Last Updated: May 18 2023
What Is A Budget?
A budget is a financial plan that outlines expected income and expenses over a certain period of time. It is a tool used by individuals, businesses, and governments to manage their finances and make informed decisions about spending and saving. Individuals typically plan monthly whereas businesses and governments plan quarterly or yearly.
A budget generally includes a list of all sources of income and a breakdown of expenses into various categories. Income may come from sources such as salaries, bonuses, investments, and other forms of revenue. Expenses may include payments for rent/mortgage, utilities, transportation, food, clothing, entertainment, education, and other necessary and discretionary expenses. The goal of a budget is to ensure that income is sufficient to cover all expenses while allowing for savings and debt repayment if necessary. Budgets are often re-evaluated and adjusted periodically to ensure they still meet expectations.
The end result of a budget can be a surplus, deficit, or income equaling expenses. A surplus means more income was earned than costs incurred for the given time period, a deficit means the opposite.
Why Make a Budget?
The simple answer is because life typically gets costlier faster than your income can increase. If you net $3,000 per month after taxes, how can you pay for housing, food, insurance, health care, debt repayment and fun without running out of money? That’s a lot to cover with a fixed amount, and this is a zero-sum game.
The answer is to make a budget. It provides you with the comfort knowing where your money is going, how much is being spent, and most importantly that income exceeds expenses. You can think of budgeting as a method of assigning each dollar a purpose. If your money has a specific job to cover, you know it will always be working for you. It also ensures you are living within your means and developing a sense of freedom with your money. At the end of the day that’s what investing and personal finance is all about.
Creating a budget is a critical step in managing your finances and achieving your financial goals. You might find a budget very useful if you:
- Don’t have regular income
- Are planning on making a major purchase
- Will be going through a big life event
- Have a large amount of debt
- Don’t know what you spend your money on
- Feel overwhelmed by finances
A budget can also help individuals and organizations to set financial goals and prioritize spending. By identifying long-term financial goals, such as saving for retirement, buying a house, or starting a business, a budget can be used to allocate resources more effectively to achieve these goals. It can also help to prioritize spending by identifying essential and discretionary expenses and finding ways to reduce expenses in non-essential categories.
Overall, a budget is an important tool for managing finances effectively. By creating and sticking to a budget, individuals and organizations can achieve financial stability, set and achieve financial goals, and make informed decisions about spending and saving.
Create Your Budget
Here are three steps to help you create a budget:
Determine your income: Calculate your total monthly income, including your salary, any additional income from a side hustle, or any other sources of income. The foundation of an effective budget is your net income. That’s your take-home pay—total wages or salary minus deductions for taxes and employer-provided programs such as retirement plans and health insurance. Focusing on your total salary instead of net income could lead to overspending because you’ll think you have more available money than you do. If you’re a freelancer, gig worker, contractor or are self-employed, make sure to keep detailed notes of your contracts and pay in order to help manage variable income.
List your expenses: Once you know how much money you have coming in, the next step is to figure out where it’s going. Tracking and categorizing your expenses can help you determine what you are spending the most money on and where it might be easiest to save.
Track your expenses over a 90 day time period. This will give you a solid average of your costs. Record your daily spending with anything that’s handy—a pen and paper, an app on your smartphone, alternatively most financial institutions allow you to integrate your spending with software to keep track. You can also manually create budgeting spreadsheets or templates found online.
There are 3 main ways that you can categorize your expenses:
Fixed vs. variable
Fixed expenses are all of those that are known in advance and are consistent month to month. Examples of fixed expenses are subscriptions, vehicle payments, cell phone, childcare, and monthly property tax payments.
Variable expenses are those that change month to month. Examples of variable expenses are food, entertainment, utilities, and clothing.
Needs vs. wants
Needs are all baseline expenses required to live. Examples of needs may be rent/mortgage payment, gas, childcare, and food. Wants are all of the expenses beyond your basic needs. Some examples of wants may be transportation, clothing, travel, and eating at restaurants.
Needs and wants may differ from person to person. If you live near public transportation, you may not need a car, but if you live in an area with no public transit, then a vehicle may be a need.
Even though needs and wants can differ from person to person, be careful not to classify your wants as needs. Needs are the necessities.
