In the delicate balance between income and expenses, the humble budget emerges as your financial helper. Your income, flowing from various streams like wages, rent, dividends, or business earnings, faces off against expenses – the everyday necessities and occasional indulgences that vie for a share of your funds. This article unveils the art and science behind budgeting basics, explaining the reasons why it’s a game-changer for financial stability.
No jargon, just clear insights into how budgeting can transform your financial landscape. From distinguishing between needs and wants to introducing common tools that make budgeting a breeze, join us on a journey to financial empowerment.
A budget is a financial plan that is used to estimate the balance between income and expenses, also termed cash flow. Income may include wages from a job, rent from rental property, dividends from stocks, business income, and other sources that put money into your bank account. Expenses include food, housing, utility bills, fuel, insurance, leisure, and anything else that takes money from your bank account. Expenses can be categorized into needs (e.g. food and shelter) and wants (e.g. eating out, or going on a holiday). Learn about the basics of budgeting below, which covers the reasons why using a budget is beneficial as well as some common tools you can use to create a budget.
Why you should create a budget
The aim of a budget is to estimate and plan current and future cash flows for some period into the future. In addition, budgets are important for planning, tracking, and adhering to financial goals.
Dave Ramsey, author of The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness (Link), describes a budget as “Telling your money where to go instead of wondering where it went.”
As with any goal, a carefully laid out plan helps to:
- identify ways to achieve the goal sooner
- identify any weaknesses in the steps required to achieve the goal, which can lead to making changes or adding other steps to address any weaknesses
- provide a blueprint to follow and review on a regular basis
A budget helps to plan out your financial goals, whether they are short term, medium term or long term goals. Whether you have a multi-million dollar investment portfolio or you have just landed your first job, you should have financial goals. A budget will help you reach these goals with the following benefits:
- Budgets allow you to easily track progress. Having financial goals with a budget will make it simple to check whether your goals are on track, and if not, correct them.
- It gives you more control over your finances. You can easily see where your money comes from and where it is spent.
- Financial decisions become more simple when you have a budget. The budget can indicate whether you can pay for something without going off track with your financial goals.
Are budgets a waste of time?
It is common for people to claim that budgets are useless and a waste of time. This is often because they don’t set out the budget and financial goals properly in the first place, or they don’t review it from time to time and update it when circumstances change.
Sometimes it is because we are all different and have different personalities. Some of us are able to create goals and are good at sticking to them. Others of us are not interested in goal setting, or we can set goals but have trouble sticking to them.
A useful book that discusses financial personality types is Budgets Don’t Work (But This Does): Drop the one size fits all approach to money and discover the power of understanding your unique financial type by Melissa Browne (Link).
Ultimately, it is your choice of how you handle goal setting and adhering to them no matter where you lie on this spectrum.
However, knowing how to create a workable budget and carefully planning your financial goals can go a long way to achieving them. And if you understand your financial type, you can unlock some of the secrets needed to stick to financial goals.
If I still haven’t convinced you, think about this quote from Benjamin Franklin: “If you fail to plan, you are planning to fail.” This applies to budgets as well as any other aspect of setting goals.
You simply cannot expect to reach a goal effectively without having spent some time planning.
How to create a budget that works
An effective budget takes into account the SMART attributes of goal setting. These include Specific, Measurable, Achievable (or attainable), Realistic (or relevant) and Timely.
Specific
Financial goals should be specific. A financial goal of “I want to be a millionaire” is not very specific.
A more specific goal might be “I will pay off all my credit card debts within 1 year”.
Measurable
Financial goals need to be measurable. The goal needs to have some way of quantifying progress.
For example, if you have credit card debts worth $6,000 and your goal is to pay them off within 1 year, you will need to reduce the debts by an average of $500 per month.
You can quantify the remaining debt at the end of each month to check progress. You can also adjust your budget to have $500 set aside each month to pay off the debts.
Achievable
You need to set goals that can be achieved. Setting financial goals that cannot be achieved will cause frustration and people will often give up.
You are better off starting with smaller goals and building to larger ones over time. Likewise, it is easier to achieve a large goal by breaking it down into smaller goals.
Realistic
Keeping your goals realistic helps to make them achievable. It also allows you to define the path required to reach the goal.
Take for example the following goal: “I will buy a house and have it paid off within 5 years.” If you have sufficient savings to purchase the house, have a high-income job, and have done your research on monthly costs, then this goal may be realistic.
If, on the other hand, you don’t have a high paying job and can only afford to pay the loan over 20 or 30 years after all other expenses have been paid, then this goal is clearly not realistic.
Timely
Financial goals should be timely. Specifying a time frame defining when the goal should be achieved helps keep you motivated.
The “I want to be a millionaire” example above has no timeframe set for the goal. Changing it to “I want to have investments worth at least one million dollars in 10 years” has a time limit and is more specific and measurable.
Breaking this long-term goal into smaller timeframes such as every year or two can help with defining a path to reach that goal. It may create new questions or challenges that can be addressed with other, smaller goals.
A budget, if created properly, is a powerful tool to help plan and reach short-, medium- and long-term financial goals.
Tools that are useful for creating a budget
There are a number of tools available to manage your personal finances. If you own a computer, tablet or smartphone, some of the options available include:
- Use online or mobile finance managers. For example, mint.com, wallethub.com and personalcapital.com. Many online personal finance managers offer free versions to make it easy to decide whether it suits your needs. Most also offer apps for iOS and Android to make them accessible and easy to use on the go.
- Use a spreadsheet application. Spreadsheets are more customizable and allow you to calculate, track and forecast cash flows. However, spreadsheet-based budgets require some level of knowledge of using spreadsheet applications.
Creating a spreadsheet-based budget takes a little time starting with a basic budget and tweaking it until it is suitable for your needs.
Once it is at a usable stage it only requires minor adjustments when income, expenses or financial needs change. What’s more, you can make it as simple or complex as you like based on your level of experience and imagination!
Continue to the following articles to gain a deeper understanding of budgeting and how budgeting can help you reach your financial goals.
- Cash flow – income and expenses
- Creating a budget – simple step-by-step guide
- Expenses – learn the differences between needs and wants, and how to reduce expenses
- Debt – good debt and bad debt and how to pay debts off quickly
- Pay yourself first – save more money to grow your wealth
- Emergency fund – build yourself a financial safety net
- Money windfall – how to spend a bonus, inheritance, or lotto win
