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How to budget: 5 steps for creating a monthly budget

Life without a budget is like a road trip with no map.

Justin Cupler

Contributing Writer at Tally

June 22, 2020

Without a proper monthly budget, managing your money can feel overwhelming. Budgeting can add consistency and predictability to your finances. This predictability allows you to plan for your future and set attainable financial goals. 

Budgeting is critical during uncertain times, like the COVID-19 outbreak that’s caused mass job loss and reduced income. In times like these, you may need to re-evaluate your budget or create your first budget to help guide you through tough financial times

Below, we'll show you how to budget and provide a few budgeting tips to streamline the process. 

How to budget

Setting up your budget involves a careful analysis of your financial situation and spending habits. The sections below outline how to budget step by step. 

1. Set your financial goals

The first step in any monthly budget is setting financial goals. Whether you're looking to pay off debt, save for retirement, save for a large purchase, get through a tough financial downturn or meet a mixture of these goals, setting a financial goal is a critical part of any budget. It provides a light at the end of the tunnel to keep you motivated.

Tying your budget to a financial goal will give you a target to aim for and help keep you on track. Three common financial goals are paying off debt, building an emergency fund and saving for retirement. 

Paying off debts

If you have credit card debt or any other high-interest debt, paying it off should be your initial financial goal. It's important to pay it off first because high interest rates rob you of cash. 

For example, if you have $10,000 in credit card debt at 19% interest and paid just the minimum monthly payment, you would pay up to $10,834.15 in interest before paying off the debt.

Building an emergency fund

If you have no debts to pay off, building an emergency fund should be your next financial goal. 

An emergency fund is critical to your financial security, whether it's to get you through job loss due to a recession, like we're seeing with the COVID-19 pandemic, or cash to cover a sudden expense, like a car repair.

Most experts recommend setting aside 3-6 months of your salary as an emergency fund. Putting this money in an accessible savings account that yields interest will allow your emergency fund to continuously grow but still give you access when you need it. 

Building your retirement accounts

If you're debt-free and have a fully funded emergency fund, your budget can center on saving for retirement

Because interest in your retirement account compounds, the earlier you start saving, the more savings you’ll have to enjoy in retirement. 

2. Calculate your monthly income

Calculating your monthly income is the next step in budgeting, but there's more to it than just tossing your monthly salary in and calling it a budget. Instead, you must calculate your take-home pay — the cash that hits your bank account after taxes, insurance, 401(k) contributions and everything else is deducted from your paycheck.

If you have a fixed income — and income that rarely fluctuates — you can calculate your monthly take-home pay by multiplying the amount in the “Net Pay” section of your pay stub by the number of pay periods you have that month.

If you have a variable income, you will need to look at the past few years of tax returns to determine your average monthly income. 

To determine your average monthly income, calculate your average yearly income from the last two years, then divide by 12. If you don't have access to this information or you just started a new job with variable income, you can estimate it for now. Just make sure to update the estimate as your income becomes more consistent.

With variable income, calculating take-home pay can be complex because you may pay your own taxes. If this is the case, you can get your annual taxes owed from the previous year’s tax returns and divide it by 12 to get your monthly taxes. Then, subtract the monthly taxes from your gross monthly income to get your monthly take-home pay. 

If you have no past tax returns to look to, you can use an online calculator to estimate your taxes. Make sure to divide the total yearly taxes from the calculator by 12 to get your monthly taxes. 

When calculating your monthly income, make sure to account for uncommon and irregular income sources, like: 

  • Alimony

  • Child support

  • Earned interest

  • Unemployment compensation

  • Social security

  • Severance pay

  • Bonuses

3. Calculate your monthly expenses

With your income calculated, now calculate your monthly expenses. There are three main types of expenses: fixed monthly expenses, variable monthly expenses and non-monthly expenses.

Fixed monthly expenses

Begin by adding up every fixed monthly expense you have. These are bills and expenses that remain consistent in cost month over month. Fixed monthly expenses may include: 

  • Car payment

  • Student loan

  • Personal loan payment

  • Rent or mortgage payment

  • Car insurance premium 

  • Health insurance premium

  • Cell phone bill 

  • Gym membership

  • Cable

  • Internet

Once you calculate the total of your fixed monthly expenses, set this number aside for future use. 

Variable monthly expenses 

Now move to variable monthly expenses. Variable costs generally stay within a certain range but will vary slightly each month. Variable expenses may include: 

  • Groceries

  • Gasoline

  • Entertainment

  • Dining out

  • Electricity

  • Water

  • Doctor visits

  • Credit card payments

Variable expenses are trickier to nail down because you pay a different amount each month. To get around this, look at the last 6-12 months for each expense and find the average monthly cost over that period. 

For example, if you spent $3,500 on groceries over the past six months, your monthly grocery expenses would be $583.33 per month ($3,500/6).

Add up all the variable expenses and put that number aside. 

Non-monthly expenses

Non-monthly expenses are those that are regular but don't occur monthly. A non-monthly expense may include:

  • Annual doctor checkups

  • Quarterly car insurance premiums

  • Gifts for holidays and birthdays

  • Yearly property taxes 

  • Yearly homeowner's insurance premiums

  • Annual club dues

Even though you're not expecting to pay these each month, plan for them as if you were. This way, when that bill comes due, there's no surprise. 

When calculating non-monthly expenses to fit your monthly budget, you'll want to add up their yearly total and divide that by 12 to get the monthly cost. 

For example, if you pay $350 per quarter for car insurance, the yearly cost would be $1,400. To figure out the monthly cost, just divide $1,400 by 12 months to get $116.67 per month.

Add up all the monthly calculations for your non-monthly expenses and set the number aside. 

