A budget is telling your money where to go instead of wondering where it went.
—Dave Ramsey, financial author
By the end of this section, you will be able to:
- Describe budgeting strategies and the pros and cons of budgeting
- Identify the steps necessary to create a personal budget
Without a personal budget, most people have a hard time gauging how much money they spend and where their money goes. If you have ever gone to an ATM to withdraw money and been surprised to discover how little you had left in your account, this section is for you. It’s also for anyone who wants to learn how to manage their money better and smarter—which is an invaluable skill to have during the penny-pinching years of college but also later on in life.
Even if you’re very conscientious about paying your bills on time and generally have frugal spending habits, creating and following a budget can put so much further ahead. In essence, a budget is a plan for how you want to spend money. It details how much money comes in each month and how much you’ve allocated for spending on each thing. The virtue of a budget is that it puts you in control of financial decisions—so you can avoid surprises at the ATM or at the end of the month. Let’s look at some strategies for creating a budget:
- Be realistic: People are often intimidated by budgets because they’re afraid the plans will be too strict or force them to cut back too much. Though a budget may reveal that you indeed spend a lot of money on clothes, that’s okay—it may just also need to show that you spend very little on restaurants and eating out to make up for it. Again, it’s about making choices and being realistic.
- Choose a time line: Creating a budget for a fixed period of time will help you monitor whether you’re meeting your financial goals. The time line you choose is up to you and your goals. For example, you might create a monthly budget to monitor how you spend your paycheck every month.
- Add financial padding: Even if you feel like your list of financial obligations is already long, try to set aside a certain amount each month for a “rainy day” fund—to pay for unforeseen expenses and emergencies, like car repair, lost textbooks, etc.
- Make adjustments as needed: While sticking to your budget is important, there’s nothing wrong with revisiting and adjusting your original targets. For example, if you find that you are actually spending $50 more per month on groceries than you intended (even after shopping for sale items), you may decide to save that money elsewhere in your budget next month—on entertainment, for example.
Pros and Cons of Budgeting
While budgeting can be a useful financial tool, it may not be for everybody. Some people may feel more confident by balancing their checkbook to see how much they have at any given time. Still, many argue that budgeting helps people stay on track and avoid overspending on “wants” such as restaurant food, clothes, and entertainment, so they always have enough money for “needs,” such as rent/mortgage, utilities, and food. The following lists summarize the advantages and disadvantages of budgeting:
- Provides a realistic view of personal finances: A personal budget provides an honest snapshot of how much money you make and how much you can spend. It can help you avoid deceptive financial thinking, such as believing that you’re “flush” right after pay day, when you really need to save that money for an upcoming bill.
- Helps you avoid excess spending: Because a budget gives you insight into the total picture of your income and expenses, you can make realistic decisions about spending. As above, a budget can help you avoid a having faulty sense of your financial resources and remind you that even if you just got paid, most, if not all, of your check may need to go toward fixed expenses.
- Assists in goal setting: Since you get to decide how to allocate your money, a budget can help you set goals. For example, if you create a yearly budget, you could plan and acccount for an upcoming family trip and start saving money for it in advance without worrying about having the money at the last minute.
- Budgets take energy: Planning a budget takes dedication. Since most students lead busy lives and are balancing different demands like work, school, and time with family and friends, it can be easy to slip up. For example, if you have a stressful week at work or school, you might overspend while going out with friends and forget how much you budgeted for leisure activities.
- Results take time: Since most budgets cover a time period of a month, year, or even longer, people may become frustrated waiting to see if their financial situation is better than it was before. Frustration can lead people to abandon their budget and go back to overspending or neglecting to save.
- Budgets may be strict: Remember that one of the important strategies for creating a successful budget is earmarking money for “treats” and extras such as entertainment. However, in an effort to become more financially disciplined, some people make budgets that are too restrictive and unrealistic. This can backfire and lead to overspending in one area or abandoning the budget altogether.
Creating a Personal Budget
Even though you may be persuaded by the downsides of budgeting and think, “It’s not for me!” don’t give up until you’ve tried it. Tracking one’s income and spending is a good exercise for anyone, and if you follow the basic process, below, it’s easier than you think.
Stage 1: Determine Goals
The first strategy to create a successful budget is to determine why you are doing a budget. Setting goals will give you motivation to stay focused and on budget: something “real” to look forward to or achieve.
Try to set both short-term and long-term goals.
- Short term goals should be things you want to do within 6 months to 1 year, such as paying off a credit card or saving for your emergency fund
- Long term goals should be things you want to do two or more years down the line, such as paying off college loans or buying a car
If you find the thought of making a budget too dreary to contemplate, start with your dreams, instead. Sit down with a pen and paper and list out all your hopes for what you want to do in your life. Consider how the stress of financing these dreams will affect you in the short-term and long-term. Be understanding of yourself, but also be realistic by asking, “Will you be able to do the things you listed at the rate you are going?”
