How to Create a Budget: Step-by-Step Guide

All of us have limited resources. As such, it is necessary to manage those resources to obtain the lifestyle we desire and become financially secure. One tool that can accomplish this task is the use of a budget. A budget helps you outline all your income and expenses to align your money with your goals.

Budget Step 1: Follow the Money

The first step to starting a budget is to determine where your money is currently going. The easiest way to document and analyze this information is to simply install an expense tracking or budgeting application (app) for your phone. Once installed, you will input every purchase you make into the app. Additionally, input any sources of income, such as your paycheck. I recommend inputting your expenses for three months (90 days) to identify patterns of spending, as well as develop an average for your spending in each category. In order to make the app useful, break your expenses into categories (e.g. housing, transportation, medical, groceries, entertainment, etc.). Once you have three months' worth of expenses, calculate the average for each category. For example, if you spent $300 on groceries in January, $280 in February, and $270 in March, the average is $283 ($850 divided by 3 months). This amount would then serve as your benchmark for what you expect to spend on groceries. However, you may need to adjust this amount if your spending for that time was irregular or you were overspending.

Budget Step 2: Identify Needs and Wants

After getting an idea of where your money is going, the next step is to categorize expenses into needs and wants. Needs (or necessities) are essential and cannot be cut out of your budget. For example, housing, transportation, medical, and food are some common necessities that you must put in your budget. In contrast, you will also notice numerous "wants," which are little extras that we enjoy but could live without. Some common "wants" include video streaming services, eating out, coffee shops, and movie theaters. By this point, you are probably thinking I am going to tell you to completely cut out all entertainment from your life to save money, but that is not always necessary. Rather, you have to determine which expenses are worth budgeting for, and that is a choice you will have to make for yourself. One expense that quickly adds up is subscriptions, so take a look at your recurring expenses to see if you can eliminate any extra services.

Budget Step 3: Compare Income and Expenses

After getting a good picture of your expenses and income, the next step is to determine your monthly deficit or surplus. If you are spending more than you make, that creates a deficit, which is unsustainable and will result in increasing amounts of debt. In contrast, if you are making more than you spend, you have a surplus that can be allocated for other purposes. When looking an income and expenses there are only two options to free up money. The first option is to increase income. This can be accomplished in numerous ways, but it typically involves taking on more hours at work or picking up an extra job. If this does not sound appealing or isn't an option, the second option is to decrease expenses by cutting out some of the "wants" identified in step 2. Even if you have a surplus, it may be necessary to take these steps in order to free up additional income.

Budget Step 4: Write a Plan

At this point, you have all the information to write out your budget. My recommendation is to utilize Microsoft Excel or other spreadsheet software to input your expenses and income. However, this can also be accomplished using your standard notebook, pen, and a little effort. Regardless of the method, the end result should be a document that accounts for every dollar that comes in or goes out. This doesn't mean that you have to spend every dollar, but every dollar should be allocated to a category, such as savings.

Budget Step 5: Evaluate Your Plan

Does your plan hold up to reality? You will need to continue tracking your income and expenses using your app (or whatever organizational method works for you) to determine if you are able to live off the plan you developed while still meeting your goals.

Budget Step 6: Create an Emergency Fund

It is essential to have some money stashed away for a rainy day. Here is where the emergency fund comes into play. The goal should be to have three to six months (90-180 days) of living expenses in reserve. This will provide flexibility in the event that an unexpected expense arises (e.g. car transmission goes out) or you get laid off from your job and lose your regular source of income. If you do not have debt, you can start working towards this 90-180 day reserve immediately. However, if you have debt, I recommend saving $1,000, then moving on to step 6.

Budget Step 7: Pay Off Debt

Whether it's student loans, credit card debt, or a car payment, most of us have some debt. The key to financial independence is eliminating this debt. In order to do so, you will first want to look at all your debts and identify the one with the highest interest. Credit cards typically carry the highest interest rates and can be in excess of 20%. Next, begin paying off the highest interest rates first. By doing this, you not only eliminate that debt, but you also reduce your interest payments, which creates a snowball effect by freeing up additional money to go towards your other debt.

Budget Step 8: Start Investing

It typically doesn't make sense to invest when you have high-interest debts because the returns from those investments will typically be less than your credit card with a 20% interest rate. Investing is essential to meeting your goals; however, it goes beyond the scope of budgeting. I encourage you to check out our articles on investing after you have established a budget and paid off your debt.

Click Here to Download Sample Budget Spreadsheet