Developing a personal budget
Most of us find creating and following a budget challenging because it is an introspective activity that may reveal unpleasant truths about our personal financial well-being. Often, we would rather avoid this than face the truth that may be revealed.
However, running on autopilot can only go on for so long. At its core, budgeting is simply a planning tool to help you make necessary financial adjustments to make your life easier. So, if you are ready, here is a step-by-step process to building a budget.
Step 1: Determine the period of your budget. Most people build budgets for a monthly period. We tend to think of managing our finances monthly as most income and expenses are monthly. Monthly budgets are the norm, but there are expenses that are less frequent but must still be considered. Examples include quarterly payments (water bill), registration for activities or sports for children (seasonal), memberships (annual) and vehicle repairs (irregular). These non-monthly expenditures need to also be included in our monthly budget. If the quarterly water bill is $600, then $200 should be included in the monthly budget ($600/3 month). If those expenses are not included, unexpected shortfalls may be encountered when that bill comes due and the benefit of budgeting will be limited.
Step 2: Determine your after-tax income. Assuming a monthly budget is being used, include your monthly after-tax income, which usually would be your take home pay. If you consistently do not have tax owing at the end of the year, your take home pay is perfectly acceptable. If you do have tax owing at the end of the year, you would need to include the tax owing as an additional expense. This would be another example of an annual expenditure. Alternatively, if you consistently have a large refund each year, you may want to consider reducing the tax withheld, to free up additional cash flow monthly. Struggling to make ends meet every month to receive a large refund at tax time does not make sense. If there are other sources of income such as interest or dividends from investments, those should also be included in your monthly budget even if those items are not received monthly. For example an annual dividend of $2,400 should be included as $200 per month ($2,400/12 months).
Step 3: Analyze your expenses. Since most people use credit cards and debit cards for their daily cash transactions, a paper trail is left, which can be analyzed. Every expenditure should be put into a category. Common categories include:
- mortgage payments
- credit card or debt payments
- RRSP contributions
You may have other categories, such as daycare, home expenses or pets. The key is that the categories should be meaningful for you, as this is a planning tool for your wants and needs. Make sure you include everything including those non-monthly expenditures. The benefit of budgeting as a planning tool is only worthwhile if it gives you a complete picture, and you’re not left scrambling throughout the year.
Step 4: Subtract your expenses in Step 3 from your income in Step 2. This is your net balance. If the net balance is positive, great. Unfortunately though, many people will have a net negative balance, so do not feel badly if this is the case for you. Most people are motivated to do a budget only when they are struggling financially, so a net negative balance is to be expected. In fact, this validates your work in steps 2 and 3. If you are struggling financially and your net balance is positive, you may have overstated your income in step 2 or understated your expenses in step 3. Review the numbers again to be sure they give you a full and accurate picture.
Step 5: Adjust your net balance in step 4 to achieve a minimum net zero balance. This is where all the work in step 2 and 3 pays off. Look carefully at the size of the negative balance and realize that if you are $100 negative every month, you are $1,200 short for the year.
To help you get to a minimum net zero balance, look for opportunities to increase your income. Taking on extra work, such as overtime or a side gig, or reducing how much you are investing for retirement can increase your monthly income.
If your income is fixed and cannot be increased, focus on decreasing your expenses. Some of the expenses, at least for the short term, may not be something you can alter, such as your mortgage. Focus on those items that can be reduced. A good guide is the 50-30-20 rule: 50 per cent of your income should be going to needs such as rent or debt payments, utility costs and food; 30 per cent should be allocated towards wants such as trips or entertainment; and 20 per cent should be allocated towards savings.
Most people are often surprised about how much they are spending in some areas. It may be necessary to temporarily allocate money to fit within the 50-30-20 rule. Be realistic about making changes. It is often necessary to reduce some wants and even savings in the short term to bring the needs to within 50 per cent of your income. For example, if you have credit card debt, you may need to reduce the wants and savings amounts so you can put more towards debt repayment. Once the debt is paid, you can rebuild your budget.
Utilizing automatic payments of bills can help you focus on your plan. Automatic payments also reduce the ability to impulse buy and will help keep you on track. The envelope system of physically putting cash into envelopes for specific purposes can also help. You spend what is in the envelope until it’s gone, and then you have no more until the next month.
Step 6: Doing periodic reviews. This step is often missed but it’s critical to developing a plan and keeping on track. Periodic reviews should be conducted at least annually but quarterly is better to ensure spending is in line or can be brought back in line before it has negative consequences.
Need help creating a budget or dealing with financial stress? Manitoba Blue Cross’s counselling services are available to all Manitobans, regardless of whether or not you have coverage with Manitoba Blue Cross. Find the available counselling support related to finances, debt and more by visiting here.
Struggling with debt? Read Personal debt management for strategies to overcome it.