Creating a personal budget can help you sow the seeds of long-term financial freedom, making you avoid the often costly pitfalls of too much debt and living beyond your means. You don't necessarily have to enlist the help of a professional to create a budget on your behalf. By following specific steps, you can draw up your own expense and income summary-the other name for a personal budget-track your overall living costs and increase your net worth over time. But the most important thing to understand here is that everything links back to getting your overall finances right.
Get Your "Income vs. Expenditures" Balance Right
I first want to talk about income versus expenditures because this equation affects the rest, including your financial situation and economic prospects. If you spend more than you earn, you build up debt that easily can spiral out of control. If you fall in that category-or, worse, teeter on the brink of insolvency-you would be in the market for all of the sections of the MoneySavingPro website. In other words, you would need to understand things like frugality, debt planning, financial management and retirement planning along with budgeting and investing.
Start a Personal Budget
Robert G., a veteran of the personal-finance industry and a certified public accountant, says that everyone should create a personal budget, irrespective of their place on the income spectrum. So, whether you are in financial straits or enjoy a comfortable economic status, you should establish a personal budget. Think of it as a roadmap toward a better, more financially secure tomorrow. Roughly speaking, a budget provides estimated income and costs for a specified period-say, a month, quarter or year.
Determine Your Assets
The first step in establishing your budget is determining your personal resources-the other name for assets. These include everything from which you expect to derive any benefit, be it now, in the next six months, or in the very long term. You must categorize personal assets in two sections: short term and long term. Your short-term resources include:
- Income tax refunds,
- Cash in your checking and savings accounts as well as money market accounts,
- Money in a certificate of deposit that matures within one year,
- Short-term investments, and
- Anything else you can use to make money in the next 365 days.
Long-term assets-those you expect to use for more than 12 months-include your lien-free car, mortgage-free house, computer and gardening equipment.
Figure out Your Income
Don't take the income question lightly because it determines the overall perspective of your budget, says Robert G., the budgeting and personal-finance expert. Your overall income covers a hodgepodge of areas, from money you receive from your employer, say, every two weeks to interest earned on savings accounts, rental income and investment gains.
Calculate Your Debts
Calculating your debts is essential in determining where you stand in the credit score equation. Remember, your liabilities-same thing as debts-affect a lot of things, from employment and credit decisions to insurance. Debts include credit card balances, mortgages, student loans, personal loans and income taxes. To figure out how much you owe, go through your checkbook or bank statements and see all payments you make on a monthly. Write down each payee and call the company to confirm the outstanding debt amount and interest rate. I also recommend you check your credit report to make sure what you think you owe is in sync with what others think you owe. By law, you can receive a free copy of your credit report every 12 months, so take advantage of the legislation and contact each of the top three credit bureaus-Experian, Equifax and TransUnion.
Determine Your Net Worth
To determine your net worth, subtract all your debts from all your assets. Personal-finance people say that you are economically stable if you have a positive net worth; otherwise, you are relegated to the ranks of the financially struggling masses. Don't panic if your net worth is negative, though. One of the reasons why you are setting a budget is to evaluate your personal situation, to see clearly where you stand, and to make the right choices to get out of the economic mess you are currently in.
Figure out Your (Monthly) Expenses
Write down your expenses and categorize them into budgetary clusters like food, entertainment, finance costs and household expenses, among others. I'm not asking you to guess. I'm saying you should delve into your credit card statements, bank statements and receipts-in sum, any paperwork in which you can find expense data-to determine how much you really spend every month. Expenses run the lifestyle gamut, from electricity and gas to phone, Internet, cable, interest, groceries, transportation, traveling and clothing.
Some specialists recommend that you review your expenses on a monthly basis, but you should choose a time frame that fits your condition. For example, I know my expenses vary significantly from month to month because of things like summer holidays, buying a new suit for work, Christmas and Thanksgiving. So I choose a weekly view-and sometimes, a quarterly view-to better understand how much I spend and take out the seasonality out of the expense tracking. That way, I look at the fourth quarter as a "block" and plan for expenses that will run from, say, Thanksgiving to Christmas and New Year's celebrations.
Input the Data in a Spreadsheet
Now that you have your data all nicely written down, input them into a database. You can use Excel to track things like expenses, assets, debts and net worth. Alternatively, you can create an account on budgeting software sites like Mint and ClearCheckbook. Take advantage of technology and don't monitor your expenses the old-school way-meaning, tracking your expenses on a piece of paper.
Overall, the beauty of these spreadsheets is that they provide the kind of in-depth view that a "number aficionado" like me would want to see. For example, on the car line item, you could go as deep as listing things like tire breakdown, gas, insurance, repairs and servicing. Similarly, on the travel line item, you could break down the expenses into things like air fare, fees for luggage overage, car rental and travel insurance.
Review Your Bottom Line
At the bottom of your budget, indicate your net surplus-or loss if expenses exceed earnings. This is why budgeting experts call it "bottom line." Similar to your net worth, your bottom line reflects your financial health, albeit at a particular point in time. Review your bottom line to determine whether it is accurate and in sync with your own expectations. If not, make the necessary adjustments, not only in the income and expense categories but also in the numbers. For example, say you indicated initially that you spend $250 on food every month. After poring over your receipts and card statements and last year's income tax return, you realize that grocery expenses actually hover around $175. So you should reduce your overall costs by $75.
When creating a budget, keep a line for personal savings. In other words, pay yourself first. Yes, I'm asking you to pay yourself-that is, set aside some cash every month to cope with the difficult times that invariably visit all of us every now and then. By automatically diverting money into a savings account, you gradually build up your nest egg and stand ready to cope with financial rainy days.
Track, Track, Track Your Information
Track your budget data constantly and be disciplined. That way, you learn to live within your means and avoid the costly mistakes that often come with a high debt burden. By monitoring your costs periodically, you can make the necessary corrections and adjust your lifestyle to be in sync with your budgetary thresholds.
Creating a personal budget does not entail the level of economic sophistication you typically see from personal-finance gurus. You can do it yourself, but don't hesitate to seek professional help if you are not good with numbers. The personal budgeting process also touches on things like financial statement review, cash flow analysis, budgeting techniques and the best way to establish financial goals.