Good money management requires a budget, which is a written plan for how you will allocate your funds. Seeing these numbers on a piece or paper, or a computer screen, can remind you of your priorities and help you stick to them when you’re tempted to upgrade to business class, or pull out the plastic for a pricey pair of shoes.
Calculate Your Income
The crucial piece of information you need to begin your budget is your income. Think monthly, and after-tax.
If you’re working, we’ll assume nothing is coming out of your paycheck yet for retirement savings, like contributions to a 401K or 403B. Besides wages and salaries, your income might also include any regular payments you get from others, like alimony, child support, pensions or Social Security checks. If you have an income-producing business or rental property, you should add in the after-expenses-and-taxes amount you pocket.
How much do you have to work with? For the purpose of this article, we’ll use the average U.S. household’s annual after-tax income of about $51,569. That leaves this typical family with about $4,297 per month.
Quantify Your Truly Necessary Expenses
List out the categories you and anyone else who relies on your income—like your spouse or children or dependent parents—need to get by every day and perform well at school or work (after all, if your income dries up completely, you’ll really be in trouble).
For most households, necessities include your housing costs, utilities, groceries and unavoidable meals out, healthcare, around-town transportation, and basic clothing and personal care costs (like for new prescription glasses and haircuts). It might also include childcare costs or other dependent care. It should also include any required debt payments, such as the minimums due on your student loans or credit cards. These are all things you definitely need to pay for every month to survive and avoid getting into financial trouble.
Here’s what this looks like for the average U.S. household.
Average U.S. Household's Monthly Expenditures on Needs
Utilities & Household Operations
Around-town Transportation (est.)
Debt Payments (est.)
Hopefully, after all the above expenditures, you still have money left. If not, you might need to think about drastic measures like getting a better paying job, or a second job, or moving for a cheaper housing cost. Since housing takes the biggest bite out of most peoples’ budget, you might be able to free up a significant amount of income this way.
Make a Plan for Your Leftover Money
Your remaining monthly income—$1,159 in the case of our average household—can be divided different ways. You can save it n an emergency fund, or for medium or long-term needs, like retirement. You can use it to pay off more of your debt. Or, you can spend it on the nice-to-haves, like entertainment, meals out, gifts, vacations, additional insurance (like homeowners or renters, life, and disability), vices like alcohol or lottery tickets, or any of the material things you may be coveting like the new iPhone, or a king-sized bed.
You might vary how you spend this extra money month-to-month, especially if there isn’t enough of it to cover everything. If you do have abundance, your goals might include:
- Paying off high-interest debt, meaning everything with an interest rate higher than about 4%. Credit card debt is usually a good place to start.
- Establishing an emergency fund that is 10% of your annual income (or about 6 months of necessities, if you’re self-employed).
- Saving for retirement: 10% of your income is a good goal if you’re on track for your age (more, if you’re not).
Also, you should find some ways to treat yourself to things that make you happy—concert tickets, manicures, birthday parties for your kids or the occasional meal at a special restaurant.
One way to plan for these kinds of fun expenses is to include them as categories in your monthly budget, and put a little money towards them each month, even if you only spend it occasionally. Some categories that work well for these kinds of things include gifts, entertainment, shopping and vacation. Some months you might not touch the money, but in others, you might blow it all.
Make it easy to stick to your budget by building in a little wiggle room in each category. This is especially important when you’re initially creating your budget, since you might not anticipate all of the possible expenses you will incur. For example, affecting your Gifts category, you might get invited to a few weddings you weren’t expecting, to add to the usual birthday, holiday and occasion gifts you need to buy throughout the year.
In your housing line, besides your mortgage payment or monthly rent, you should also include a sum that will add up to the amounts you may only spend occasionally, like for property taxes or homeowners insurance or renters insurance. Same for any other insurance you might pay, like auto insurance in your transportation line.
By including more money in a category than you think you’ll actually need, you’ll have some options when you need to adjust your spending plan, as you inevitably will when your circumstances change.
Keep an Emergency Fund
Emergencies happen. Your car will break down. You’ll need a new hot water heater. You, or your spouse or child, will get an illness or injury that eats up your health insurance deductible. This is why you need an emergency fund. If you don’t have one, these kinds of expenses can completely ruin your budget. Or, you might be tempted to pay the bills with credit cards that charge high interest rates.
A good emergency fund size is about 10% of your annual household income before taxes. Why this amount? It could see you through a period of unemployment of about six months if you would have access to jobless benefits or severance. If you’re self-employed, however, you need a much heftier amount, about six months worth of your basic expenses. If no job loss is looming, you can feel free to use your emergency fund as needed for, well, emergencies.
If you’re creating an emergency fund from scratch, make it a category in your budget. Try to save about 10% of your take-home income each month to reach that comfortable level of liquid savings in a year. And whenever you need to use the money for something, make sure to replenish it.
Tools for Making a Budget
There are various tools you can use to make a personal budget, depending on how comfortable you are with technology. If you’re a whiz with your thumbs, consider budgeting software like Mint, You Need a Budget, or one of the other options available.
Mint is free software that allows you to connect all of your accounts, including checking, saving, retirement, investment and credit cards , and it automatically pulls information from them. You can create a budget in Mint, and then monitor your income and outflows to make sure you stay on track. You Need a Budget works similarly, except you need to pay for access at the outset. It costs $60, unless it’s on sale and it often is—but it never expires. The price of admission also includes financial literacy classes and lots of tips from the active user community.
You can also make a budget in Excel or on a Google spreadsheet. This is a good way to break out each budget category and show the percentage of your income it’s consuming. The downside is you will have to track your actual spending yourself.
Then, there’s the old-fashioned paper method. Just get a piece of paper—the back of an envelope will do—and set up a budget by writing out the categories you need to spend on.
Monitor as You Go and Adjust Your Budget
With a budget, you cannot just set it and forget it. It’s more like menu planning—you start with a strategy for your upcoming meals—Meatless Mondays; Tuna Tuesdays, etc.—but make changes as you go along. And just as you monitor the groceries in your fridge so you know what to make for dinner every night, you need to track your spending as you go, so you’ll know when to put those shoes back on the shelf or to pick up the check when your college roommate is in town.
Software like Mint tracks your spending for you. The Luddite approach would involve recording every single expenditure in a small notebook, and then adding up each category at the end of the month. A computer spreadsheet would make this process a little bit easier.
However you choose to do it, you must track your expenditures, so you can see where you are over- or under-spending each month. Then, you need to either adjust your budget, or adjust your consumption to make the numbers match.
It doesn’t always mean cutting back, sometimes you just need to shift things around. For example, you might find that you don’t need $51 for personal care expenses; because you’re only spending about $26 per month on haircuts. Meanwhile that $25 is a welcome addition to your transportation funds because you are using more gas each week to get your kids to and from their soccer practices and games.
Looking over your budget as a whole helps clarifies the trade-offs you make with your money. You might realize you’d rather paint your own fingernails so you can order takeout one more time per month. Or you skip the tickets to the big game because you’re saving up for a flight home for the holidays.
In an ideal world, we’d all have plenty of money to pay for all of our needs and wants, we’d be debt-free and saving lots for retirement. It’s clear that very few U.S. families are in this situation. Still, creating a budget is a smart step towards managing your finances well.