People live paycheck to paycheck at a high rate in America, and there’s a good reason for this: inadequate financial management. While the high cost of housing can make life difficult, there are things we can control to build a solid foundation. The first step towards financial wellness is effective budgeting.
Step 1: Where is the Money Going?
It’s vital to know where all your money is going. In order to do this, take a look at your financial accounts. This includes your checking/savings accounts, credit cards, and retirement vehicles. You want to track every dollar that flows out of your bank account.
For instance, the check for $1,000 written on the first of each month might be your rent or mortgage payment. You might spend $2.50 at Starbucks each morning. For debit/credit card transactions, your online banking portal should have an itemized summary of every transaction.
If you prefer cash, make note of monthly ATM withdrawals.
Consider using a budgeting aid to automate the process. This can be as simple as a spreadsheet that is a rough summary of fixed expenses i.e. mortgage, cell phone, utilities, etc.
You have to understand where the money is going to make an accurate budget.
Step 2: What’s Coming In?
Track your total household monthly income. If you work for a traditional employer, a bank statement should show a monthly deposit. For those that own a business, work in sales or consulting, or have volatile income, consider estimating or taking a monthly average from your last tax year income. No matter how you make your money, it’s important to know how much you’re bringing in.
Generally speaking, for the purposes of a budget you want to know how much you make after tax. For W-2 employees, this is relatively simple: look at the gross pay and subtract the amount your employer is taking out for taxes. Consider expenses you might be paying directly. Examples include health insurance and 401(k) contributions.
Self employment and other forms of income should also be considered. For the self-employed, check your 1099s or profit and loss statements. In this case, you’ll want to subtract your expected tax burden from the raw numbers. Those with multiple sources of income should add up the net pay from each source to get the total.
Step 3. Categorize Expenses
There are three basic categories of expenses. Experts use a variety of terms, but they fall under the categories of needs, wants, and improving your finances.
Needs are the things you can’t do without. For instance, housing in the form of rent or a mortgage, property taxes, basic utilities, food, transportation, and anything necessary to work.
Wants are the extras: Cable subscription, dining out, travel, entertainment, or a new TV.
Essentially, the goal here is to figure out how much money you must spend, as opposed to how much you’re currently spending (fixed vs. variable expenses). For instance, you might find that dining out is costing you a large amount of money. You might find the cost of housing and utilities is eating up over half your salary. Neither of these situations are optimal, because it means that these oversized expenses are keeping you from achieving your goals.
As you go through each expense, place it in one of the three buckets: Needs, Wants, and Savings. Knowing where the money is going is a major step towards crafting a sound budget.
Step 4. Compare with Spending
This is the part of budgeting that can be the most eye opening. Experts recommend that you spend about half of your take-home income on necessities. Once you have a handle on the amount of money you’re spending on essentials, compare your actual and ideal spending levels. For instance, if you’re spending half your income on just rent or the mortgage, then your other necessary expenses put you over the limit. Reducing fixed or necessary expenses can prove difficult. However, there might be ways to adjust your non-essential spending to balance the budget.
The next spending category is wants. This category includes cable TV, Netflix, new clothes, etc. Many people spend too much on what they want, because they lack self-control or awareness of where the money is going. Spending around 30% of your take home pay on wants is a good starting point. If you want to make financial progress, this could mean avoiding the urge to spend now for a better life later.
Perhaps the hardest category to prioritize is saving. Resisting the urge for instant gratification in a consumer obsessed culture is difficult. Most advisors suggest allocating 20% of income to this category. You’re sacrificing today for a better position tomorrow.
If you carry debt like credit cards and student loans, you’ll put the payments in this basket. When possible, you’ll want to pay down debt quickly. Debt comes with interest, and it keeps you from saving money and building wealth.
Ideally, you should save both for retirement and major expenses or emergencies. Retirement money is often shielded from creditors and can be added to by your employer. Emergency funds reduce the risk you’ll have to borrow for unexpected expenses or home repairs. Unfortunately, savings are usually the last thing that people do with their money.
Step 5: Balancing Expenses
If you’ve looked through your income and expenses and found that your numbers are in line with recommendations, good for you. Unfortunately, this is uncommon, and most people will have to align their expenses to match income percentages. When the problem is high housing costs, you have a tough decision to make: reduce housing costs, budget for fewer wants, or increase your income. This is because housing is not only our biggest expense, but where you live isn’t always easy to change. Consider bringing in a roommate to reduce costs, if appropriate. You can try to move somewhere less expensive or refinance your home loan.
For those with high fixed expenses in general, consider increasing your income. This might mean taking a second job or trying to find one in your field that pays more. Gigs like tutoring and driving for Uber are popular side hustles.
If you’re spending too much on wants, consider reducing that amount in favor of your future. Few Americans have significant savings, you’ll put yourself ahead of the pack. This helps reduce the risk of needing loans in the future. If you have debt, Increase the amount of money you’re paying towards debt reduction.
Knowing what you earn and spend is the gateway to a much more secure future. If you’re tired of being broke, a sound budget is the first step towards financial stability.