Creating a budget is an essential skill to develop when you begin earning your own money. Budgeting requires you to distinguish between needs and desires. This article in our series on financial literacy discusses ways of making better financial decisions and the need to balance spending with income.
Needs vs. desires
Living on a budget involves sustaining yourself from day to day while striving to meet your future financial goals at the same time. This balancing act requires you to distinguish between your needs and your desires, which can be a more subjective decision than you might think. The distinction between needs and desires is usually clear when you think about it in general terms, but becomes less so when you get into specifics.
For example, no one can reasonably argue that you do not need a certain amount of food to live. However, the line between needs and desires starts to blur when you are posed with the decision of whether to eat instant noodles or a steak dinner. Noodles are certainly much less expensive and perhaps better for you in some ways, but they lack many nutrients that are abundant in steak. Similarly, the decision to drink bottled water may seem like a needless extravagance, but it can be a practical necessity if public water is high in contaminants.
Once you have sorted out your needs from your desires, you are in a position to formulate a budget. Your needs -- food, clothing, shelter, transportation -- will become an essential part of your monthly budget. If there is discretionary income left over after you’ve budgeted your needs, you may be able to budget judiciously for some of your desires, keeping in mind that there is not likely to be enough room in your budget to satisfy all of them. But that’s OK; they can be carried over for future months. And one other thing: Try to make some room in your budget for savings, especially those of the rainy-day variety that you might have to call on in an emergency.
Making better financial decisions
Slowing down your thinking can help you make better financial decisions. The following steps show how to do this:
- You should never need to make a financial decision quickly. Always take at least a day to make such a decision, especially if it seems too good to wait. Walk away from the offer if someone tells you it’s only good for today.
- Create a list of possible outcomes. For every positive outcome of a financial decision, there’s usually at least one negative outcome, and usually more. If you can’t see any way for a decision to go wrong, that’s a sure sign that you’re not thinking about it logically.
- Place yourself in the other party’s position. Consider how that party might benefit from your decision. If you don’t understand how that person could benefit, delay your decision until you do.
- Get more data. It’s extremely unusual to have all the data you will need to make a financial decision immediately at your disposal. Obtain data from unrelated sources and compile a list of pros and cons.
Income and spending
Creating a successful budget requires you to clearly understand the difference between your income and your spending. You can do this with financial software, but it’s also possible with just a pencil and paper.
Income is usually relatively simple to analyze. For many people, income is just the salary from their job. However, it can include other sources such as investments, alimony, legal settlements and royalties. Don’t count money from future events such as bonuses and raises, no matter how likely they are to occur.
Expenditures are much more difficult to assess. Financial software can help with this by accessing your financial records and downloading your transactions into a spreadsheet. Once you have a list of your expenditures, you can place them in categories such as housing, groceries, utilities, insurance and so on.
You should also group your expenditures into fixed expenses such as rent, over which you have no control, and discretionary spending such as dining out, over which you do have control. Identifying discretionary expenditures will help you find ways to reduce spending more easily.
Creating a budget
Many approaches to budgeting are possible. Your best choice will depend on a variety of personal factors such as financial goals, lifestyle, spending and your overall relationship with money. Common budgeting methods include the envelope method, the 50/30/20 rule and a zero-based budget.
The envelope method is so-named because it involves placing budgeted cash in envelopes by category of expense. On each envelope, write the category and monthly budget for the expense, such as “eating out, “$100.” Once the envelope is empty, you can’t eat out again until the following month. The envelope method is most useful when your budget needs to be especially strict.
The 50/30/20 rule says that you should allocate 50% of your income to essential expenses, 30% to personal expenses and 20% to savings. Essential expenses include housing, utilities, groceries and debt payments. Personal expenses include eating out, dating expenses, entertainment and other non-essentials. Savings can take such forms as retirement accounts, college funds and emergency funds. This budgeting method is best for young professionals with a steady income stream.
Zero-based budgeting means that every dollar you earn has a designated purpose. Assume for this example that your take-home pay is $4K per month. Allocate your fixed expenses first since they are a constant, and then allocate the remainder of the $4K between discretionary expenses and savings. The balance of your budget is zero at the end of each month because every dollar has been accounted for, not because you spent everything you earned.
Figure will be educating readers, especially young adults, on budgeting and other topics during Financial Literacy Month. Figure provides a range of lending tools and solutions for home buyers, homeowners and other prospective borrowers.