Earlier this week in the reader mailbag, I mentioned offhand that I built a strict budget for the first several months of my financial turnaround, but now I am much looser about my budgeting. At the same time, I stated that this strict budget was vital in my financial turnaround.
This spurred several readers to write in and ask how exactly I built this budget – starting from scratch and having no real idea how to do it – and how I eventually loosened the reins on it as well.
So, here’s my guide on how to build a budget. This isn’t just a rehash of the budgeting guides that appear in countless personal finance books – this instead is exactly what I did. It’s the plan that I personally found very effective in helping me right my ship.
Let’s get started.
Save Your Receipts and Statements
Sitting down and immediately writing out a budget in the way most personal finance books describe is a giant waste of time. They often instruct you to write down how much you should spend in a bunch of categories that may or may not apply to your life and then stick to those amounts. That’s completely useless for the average person.
If you want to budget, the only way to start is to get a very firm grip on exactly how you’re spending your money right now.
Step 1: Starting today, save every single bill statement, receipt, or check that crosses your desk for at least one month, preferably three months.
You should be building two piles: money coming in (paychecks, etc.) and money going out (bills, receipts, checks, etc.). If you spend money in any way, record it in some fashion by saving the bill statement, a copy of the check, a receipt from the shopping trip, or even by simply writing it down on a sheet of paper. Every single penny should be accounted for.
The longer you do this, the better, but you need to do it for at least one month at the absolute minimum so you can scoop in all of your monthly bills. For most families, you’re better off scooping in three months’ worth of receipts so you can get a good “average” of what you’re spending.
I found it convenient to keep a “spending notebook” in my pocket. Whenever I spent a dime, I’d either make a note of it directly in the notebook or stuff the receipt in there. If I made an ATM withdrawal, I’d write on the back of that receipt what I did with all of the cash.
Sort Your Receipts and Statements
Once you’ve saved all of your receipts and statements up over a few months, it’s time to sort them into some sensible groups.
Most personal finance books provide a big list of groups for you to sort your stuff into, but the problem is that these lists try to be all things for all people. Very few people have financial lives so complicated that they actually cover all of those categories.
Instead, try this.
Step 2: Take all of the receipts/statements/notes/etc. you saved up and start making piles on the floor in a way that makes sense to you.
Just define your own categories. When I first did this, I basically had the following categories, which really didn’t match up very well with any personal finance book:
Required utilities (electric, gas, water, sewer, etc.); non-required utilities (cable, internet, etc.); gas; other car expenses; good food; junk food and eating out; household supplies; books; magazines; golf; video games; Magic: the Gathering; other entertainment; insurance; bank fees; finance charges; student loans; baby supplies; and miscellaneous
I still have that ancient budget, actually, and those were the categories listed on it, and they all started by piling papers and receipts and statements on the floor in various groupings.
Some receipts I came across actually fell into multiple groups, like receipts from Super Target. What I did then is go through the receipt, figure out which items went into which group, and then wrote a note for each pile with that total (including sales tax, which I divided up proportionately).
You’ll probably find yourself shifting piles around and making new piles throughout this process, as you should. The goal is to find ways to group your spending that’s natural to you. Don’t try to force it to match someone else’s groupings – if a group of receipts or statements feel like a natural group to you, that’s how they should be sorted.
Tally Them Up
Once you have all of your piles figured out, it’s time to tally up each pile.
Step 3: Add up the totals on all of the receipts and statements in each pile, then divide these totals by the number of months you’ve been accumulating data.
So, if you saved all data for three months, you’ll want to divide each total by three (remember, the more months’ worth of data you have, the better).
As you calculate the tally for each of your piles, start writing these totals down, making a list of the category names and how much you spent in that category for an average month. When you’re finished, you’ll have a picture of what you are really spending each month in each category.
When that’s done, total ’em up and you’ll see how much you’re spending. Do the same for your income over an average month – see how much you’re earning. Those two numbers really make up the reality of your financial situation – are you spending less than you earn?
Find the Fat
If you’re like many people, the total amount you earn in a month and the total amount you spend in a month are going to be pretty close to each other – and that’s what you’re trying to correct. Spend less than you earn is the mantra, and it’s a good one – the bigger the gap between the two, the better off you are.