4. Determine your discretionary cash

Discretionary cash is the leftover money you have after accounting for all your expenses. 

To determine your discretionary cash, subtract your fixed monthly expenses, variable expenses and non-monthly expenses from your monthly take-home pay. 

For example, if you have $3,000 in take-home pay and $2,500 in total monthly expenses, your discretionary cash is $500. 

Discretionary cash is what you put toward the financial goals you set at the beginning of the budgeting process. You can use this extra money to pay off debt, build an emergency fund, pad your retirement savings or any other goals you have. 

If you have no discretionary cash — or are coming up with negative discretionary cash — consider changing your spending habits.. 

A lack of discretionary income can be more prevalent in times of recession, like the one fueled by the COVID-19 pandemic, because out-of-work people are often more reliant on lower pay from temporary jobs or unemployment compensation. You can adjust for it by trimming expenses or increasing income. 

Trimming monthly expenses

The reality is budgeting sometimes exposes overspending. Sometimes, overspending can sneak up on you, but it's something you can fix. 

Start by going through your monthly expenses and seeing where there’s an opportunity to lower what you spend. Things like switching to a lower-cost cell phone plan, lowering your cable package or negotiating the price, dining out less or even consolidating your credit card payments with a debt consolidation loan or a line of credit

If lowering expenses doesn't put your discretionary cash in the positive, eliminating them is the next step. 

To eliminate expenses, list all your monthly expenses in order of importance and eliminate the least important ones. This may result in small sacrifices, like canceling cable or dropping your gym membership, but may also include more drastic cuts, like selling your car. 

Increasing income

If you've cut your expenses as far as you can but still lack discretionary cash, look into boosting your income with a side hustle. 

This extra income can give your budget the boost it needs to put your discretionary income in the black and get you on track to hitting your financial goals. A few examples of these side hustles include: 

  • Being an Uber or Lyft driver

  • On-demand food and grocery delivery

  • On-demand task completion

  • Freelancing

5. Tracking and fine-tuning

With all your budgeting calculations now in place, track your expenses each month to ensure you remain on target and meet your budget.

Each time you spend money, categorize it and add it to your budget. The categories you use may vary, but some common ones include: 

  • Rent or Mortgage: This is the cost of your mortgage or rent payment.

  • Utilities: This category covers electricity, water, heat, trash pick up, cable, internet, etc.

  • Groceries: This is the amount you spend on groceries each month. 

  • Transportation: This can include your car payment, fuel, maintenance, repairs and car insurance, but it may also be your monthly public transportation costs.

  • Medical care: This covers medical and dental expenses.

  • Personal care: This is a broad category, but it can include haircuts, manicures, massages and similar expenses.

  • Clothing: This covers any clothing or shoes you buy in a month.

  • Entertainment: This is the money you spend each month on fun things like concerts, plays, movies and nights out with friends.

  • Dining out: This is the amount you spend at restaurants each month.

There are many ways to track your budget. Some prefer to use a notepad, pen and calculator  to manually write down all their expenses and track them. Others may work with computer software, like Excel to help with the calculations and tracking. 

For those who prefer something more automated, there are plenty of budgeting apps that connect to your bank to import your transactions. All you do is enter the budget for each category, and verify and categorize each expense as it comes in. 

For example, if you go to the movies and out for dinner with some friends, this will go in the “entertainment” category. When you pay your electric and cable bill, this will go in the “utilities” category. 

Each month, review your tracking to see if you over- or under-spent against the budget you set. Then, make small tweaks to balance it again. Using the categories, you can get a quick look at any areas where you may be overspending in a given month. 

Budgeting tips

On top of knowing how to budget, there are several tips that'll make the budgeting process smoother. 

Create a budgeting schedule

Budgeting takes some time commitment, but you don’t want to let it consume too much of your life. Consider the amount of time you’ll need to calculate, track and adjust your budget each month. Then, schedule time each week to handle this. 

Make this a routine that rarely changes, so it becomes just another part of your life. 

Automate where possible

Budgeting can be a time-consuming project, and automation can help free up some time. Automating the budgeting process with various apps, as mentioned above, can help, but you can also automate paying your bills to save time and prevent a forgotten payment. 

Call your provider, credit card issuer or lender, and ask about setting up automatic payments. In some cases, you can even set these up online. 

Once you set up automated payments, keep an eye on your checking account to make sure the payment goes out. 

Keep in mind that automated payments require some level of consistency in your income. So, if you have variable income, this may not be a good option for you. 

Make a backup

Whether you use computer software, a budgeting app or paper and a pen, always create a backup of your budget when possible. Computers crash, budgeting apps can close suddenly and paper can get lost or destroyed. Backing up your budget can save you from recalculating everything if something goes awry.

If you use computer software, save an extra file on a thumb drive or in a cloud system like Google Drive. 

When using budgeting software, see if the system allows you to export a file version of your budget and save the file on your computer and on a thumb drive or in a cloud system. If the app doesn’t offer a file, at least take a screenshot of your budget each month and save each screenshot on your computer and on a thumb drive or in a cloud system.

If you run a pen-and-paper budget, either make copies or take a picture of each month’s budget and save them in a secure place.  

Create your budget, meet your financial goals

Budgeting is like investing: The earlier you start, the sooner you reap the benefits by reaching your financial goals. 

There is nothing overly complex about the process. It simply requires setting your goals, calculating your income, deducting your expenses and making adjustments to your spending to create the discretionary cash needed and meet your financial goals. There are even budgeting tools online and on your smartphone or tablet that eliminate the tedious task of manually creating a budget.

Now that you know how to budget, it's time to review your financial situation and create one of your own. With the steps and budgeting tips we've offered above, you're prepared to take on this important step toward financial security. Now is the time to take that first step.