Creating a personal budget is one of the first steps toward improving your finances. No matter if you are struggling to pay off debt or saving up for something big like a house, retirement, or a vacation, creating a personal or household budget will help you reach your goals
A personal or household budget is simply an itemized list of planned income and expenses over a period of time. Although people generally consider the term “budget” to mean restricting spending, budgeting is really about getting control of your spending and spending in the areas that are highest priority to you.Budgeting is simply a plan to help you prioritize your spending on areas of life that are most important to you. Click To Tweet
A budget is a plan for how to spend your money. To make that plan it’s helpful to begin by understanding how you have been spending in the past.
Step 1: Gather all of your financial statements
Begin by gathering all of your financial statements such as pay, bank, credit card, debit card, and mortgage statements. You will need at least one month of statements but may want as many as 12 months of statements to reference, especially if your income or spending fluctuates throughout the year.
Note, some credit cards and banks have spending tracker tools online that will automatically categorize your spending which can also be a great reference while creating a budget.
Download a free Microsoft Excel budget template
Step 2: Make a list of your monthly income sources
Begin by making a list of all of your income sources and amounts, usually on a monthly basis. For most people, this is income from wages. Some people may have other sources of income such as dividend, interest, rental property income, pensions, etc.
Because the budget is a plan for the future it’s important to create the budget for the average or generic month. Meaning that you the income amounts should be the average or normal amounts. If you are paid salary on a monthly basis this will be very easy to know. However if your income varies each month, you are paid hourly, or you are paid every two weeks, you might have to estimate your average monthly income.
The easiest way to estimate your average monthly income no matter how frequently you are paid is to take your total income for the last year and divide by 12.
If you receive any large annual one-time income, such as bonuses, you will need to decide whether to include them in your average monthly income or not. If you decide to include them in the monthly average you will have to remember that the income is already allocated when you receive it. Personally I prefer to exclude any large one-time payments from the monthly budget and instead create a mini budget plan for those sources of income (such as funding an emergency fund, paying off debt, or investing).
Step 3: Make a list of your monthly expenses
Similar to income you also need to create a list of your typical or average expenses. Begin by creating a list of all of the items you typically spend money on by using your statements or online spend analyzer tools.
It’s important that expense amount are monthly averages so if the amounts vary over different months you may need to take an average over a few months period. For the same reason you should also exclude large, one-time expenses unless you expect them to occur again in the future.
Typical expense categories include:
- Household items
- Personal items
- Charitable giving
Step 4: Calculate your net income (unallocated budget)
Once you have a list of your average monthly income and expenses, add up the totals of each. Then calculate your monthly net income (or unallocated budget) by subtracting your total expenses from your total income.
Hopefully your net income is a positive number which means you have money left over. If not, don’t worry, we’ll address that in the next step. If you have money left over in your budget, you may want to allocate the money to an area such as savings.
Step 5: Review and revise your monthly expenses
Now that you have a good perspective on how you have been spending your money, it’s time to think about how you would like to change your spending. This isn’t about restricting your spending, but rather deciding to spend money on your priorities. A budget is a tool to help you deliberately use money on things that are important to you.
Some expenses are fixed and necessary, such as housing costs (mortgage or rent), utilities, etc., while other expenses are variable and easier to reduce.
Considering your variable expenses, what is important to you? Are there particular hobbies you enjoy? Are you saving for travel or a vacation? Or saving and investing for an early retirement? Make whatever is important to you a priority in your budget and ensure it’s funded.
Now take a look at your other variable expenses that are less important to you. Are there any areas where you can reduce spending? Look for areas that are not important to you and you don’t receive any satisfaction from. Those areas are opportunities to reduce your spending in order to fund the areas that are more important to you.
Typical expense ratios
Here are some typical expenses as a percentage of income for reference (Source: U.S. Bureau of Labor and Statistics). Note, these are general averages and may not be relevant for you if you live in a high cost of living area or have an unusually small or large income.
|Expense category||Percentage of income|
|Utilities and household items||10-15%|
Make savings part of your budget
Your expenses should include all areas where your money goes or you would like it to go, including saving and investing. Savings should be a priority in any budget. So I recommend making a savings expense category to specify a certain amount to allocate to savings each month.
Make this a habit as soon as you can, and even better, automate the savings transfer with online banking tools to put the money in a separate account each month. If you can, start saving money as a teenager and you’ll develop a habit that will help you build wealth throughout your life.
As you adjust your budget you should try to make sure that your total expenses are less than your total income. Depending on your financial situation this may be challenging to do. You may have to cut spending, or try to increase income, or both.
How to use your budget
Now that you’ve created a budget it’s time to put it to use. For the next month consider your budget plan as you spend money.
If you overspend in a certain area, don’t beat yourself up about it. Using a budget is not a precise science but a tool to help you live your financial life more deliberately. If you find yourself overspending on the same things month after month, you may want to adjust your budget if those areas are important to you.
Additionally, large unexpected expenses should be funded from an emergency fund, not your monthly budget. These expenses, if included in the monthly budget, will typically make your expenses exceed your income, so plan to pay for these out of an emergency fund. If you don’t already have an emergency fund, you should create one and begin funding it with your budget.
Finally, don’t be afraid to adjust your budget over time as your income sources and expense priorities change. Budgets should not be a rigid measure of success, but rather a planning tool to help you with your finances so that you can lead a fulfilling life.
3 thoughts on “How to create a budget in 5 simple steps”
Always good to keep things simple when starting a behavior change! This is great advice and I hope some people follow it.
Thanks for sharing these tips! It would really help a lot people in creating a budget by easily following it.
Creating a good budget like having the ones that you needed and much less on the wants is also a pretty good tip! Thanks for sharing your tips by the way, great article!