One of the biggest barriers to creating and following a household budget is the hurdle of looking at the numbers in the first place. It’s stressful, and it often comes with unspoken guilt and shame about how you handle money.
Let’s start by getting to a more neutral place about your financial literacy. None of us receive a standardized “how to use money” lesson, and the things we learn about personal finance are always delivered and received through a lens of lived experience. Someone who fought hard to get out of credit card debt may advise you to never open a line of credit in the first place, but someone who leveraged a card’s promotional period to pay off a large balance may recommend a strategic use of credit.
Neither one is “right.” They are both valid options, and the advice you take will depend on your own situation, needs, and goals.
Step One: The Financial Review
The purpose of a financial review is to evaluate your spending and make sure it lines up with your priorities. If you aren’t intentionally spending, saving, and investing, then you’re likely to end up wondering where all your money went in the first place!
Start by gathering up your bank and credit card statements for a certain period of time – we recommend starting with at least three months, but going through a year of your records will give you the best baseline numbers. Your bank may offer a spending review each month, breaking down your transactions into categories like utilities, entertainment, dining, travel, etc., and this is the same approach you’ll take with your review.
Once you have your numbers laid out in their respective categories, examine them. What percentage of your income do you spend on housing, transportation, food, and fun? Are you saving for retirement or a college fund for your kids? Does anything look out of place?
Finally, go over the numbers again, this time noting which of your expenses are essential (necessities), strategic (savings, investments, debt repayment), and discretionary (vacations, gifts, entertainment, etc.).
Step Two: Creating Your Budget
Ideally, you’ll be able to cover all of your expenses with your income, without needing to borrow or use credit to make ends meet. We’ll use the 50/30/20 budgeting approach for nice round numbers: roughly 50% of your after-tax income should be spent on essentials, 30% for discretionary spending, and 20% for savings and debt payoff.
This breakdown isn’t a strict rule. Adjust as needed to fit your financial situation.
Essential Spending
Essentials may differ from person to person, or family to family. A family with great health insurance from an employer won’t need to plan for medical expenses as much as a self-employed person with insurance from the marketplace with a high deductible. Consider the following expenses when determining your list of essentials:
Housing: Rent or mortgage payments, insurance, utilities, HOA fees
Transportation: Car payments, insurance, gas, tolls, parking fees, public transportation fare, ride-share costs, vehicle maintenance and repairs
Healthcare: Health insurance, medications, copays, supplements, consumable medical equipment like blood testing strips or CPAP components, etc.
Childcare: Daycare expenses, school fees, costs for extracurricular activities, club dues, babysitting costs, diapers, clothing, etc.
Groceries: Food, drinks, household items, a portion of restaurant spending (some is discretionary, but it’s also okay to include a budget line item for takeout as a necessity—we’re overworked).
If these costs come out to more than 50% of your take-home pay, look for wiggle room where you might be able to decrease spending. There may not be room to reduce costs, in which case you might need to adjust your percentages to accommodate the need for more than 50% of your income in this category.
Strategic Spending
Roughly 20% of your after-tax income should be dedicated to strategic financial moves, such as saving an emergency fund, investing in your retirement, saving for large purchases, and paying off debt.
For an emergency fund, you’ll want to set aside enough money to cover three to six months of your essential spending. That number will vary based on your situation, family size, etc., so it’s okay to break it down and save a little each month instead of making huge deposits to get it done ASAP.
You can also set up sinking funds for larger expenditures like a down payment, car or home repairs/upgrades, or lump sum insurance premiums. For instance, if you have a life insurance policy that renews in April for $360, setting aside $30 per month means you don’t have to adjust your monthly budget that month to accommodate the large payment. Changing payment plans (such as car insurance, cell phone service, or subscription services) to be annual or semi-annual can often trim costs and offer savings, and then you can set aside the monthly amount in a sinking fund to pull from when the bill comes due.
If you aren’t already saving for retirement and your workplace offers a matching contribution as a benefit, start there. If you’re already investing and getting it matched, you could open a Roth IRA, which has a max contribution of $7500 per year (this number may change in the future). If you can dedicate $7,500 of your annual budget to retirement, this is a great choice to allocate funds strategically.
Paying off debt can be done in a couple different ways – namely, the debt snowball vs. the debt avalanche. First, list your debts including their balance, minimum payment, and interest rate. Before beginning either approach, make sure you’re only paying the minimum payment on all of your debts except the one you’re focusing on first.
For the snowball method, you’ll start by paying off the smallest balance first, then adding that payment onto the minimum payment for the next debt. Your payments will grow as you continue to pay off balances, like a snowball that starts small and continues to pick up snow as you roll it. The debt avalanche starts with whatever debt has the highest interest rate, with the goal being to reduce the amount of interest paid overall.
If you have trouble sticking to long-term financial plans and budgets, the snowball method may be better for you, because it offers easier wins to start, which psychologically reinforces your new debt payoff habits. Brains love dopamine, and paying off a balance in full is an excellent way to give yourself a little dopamine boost.
Discretionary Spending
The remaining 30% of your after-tax income can be used on discretionary spending like entertainment, restaurants, gifts, vacation, etc. This is the most flexible area of the budget, because it’s truly subjective. Some may consider clothing and haircuts to be discretionary, while others may consider a monthly trip to the salon part of their essentials. You may hire a cleaner or use a meal subscription service to accommodate your needs, while others consider those services a luxury.
At the end of the day, discretionary spending is anything that you could cut out if an emergency happened and you needed to reduce your budget to just the essentials. You’re the best judge of what counts for each category.
Step 3: Create a Plan
Great, you’ve got a budget, and you know roughly how much of your income you can spend on essentials, strategic plans, and discretionary funds. But why bother doing this at all? Simple: so you can intentionally plan your financial future.
What financial goals do you have? Some common goals include:
- Get out of credit card debt
- Pay off your car
- Buy a house
- Save for retirement
- Start a foundation or scholarship fund
- Pay for a child or grandchild’s college education
- Start or expand a business
Get as specific as you can. Instead of “save for retirement,” really think about how much you want to save. How much money do you want in your retirement fund when you reach retirement age? How early do you want to retire?
You can get help answering these questions and strategizing your financial future by working with a Financial Advisor or Financial Planner – we recommend Morgan Financial Associates!
Step 4: Keep It Up
Once you’ve reviewed your finances, made a budget, and created a long-term financial plan, all that’s left is to keep up with the process. Check in with your budget regularly to make sure your spending is in line with your 50/30/20 target.
Teach others around you how to manage their finances this way too – if you have children, it’s never too early to start teaching them how to spend and save wisely.
Need help with a financial review and budget? We can assist! Book a free consultation today to talk about our personal finance services, including year-round tax advising.