Do you know how to make a budget? Apparently, one-quarter of British adults do not as they reportedly do not have any savings. Moreover, one in ten adults admits they regularly spend more than they earn. Without any savings, you are in danger of entering a vicious cycle of debt as soon as anything unforeseen happens. This could be something as simple and common as your car breaking down or an illness. The consequences of this are disastrous, yet easy to prevent. How confident are you in your budgeting skills?
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Why do I need a budget?
A budget is a tool that allows you to build up savings and avoid or pay off debt. You basically set yourself limits on how much you plan to spend during the next week/month/year. The specific amount depends on your payslip and your circumstances but within your budget, you reserve money for savings or paying off debt. At the end of your budget period, you look at your accounts to see whether you have adhered to your set limits. Simply by doing this, you will become more aware of your money and probably spend less. Even if not, you will know where your money went and identify potential for savings.
Why do I need savings?
You may be living paycheck-to-paycheck every month and feel completely fine. And it is true that if you spend as much as you earn, you do not accumulate any debt. Yet, having no savings equals future debt. It means you are owing your future self money.
Let me explain this. It is the end of the month, your bank account has just hit zero and suddenly your roof starts leaking or your fridge/washing machine/car breaks. At worst, this happens all together. If you are lucky, you have parents that will help you out. However, your parents’ money is not something that is under your control. They may have just undertaken a major house renovation or just been laid off. As loving parents, of course, they give what little they have left to you. But do you really want to inconvenience them that much? As an adult, keeping your finances under control is your responsibility.
Living a fullfilled life
Other than for emergencies, savings are also useful for important life events such as weddings, holidays and to treat yourself. Not being able to afford anything can quickly lead to feeling deprived and being envious of others.
Money-related anxiety is common and affects more than half of British adults. Without any savings behind you, you may feel stressed, worried and depressed at worst. This may result in a form of paranoia, for example, my mother is not answering the door or phone if it rings unannounced.
This is no way to live a happy life. Imagine how much better you would feel if you had £10k in savings in your account. How much safer would you feel?
Why your debt is an emergency
Today, many people appear to be very relaxed about their debt. It is not uncommon to have one or two credit cards that are not paid of or a new gadget bought on finance. People seem to think they are fine just because they can afford the monthly minimum payment.
Sadly, this is not how reality works. Unless your debt has zero interest associated with it, you need to pay it off as soon as you can. This is because you are paying interest on your debt AND you are missing out on making interest on the money that you owe. For example, if you are using your overdraft you will, on average, pay 20% interest for this. If you take out a small loan, you will, on average, be paying 8% interest on the money you borrow.
Example of debt
Let us assume you borrow £1,000 at 20% interest over three years. You will end up paying back £1,308 which is £308 more than you borrowed. Most people tend to treat their overdraft more sensibly, so let us assume you took out a loan under the same conditions but with 8% interest. Now you would pay back £1,124 which still leaves you with a loss of £124. You can have a play with the numbers yourself here.
Bad enough that you are losing £308 or £123 on interest. And this is not all. Had you invested this money into an index fund instead (7% average interest), you would have made an extra £70 or £28 interest on your investment. Hence your total loss is £378 or £151.
To pay off your debt, you may find Dave Ramsey’s baby steps useful.
Spiralling out of control
When having a debt, you run the risk of it spiraling out of control. For example, you may lose your job or simply overspent so that you can no longer afford the minimum payment. You may then have to get another loan or a credit card to pay back your initial debt. If you have your finances under control, you may think that this is unlikely to affect you (and you might be right), but why run this risk, no matter how low, if it is completely avoidable?
How to make a budget
Making a budget is a fairly simple process. All you need to know to make a budget is your income and your regular expenses. My completely free and interactive Never Be Broke Again workbook can help you with this.
There are two methods to assess your expensive, prospective (anticipated) or retrospective.
For this approach, you simply make a list of what you think you will spend for the upcoming budget period (week/month) by category (see below for category). This method will only work well for those who already know roughly what they spend each month, everyone else should follow a retrospective budgeting approach.