Step 4: Go through each category and find ways you could reduce your spending in each one.
Some categories won’t have much room to breathe, while others will be loaded with fat.
The key here is to be realistic. Look for ways to trim spending that you can easily maintain. For example, you can often trim your electric bill a bit by installing a programmable thermostat, or you might be able to cut some entertainment expenses by finding a different route home from work that doesn’t take you near your most tempting places. Maybe you could challenge yourself to cook one more meal at home each week, cutting down on food expenses a bit. If you’re a book or a movie lover, you can probably cut some fat there by digging into what’s available at the library. The next time you go grocery shopping, maybe you can make a list first or, even better, make a meal plan using the flyer before you even walk in the door.
Going overboard, though, is a bad thing. Just focus in on the baby steps – the easy things you can do to reduce some spending. If you go hardcore, it’ll fail just like most diets do. You’re developing a basis for the long term here, and by trying to force yourself into a bunch of activities that don’t come naturally, you’re asking for failure. Focus on things that are wholly automatic, like a programmable thermostat or a CFL (or a more fuel-efficient car in the future), and on just a small handful of changes you need to make to your behavior.
In a nutshell, go through all the categories and identify automatic ways to save money as well as five other ways you could trim the fat a bit. Estimate how much these will save, then subtract them from the total in that category. You now have your target numbers for next month (don’t worry about extras, we’ll deal with that later).
One more thing: add one additional category called “Flexible” and put in a dollar amount next to it equal to about 5% of your monthly take-home. This will help you during the month if a crisis comes up – just take the money from this piece to help with those unexpected. If there’s anything left over at the end of the month from this category, put it into savings.
Try It Out
Over the next month, just do things as normal except with the changes you thought up based on how you spend money – and one other little change.
Step 5: Work hard to stay within your target numbers in each category for the next month.
Remember, these numbers are completely realistic and based on how you’re really spending money minus just a few little lifestyle changes, so these are goals you should be able to meet. Even better, at the end of the month, you’ll find that you’ve spent a little less money overall.
You’ll likely stay under those numbers in most categories and go a little over in others – that’s fine, just as long as you know the reasons you went over and your total across all categories doesn’t exceed the total of all of your targets.
Even better, you’ll have a little left over, so do something productive with it. Use it to make an extra debt payment or sock it away in a savings account for a big emergency.
But even more important than that…
Rinse and Repeat
Budgeting doesn’t work unless it’s repeated, so just get in the habit of doing it at the end of each month.
Step 6: At the end of each month, refresh your budget.
This simply means go through all of your receipts and statements for the month and verify that you did indeed hit your targets overall. If you did, that’s a good thing – it means you’ve added real change to your life.
So, if you did make your targets, take that total amount that you have left over and add another line to your budget – debt repayment (or savings, if you have no debt) – and write that dollar amount in next to it. Each month, you’ll use that money to follow a basic financial security plan – first, build up a small emergency fund with it in a savings account, then start making extra payments on your debts.
Then repeat the whole process of making target numbers. If you feel confident, try adding in some additional cost-cutting tactics. If last month didn’t go so well, don’t be afraid to revise some numbers upward (and thus reduce the amount going into debt repayment or savings).
The goal of budgeting is to keep in tune with your spending and don’t overdo it. Instead, treat it like an exercise plan or a diet – you gradually become more and more fit as time goes on and the budget begins to feel more normal in your life. Eventually, the little changes will become natural and you can take the training wheels off.
It took me almost a year to reach that point. I became so confident with my budget that I simply set up most of my bills to be paid automatically with online bill pay at my bank and I set up a bunch of automatic savings, too.
All of those little cost-saving tactics that I developed had become so natural that I was simply no longer spending money at an outrageous pace. Going to the library had become natural. Cooking meals at home had become natural. We were buying groceries in bulk as a matter of course now, saving money over time. We stopped shopping just for social reasons, as well.
Combining the automatic nature of my savings and bill paying with the natural reduced costs of my life was the very goal of budgeting, and thus the next natural step was to take those training wheels off and ride that bicycle of financial stability.