SINGLE ONE OF THEM. Yes. This means you need to track the $5.25 latte you splurged on Wednesday morning, and the $25 monthly subscription you pay for your favourite magazine. By the way, you may subscribe to my newsletter for free! Although it may seem daunting, once you get used to it, it will be a lot easier than you think.
There are two ways to track your expenses that I find the most effective:
Ask for receipts for every purchase you make
This method can be tedious, but it is also the most accurate. Receipts serve as physical reminders that you need to track your expenses.
If you want to be a bit more environmentally-friendly and save on paper, you can ask for electronic receipts whenever possible.
Go through your statements in detail at the end of the month
If you find asking for receipts to be too much of a hassle, then you should at least commit to going through your debit card and credit card statements once a month. This approach is definitely less time-consuming, but vendors can use very cryptic names on the statements, and you may not necessarily remember what exactly you bought at the end of the month. Still, committing to going through the statements can be sufficient in understanding your general spending habit.
Step 3: Sort your expenses into categories identified in the spending tracker
Once you have all the receipts or statements in hand, you will want to take out your spending tracker, and sort your expenses by category. For example, my spending tracker has one category called “Utilities”. This is where I input my water and electricity bills.
I recommend that you start with just a few general categories, and then only break them down into smaller sections if you see a need of it. For example, if you find a general “entertainment” bucket to be sufficient, then don’t break it down into movies, nights-out-with-friends, and so on.
By having only a few categories, you will have a very clear picture, and you won’t get lost in all the details.
Of course, once you are comfortable with tracking your expenses and you want to laser focus in on controlling, for example, your going-out expenses, then you may want to add a line specifically for that for better visibility.
Note that one important spending category you cannot miss is spendings on future self, aka savings. Set an achievable savings goal based on your actual expenses, and use that as the budget for your savings.
To start, I recommend that you have two savings categories, one for short-term goals such as your next vacation, and one to save money for long-term goals such as retirement.
Step 4: Repeat steps 2 & 3 for at least three months
I recommend that you track expenses for at least three months to establish a general baseline. This is because many expenses are seasonal. For example, your birthday party, Christmas, etc. Three months is just enough to have a reasonable baseline without dragging it out for so long that you lose momentum.
Step 5: Use your actual expenses as the baseline for your budget
Once you have a good understanding of how and where you spend your money, it is time to set up your spending budget.
The categories in the spending tracker are now the categories for your budget. Yes, you read it right. The spending tracker has now revealed its second use: it is a budgeting tool as well!
To start, you can simply use the average of the expenses as the baseline for your budget. Very simple, right?
Step 6: Set realistic targets
Were you surprised by how much money you spend on take-outs in the last three months? Chances are, you will find one or two spending habits of yours that surprise you. We oftentimes fall into the trap of mindless spending. Unless we specifically bring our focus to it (which we are with three months of diligent tracking), we may not even be aware of how we are spending our money.
If there are any specific areas that you’d like to improve on, you may want to reduce the budget for those specific areas. Discretionary spending is usually good to tackle.
Ask yourself, can you really reduce your spending by 50%? If the answer is no, then don’t set your budget to be 50% less than your average spending historically. You would most likely feel defeated and abandon your budget altogether.
A better approach is to reduce it by a more manageable amount, say 10%. Once you can achieve that consistently, then consider reducing it even more.
Step 7: Review your budget every month
If you finished the above steps, then congratulations, you have already built yourself a budget! Get yourself a nice little treat, such as a delicious Starbucks drink, to celebrate!
Of course, just having a budget is not enough. You need to use it as a benchmark, and monitor your progress every month.
Personally, I have established a month-end budget tracking routine to help me monitor my budget.
Here is how you can do it:
Continue tracking your expenses using the monthly expense tracker.
To compare vs. budget, you will need to have actuals. Hopefully, by now you have developed the habit of tracking your expenses. Yes, keep using the monthly expense tracker that you set up initially.
Compare actuals vs. budget
At the end of each month, compare your actual expenses to your budget. You will want to do it by category.
If there are any deviations, especially when your actual expenses exceed your budget by more than 10%, understand why. Did you overspend on a gift, or was there an emergency?
If you don’t have a sufficient emergency fund to covers at least 3 months of fixed expenses, you will want to make it a priority to build one.
Bring yourself back to track if you consistently find yourself overspending vs. budget
If you find that you consistently deviate from your budget, consider what specific actions you can implement to bring yourself back to track. For example, you can try a cash diet for a month and see how it helps. You can also cut back on variable expenses such as entertainment.
Consider modifying your budget if your goals are too unrealistic
Of course, it is also possible that your budget is too tight. After all, we want our goals to be SMART – Specific, Measurable, Achievable, Relevant, and Time-bound.
If you are spending within reason but are consistently underdelivering versus your budget, cut yourself some slack and relax your next month’s budget a little bit. Yes, it may take you a little longer to get to your savings goals, but you will get there in a much more sustainable and manageable manner.
Make adjustments if necessary.
Other approaches to building a personal budget
The above step-by-step guide illustrates how I build my personal budget. That is, I build my budget based on my actual historical expenses. The advantage is that my budget is more likely to be realistic and achievable. The downside is that it can take quite a while to gather enough historical data.
If my approach is too tedious for you, there are also other approaches. Here are a few popular ones.
Follow the 50/30/20 rule
This is a classic rule of thumb in personal budgeting. That is, you spend 50% of your budget on needs, 30% on wants, and 20% on debts and savings.
If you use this approach, the steps are simple:
Know how much you bring in each month
This is fairly straightforward for people who earn a regular salary because the take-home pay is fixed month over month. For those of us with irregular monthly income, it may require a bit more work.
I recommend that you look at your earnings for the past 12 months, take the average of your 6 lowest-earning months, and use that as the baseline. This is a very conservative approach to make sure that you have enough money in your bank account to cover all the basic.
Note that you must use the after-tax income when doing calculations.
Allocate your money based on the rule of thumb
After you know how much you bring in each month on average, simply apply the percentages to the sum. 50% of your income goes towards fixed monthly expenses, 30% goes towards wants, and 20% goes towards debt repayment and savings.
What I like/dislike about this approach
What I like about this approach is its simplicity. You don’t have to spend 3 months of diligent tracking to come up with a budget.
However, it can be too big of a blanket statement that it doesn’t necessarily reflect your reality. For example, the crazily rising real estate market in my city means that you may have to spend 40% or more on housing alone just to live in a reasonable space.
Use the “no” budget
Rather than creating a budget, you mainly keep track of your checking account balances. You set aside money for recurring bills (including credit card bills) and predetermined savings and debt payments, and spend the rest.
What I like/dislike about this approach
This is probably the easiest budgeting method. The only thing you need to keep track of is your checking account!
However, this approach doesn’t really help you understand where you can improve on. It also doesn’t provide as much visibility to the details of your spending.
This is it, my step-by-step guide on how to make a budget and two alternative methods that you can explore. Having a realistic personal budget is key to reducing financial stress and having a healthy money mindset. It is also important for achieving financial independence, which is a key item on my bucket list!
What is your budgeting method? Share in the comments below!
Last but not least, don’t forget to get a free copy of my monthly expense tracker to jump-start your budgeting journey!