This is the recommended approach. Not only do detailed categories include your fixed and variable expenses and needs and wants, but they also provide a clearer picture of your spending. Detailed categories would not bucket expenses as needs and wants but would individually list each item. This will help identify which category has room for cuts.Credit card and bank statements are a good place to start since they often itemize or categorize your monthly expenditures.
3. Set your budget: This is where everything comes together: What you’re actually spending vs. what you want to spend. Leverage whatever method you used to get a sense of what you’ll spend in the coming months. Then compare that to your net income and priorities. Consider setting specific—and realistic—spending limits for each category of expenses. Don’t forget to allocate funds for investing and emergency purposes.
Implementing Your Budget
First subtract your expenses from your income. Subtracting your total expenses from your total income allows you to see how much money you have left over each month.
Next you should look at making adjustments to your budget. If you find that you’re spending more than you’re earning, you’ll need to make adjustments. Look for areas where you can cut back, such as eating out less, canceling subscriptions you don’t use, or finding ways to reduce your utility bills.
Now that you’ve documented your income and spending, you can make any necessary adjustments so that you don’t overspend and have money to put toward your goals. Look toward your wants and variable costs as the first area for cuts. Try making dinner at home instead of going to a restaurant. Bonus, you can show off your cooking skills. If you’ve already adjusted your spending on wants, take a closer look at your spending on monthly payments. Be honest with yourself and ask, is this expense really a need?
If the numbers still aren’t adding up, look at reducing your fixed expenses. Is it possible to look at a cheaper cell phone plan? Can you cancel a seldom used subscription? Such decisions come with big trade-offs, so make sure you carefully weigh your options.
Remember, even small savings can add up to a lot of money. You might be surprised at how much extra money you accumulate by making one minor adjustment at a time.
Of course, make sure you stick to your budget. Use a budgeting app or spreadsheet to track your expenses and make adjustments as needed.
Tips To Help Stick To A Budget
Now that you have a budget, try to stick to it and improve it as you go.
To help you with this task, try the following:
- limit your spending as much as possible to what is in your budget
- organize documents such as bills and receipts either electronically or in a filing system
- review your budget to what was actually spent each month
- update your budget as financial circumstances change (income change, new bills, life change)
Evaluate your budget on regular basis, every three to six months. If your actual spending often varies from your budget, recalculate your numbers to make it more realistic, but don’t make the mistake of increasing your budget to accommodate a lack of self control. When reviewing your budget to your actual spending, ask yourself the these questions:
- if there are large discrepancies in your budget, what is causing them
- which categories have the largest differences
- are the differences considered to be one-off scenarios or is this likely to happen each month
- can you save enough money to reach your financial goals or pay off your debts
- is each category budget still relevant today
You can set a reminder or book time in your calendar to make sure you review your budget regularly. If you make it a habit, you are more likely to stay on track.
Mistakes To Avoid
Errors in budgeting can be costly. Consider these pitfalls to avoid so you can have as clean a budget as possible.
- Forgetting to track expense. If you set a budget but don’t track your spending, it makes it very difficult to adhere to your budget. As preached earlier in this guide, keep track to see if you’re on target.
- Not budgeting because of fluctuating income. If your income is variable and changes on a monthly basis. That can make it a challenge to budget, but it doesn’t mean it’s not worth it. Taking a two year average income for yourself should give you a solid baseline. If you are expecting a large pay raise in the coming months, considering using 80% of your new income in your revised budget to build a margin of safety.
- Not reviewing your budget. Your budget should be updated on a regular basis. These can include transition times like a job change, new marital status, as well as if you consistently go over or under budget and need to update the amounts in each category.
- Not planning for all of your expenses. The non-negotiable payments that are the same each month will be easier to forecast. But you may not properly plan for variable expenses that can shift from month to month. Plus, you may underestimate your discretionary spending. For example, you may budget $80 per month on subscriptions but find that one or two subs already eat up your whole allocation.
- Taking from one pot to satisfy another. This one might be the most easy to fall victim to. You may grab funds from other categories if you’re at capacity in one area and use it as an excuse to spend. For example, if you set a $350 entertainment budget that is already spent, you might be tempted to use more money in a different category that hasn’t been spent. While it’s not the end of the world if you avoid taking on debt, it can undermine the budgeting process.
Now that you have a clean budget in place, if you have a surplus it would be a good idea to get that money working for you. Have a look at our Tax Free Savings Account page to see how you can use those spare funds to build your net worth.