How To Create A Budget That Works

Today, I’m going to show you how to create a budget that really works. I must say that budgeting is a solid foundation of all finances and that includes personal finance. Imagine a business or a restaurant that is operating without a budget. There’s no way to know how much profit the restaurant makes.

Without a defined budget for managing your spending each month, you could put your business in jeopardy. Therefore, the same holds true when it comes to your own finances.

What is a budget?

A budget is a spending plan to tell your money what to do each month.

What? Wait!?! Did you just say a budget is a spending plan?

Yes, it is. A budget is a SPENDING PLAN.

For most people, they think of a budget as a penny-pinching money spending plan. So when we hear the word “budget”, we think of “no-spending” plan. In reality, a budget is a tool that you tells your money where to go. It’s up to you how you set and control your spending each month. You want to control your money. Don’t let your money control you! You decide how much or how little you want to spend on each category. This includes things like movie night, summer vacation, holidays, and shopping! A good rule of thumb is your spending needs to be less than your income.

Guidelines to follow for a successful budgeting

1. Set your financial goals

You need to have a goal to aim for in any life situation throughout your life. Similarly, the same is true when it comes to money. What are your financial goals? Do you have one? If not, think about one.

You’ve been wanting to get out of debt. You’ve been thinking about building up your emergency fund and helping with your kid’s college fund. Or perhaps you are planning to buy a house. Whether it’s a short-term goal or a long-term goal, creating a budget is the first step to help you reach your financial goals.

2. Be realistic

If you never had a real budget in place before, don’t expect everything to be perfect first time. Because it won’t be. It takes time. Your first month or even the first-year budget won’t be perfect. Be true to yourself. Don’t beat yourself up. It’s good to aim for the best. But at the same time, keep in mind that your budget is a work in progress. If your family has been spending $200 on groceries a week, don’t assume that you’ll be able to crush your grocery monthly budget down to $500. It’s not realistic. Instead, use real numbers on your very first few months of budgeting, and gradually reduce it until you are satisfied.

3. Keep it simple

Creating a budget doesn’t need to be complex. The more complexities you get, the less successful it will be. Keep in mind, a budget is a plan you tell your money what to do. It’s not rocket science either. The fewer categories, the better. So I’m going to talk about a 5-category budget which I personally use later in this post. It’s simple and easy to remember and most importantly, it works.

4. Track your expenses

Do you really know how much you spend each month on food, shopping, etc.? How could you create a budget if you don’t know your expenses? This is where tracking your expenses comes into play. If you don’t have a tool or a system to track your monthly expenses, creating a monthly budget seems difficult. This free tool helps me track our income and expenses each month. I didn’t realize that we spent a ton on general merchandise (AKA shopping) until I started using this tool in 2016. The good thing was that it brought this issue to my attention. We are now so much better with shopping (rarely go shopping these days, thanks to this tool 🙂 ).

Start tracking your expenses now so you know your purchasing habits. This way it can help you see your financial weaknesses so you can improve.

5. Talk to family members

If you have a family, then it’s a good idea to get everyone on board with goals and the budget. Talk about the “why” behind every goal and spending decisions you have. It takes some adjustment at first especially if your family has been floating through life without a budget. Just don’t give up. The key is to adjust your budget as you go. Don’t make a big or drastic change. Instead, set incremental goals for each month. Eventually, you’ll get to the point where everybody understands and is adjusted to a monthly family budget.

A 5-category budget

You may have heard of the 80/20 budget or the 50/30/20 budget rule. In my opinion, the 80/20 budget is too broad. This budget rule simply tells you to spend 80% of your income and to save 20%. Eighty of everything else is too broad for me in my opinion. You might want more detail in your budget. A 50/30/20 budget which simply tells you to spend 50% of your income for needs, 30% for wants and 20% for savings. I still think this is too broad so I have developed my own version which I am calling the 5-category budget. This model is more structured and specific, the 5-category budget provides a perfect balance; not too few and not too many.