First, look at your bank statements to find out what your expenses are. If you pay mostly in cash, simply spend a month collecting receipts of every purchase you made (or write down what you bought). To make this easier, you can break down your expenses into categories such as
- Debt repayment
- Phone bill
- Subscription services e.g. Netflix
- Gym membership
- Beauty and hygiene products
- Eating out
If you are unsure what your categories should be, start as narrow as possible and then, as you get more experienced, you can broaden your categories. For example, you may start with a category for beverages, but over time find out that you do not actually spend that much on drinks. Therefore, it would seem sensible to combine beverages with food.
Your final categories will depend on your circumstances. For me, I do not spend that much on clothes, so when I buy a jumper I would file it under “other purchases”. Someone else may need a separate category for jumpers, trousers, shoes, etc. There is no clear cut-off but if you spend less than £5 on something per month, it probably should not have its own category.
How to make a budget out of this
Once you know how you are spending your money each month, you can set a limit for each of the category you made. For example, if you have a category for petrol and in the last budget period you have spent £40 on petrol, you can set your general limit to £40. You may have to adjust this limit for a month in which you plan to drive more than normal or if petrol prices increase.
Have a positive budget
To bring your budget together, subtract your expenses from your income. Your number may be positive, negative or zero. If your number is positive, you can put the remaining money into a savings account. I recommend doing this at the start of every month so you are not tempted to waste this money.
If you are currently spending as much as you earn or more than you earn, you can either increase your income or reduce your expenses until your result is positive. Look at each category and decide whether you can reduce costs. You may find helpful ideas here. As soon as you have a positive number (spending less than you earn), you can put that money towards further debt repayment or start building up savings. If you can, transfer this money at the start of every month so you are not tempted to spend it otherwise.
Other methods to create a budget
Prioritising savings (top to bottom)
You are probably not surprised to hear that there are other ways that show you how to create a budget. For example, you can look at your income first and then deduct the amount you intend to save and use the rest for your monthly expenses (top to bottom).
This method is often recommended as it prioritises your savings over your expenses. Savings are super important, but having food to eat and a roof above your head is even more important. Therefore, I prefer to look at expenses first and build the budget from there.
The top-to-bottom method also is not a good approach for those who describe themselves as bad with money. You may have no idea what you are currently spending or how much you can realistically afford to save. Therefore, you may unnecessarily pressure yourself by setting the savings amount to high.
Percentage-based budgeting rules
You may have heard about the 50/30/20 rule that recommends spending 50% of your post-tax income on essentials, 30% on things you want and save 20%. There is also a general rule of thumb of spending no more than 30% on housing, and many other percentage-based budget approaches.
Here is why I think you should forget them all. Everyone of us is in a unique situation e.g. country, city/town, material status, number of dependents, medical conditions, etc. How could one percentage-based method be appropriate for all 7.7 billion people on this planet? Some in London or New York city likely spends more than 30% on housing and someone living in Pineleigh village may spend only 10% on rent. Not to mention that these percentages are income dependent.
Secondly, assuming you can waste 30% of your income because you have already covered your needs and saved 20%, is dangerous. Rather, you should aim to save as much as possible (without depriving yourself). This is especially true if you have no emergency savings or are aiming for financial independence.
How to be a successful budgeter
If you are not good with money, you may fail on your first try. In fact, you probably will. Budgeting is a skill like playing football. I certainly would not manage to shoot a goal in a football match. To do so, I would have to practice for a few months (or longer given that I do not think of myself as talented in sports).
The key message of this is that failing is part of the process and you will get better as you continue. Everyone can be a budget god but nobody is one from the start.
How to make a budget Excel budget tracker
To help you out, I have created an Excel budget tracker. You can download it for FREE from Monethalia’s Resources section. To get access, simply pop your details in the form below. You also sign-up to my free newsletter, from which you can unsubscribe at any time.
How to make a budget summary
Having a budget is important to build up savings or avoid debt. While making a budget may be a daunting task, it is less daunting than accumulating debt or living with financial worries. To make a budget, find out what your expenses are and categorise them. Going forward, you can set yourself limits on how much to spend per category. Always ensure you are spending less than you earn and do not worry if you fail a few times.
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