Stage 2: Define Categories
Making categories helps make the budgeting process easier and quicker. Create a category for each of the areas you spend money or save money by grouping like items. Tracking fewer categories makes it easier to budget overall.
Make a list of all the things you spend money on and save money for. Once you have your list try to group items together.
Potential categories might include:
- Car – gasoline, oil changes, cleaning, upkeep
- Entertainment – dates, parties, activities, Netflix or other streaming service subscriptions. Anything fun generally ends up in this area
- Food – groceries, dining hall, coffee shops, restaurants, and bars
- Household – food, cleaning supplies, personal care, over the counter medicine, and small appliances
- Housing – rent or dorm costs
- Gifts – gifts for birthdays, Christmas, showers, weddings, Father’s Day etc.
- Clothing – clothing, shoes and accessories
- Insurance – auto, rental, health, etc.
- Savings – any money going to savings for specific reasons or a general emergency fund
- Utilities – cell phone, Internet, cable, electric, gas, water, trash, etc.
Stage 3: Schedule Adjustments
Getting a budget up and running often works well for a month or two, and then encounters mysterious problems. Spending may balance out well initially, but then grow harder to predict or control.
A key secret: budgets need attention and adjustment every month.
You’ll have the same expenses every month, but they won’t always be for the same amounts. Therefore, your categories of spending will stay the same, but you’ll make adjustments to the amount you budget every month.
For example, if your significant other’s birthday is coming up, you’ll need to consider what you’re planning to do or buy for that event, and how that affects other spending for the month.
Each month, consider:
- What events or activities do I have coming up?
- Am I going to be driving more or less?
- What holidays are coming up, and what do I need to do to prepare?
- Is anyone going to be helping me pay for some categories this month?
If a category of your budget needs to increase its spending, then another area will need to decrease its budget for that month.
Stage 4: Consider Expenses that Don’t Happen Each Month
Another challenging area for budgeting concerns things you know you’ll have to pay for, but infrequently or not on a set schedule. Such items include:
- insurance premiums
You don’t want April to roll around and suddenly have to come up with a big amount of money to pay your taxes.
To prepare ahead of time, start setting money aside every month in a savings account. This will become a new category for your spending. You can divide things like insurance premiums into monthly chunks and sock that away ahead of time, in order to have enough for the lump payment when it comes due. Add an additional amount for less-predictable spending. That way, if you encounter a big sale at your favorite store, then you can stock up and not wreak havoc on your budget. It will take several months to get a cushion, so take that into account now.
It doesn’t matter what precise system you use. You just need to have a plan for these expenses.
Stage 5: Unexpected Expenses
The hardest part of budgeting for most people is unexpected expenses. These may be unexpected, and sometimes unpleasant, but you can still plan for them.
Types of unexpected expenses include
- auto repairs
- home repairs
- veterinarian expenses
- medical bills (like co-pays and prescriptions)
If you have a car, plan to have it repaired. The unknowns are when that will be and how much it will cost. To prepare, set money aside ahead of time. You may think, “Easier said than done!” But putting aside as much as possible (and as realistic) will reduce your debt as well as lower your stress level!
Two ways you can set money aside:
- Set a lump sum of money aside (the easiest way)
- Set up categories for these expenses (like you did for your monthly expenses). This is more time-consuming but you can track exactly where your money is going.
Note – This is separate from your emergency fund. Most financial experts recommend that you have 3-6 months’ worth of income in savings for emergencies. Unexpected expenses are not emergencies. Emergency funds should be untouched and on-hand for dire situations like losing a long-term job or encountering a major medical issue.
How much money should you set aside?
The best way to figure how much to budget for unexpected expenses is to list all the unplanned expenses you had last year, plus ones you can predict are coming soon. For example, you might predict that if you have a dog, he will have to visit the veterinarian at least 2 times a year for unexpected reasons.
- Make a list of all unexpected expenses
- Estimate how much money you should have set aside for the year
- Take your total and divide by 12 and set this much aside each month
It might take you a while to get enough money set aside. Keep working at this, and don’t give up if you don’t always meet this target each month.
The Envelope Method
Still not convinced that making and following a budget is doable? The following video describes a budgeting technique that’s very easy and straightforward to follow: the “Envelope Budget.” Simply placing cash in labeled envelopes (one for each category or purpose) each month can be a very effective means of building healthy spending habits.
Check Your Understanding
Answer the question(s) below to see how well you understand the topics covered in the previous section. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times.
Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.