Keep in mind, this is my personal guideline. I’m giving a general percentage of a guideline in each category you could follow. I also include our percentage for each category. So you have an idea what our budget looks like. 🙂 We tend to do more on the savings side as we are pursuing Financial Independence (FI).

Category 1: Housing

Housing category should include everything housing related. This includes your monthly mortgage payment or rent, all utilities, trash & recycling service, property taxes, homeowners or renter insurance, HOA fee, and all home repairs & general home maintenance. Housing-related expenses should not be more than 35% of your take-home income. Experts also say, your mortgage payment or rent should not be more than 25% of your take-home pay.

We are trying to not exceed 25% of our take-home pay on all the housing-related expenses (this doesn’t include the extra principal payment we make toward our mortgage).  Since we don’t have trash/recycling service, cable/satellite TV, home phone, and HOA, it really helps to keep our housing budget low. We are also very careful about wasting money through utilities like water and electricity usages.

Category 2: Living Expenses

Living expenses include everything you need and want for your everyday living. This includes groceries, clothing, medical/dental/vision expenses, life insurance/health insurance, vacations, entertainment, shopping, eating out, daycare, cell phone, pets, club/membership fees, subscription, and the like. Living expenses should take up about 25% of your take-home pay.

For us, we aim to not exceed 15% of living expenses on our budget. Read how we live a happy and simple lifestyle by practicing these simple frugal ideas.

Category 3: Transportation

Transportation includes your car payment (if you have one), fuel, car maintenance & repairs, car insurance, public transportation, parking, and toll. This should not be more than 10% of your take-home pay.

Our transportation budget is very low, around 5% or less. Other than a daily commute to work, we don’t drive much. We stop by the grocery store on our way home if we need to get something. This way we don’t need to make extra trips and put extra mileage on our cars.

Category 4: Savings

You should budget at least 15% for savings category.  Aiming to have an emergency fund of 3-6 months worth of living expense is a great goal to start. Your kids’ college fund or your saving for a big purchase is next in line. Savings can include your contribution to your employer-sponsored retirement plans. Once you max out your employer-sponsored retirement plans and paid off all of your debt (besides your home mortgage) you should consider opening a retirement saving plan outside work like a Roth IRA.

We aim to budget our savings of around 35% (give or take) of our take-home pay. This percentage includes our contribution to our employer-sponsored retirement plans and contribution to outside work savings. My contribution to my work retirement is after-tax (to a Roth 401(k)). My husband’s contribution to his work retirement is pre-taxed (there is no Roth 401(k) available).

Category 5: Debt Payoff

If you have consumer debt, you should budget around 15% of your take-home pay for debt payoff. This includes your student loans, personal loans, credit card debt, any other debt like medical bills, etc. This debt payoff category does not include your regular monthly mortgage payment or your car payment. They are listed under the “housing” and “transportation” categories. However, if you aim to tackle your mortgage or your car loan (paying off early) and you make extra principal toward those loans then the extra principal is included in this category.

We are trying to pay our mortgage off early. So we aim to set aside 20% of our take-home pay to debt payoff category. As a result, we budget around 55% of our take-home pay for savings and debt payoff (our mortgage). We were able to reach a 46.15% savings rate in 2017 and 51.79% in 2018.  🙂

By now, you have learned what a budget really is, what to do to create a successful budget and basic knowledge about a 5-category budget. Are you ready to create your own awesome budget?

Let’s do it!

Steps to create an awesome budget that works

1. Determine your total income

The first step to create a budget is to determine how much income you have each month. This is easy. Go get your last pay stub (and your spouse’s pay stub if you have one 🙂 ). Make sure that you include any extra income from your side jobs, part-time, side hustles, interest, etc. Then get a pen and paper to calculate your monthly average income. If you get paid weekly, multiply your pay by 52 or by 26 if you get paid bi-weekly. Take that number and divide by 12 to get your average monthly take-home pay.

If you’re self-employed or a freelancer, you’ll need to determine your average yearly income from your last year tax return. Look at your income from last year tax return, then divide it by 12 to get the monthly average. This can give you a baseline income for creating your budget.

2. Tell your money what to do

Now, it’s a fun part. You need to tell your money what to do. By following the 5-category budget I explained earlier, you’ll need to roughly draft your monthly budget based on that.

For example:

Let’s pretend that your take-home pay is $1,000 a month. You will want to divide your money as followed:

• $350 goes to housing expenses (35% of your take-home pay)
• $250 goes to living expenses (25% of your take-home pay)
• $100 goes to transportation (10% of your take-home pay)
• $150 goes to savings (15% of your take-home pay)
• and $150 goes to debt payoff (15% of your take-home pay)

Total = $1,000

If you don’t use up your money for any of these categories, you’ll have money left over so you can choose to spend it, put it toward debt, or save it. I would put any money left toward debt if I were you. You’ll be surprised that you have money left over after successfully create a budget. Isn’t that awesome?

3. Create your budget

It’s time to get real. Start with your expenses from last month’s tracking. Categorize your last month’s expenses based on the 5-category budget rule, sum each category up and write them down. Does it agree with the budget rule?

If your expenses exceed your income in any category or you get a negative number, don’t worry! It just means you have plenty of room for improvement! Stick with your real numbers and be realistic.

If your expenses are less than your take-home pay, congratulations! You’re ahead of the game.

Example:

Let’s use the same numbers above.

Here’s your rough draft budget based on the 5-category budget rule and a $1,000 take-home pay:

• $350 goes to housing expenses
• $250 goes to living expenses
• $100 goes to transportation
• $150 goes to savings
• and $150 goes to debt payoff

Total = $1,000

Your real numbers based on last month’s expenses were:

• $375 went to housing expenses
• $480 went to living expenses
• $120 went to transportation
• $0 went to savings
• and $100 went to debt payoff

Total = $1,075

You were $75 above your take-home income. That’s ok! You’ll learn to budget. Remember, I said a budget is a work in progress.

Finally, you need to create a budget based on your real expenses but you’ll aim to be better month after month. So your first month’s budget will be as close as your last month’s expenses.

So probably your first month’s budget will look like this:

• $375 will be going to housing expenses
• $400 will be going to living expenses
• $100 will be going to transportation
• $50 will be going to savings
• and $100 will be going to debt payoff

Total = $1,025

If you never have a budget in place before, it’ll be too difficult to follow. Instead of crushing your living expenses down to $250 or trying to keep everything within your $1,000 take-home pay first month, try to set incremental goals. Next month try spending 20% less on a category you went over. Keep at it month after month and eventually, you’ll reach that mark. Small adjustments over time are more achievable and sustainable.

Basically, your budget is going to have 2 columns. The amount you intend to spend and the amount you actually spend. As time goes by, you’ll notice the trends you make. You’ll discover your financial habits, in turn, you’ll know where your problems are. Review your weaknesses & your strengths and make adjustment accordingly.

4. Follow-through

This step is the hardest and the most crucial. Once you have a budget in place, you need to stick with it! Why would you waste your time tracking your expenses and creating a budget just to find yourself to not follow it? That would be silly. It’s important to create your budget realistically so it won’t be so hard to follow.

5. Adjust and Improve

By this point, you’ll better with budgeting. It’s time to adjust and get better! Try to aim for your ideal allocation percentage and follow through. Rinse and repeat!

Most importantly, you need to keep going and sticking with your plan. Even if you make small changes every month or every few months, those improvements add up to a major change over time.

Are you ready to create a budget? Don’t just read my post and do nothing. You need to implement it. If you need help, I have typed up a nice monthly household budget worksheet to help you create a budget. It can help you track your expenses month after month. So subscribe to my newsletter and you’ll get a 12-month household budget worksheet for free. You can print it as many copies as you’d like. It can be used years after years. 🙂  No spam ever and you can unsubscribe at any time.

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Do you have a budget? If not, why don’t you have one? 

If you do, what kind of budget plan do you have?