Budgeting Basics: The Key to Financial Stability

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What is Budgeting?

Budgeting describes the process of tracking income and expenses over a specified period in the future. It is often referred to as the backbone of personal finance, providing a structured approach to managing financial resources and ensuring that individuals can meet their needs, achieve their goals, and avoid unnecessary debt.

Budgets are extremely versatile as they can be utilized by governments, businesses, and individuals of any income level.

Why do we Budget?

Budgeting is a crucial step towards achieving long-term financial and personal goals, forcing you to keep track of where your money is coming from and going, and helping you manage your spending and savings more strategically. By monitoring income and expenses over time, budgeting helps you understand your spending habits and provides peace of mind by showing exactly where your money is allocated.

In addition, creating and sticking to a budget is one of the most effective ways to manage debt, prevent overspending, and achieve financial stability. This is especially relevant considering that the average credit card debt per borrower is $6360 in America, meaning many people fail to manage their finances effectively (Warren, 2024). Creating a budget prevents this by letting you know exactly how much money you earn, how much you can afford to spend each month, and how much you need to save.

Budgeting also helps you prepare for any emergencies that could otherwise lead to serious financial turmoil. The extra money allocated will also ensure that you don't interfere with other funds saved for long-term financial goals such as saving for retirement or paying off debt.

Ultimately, a budget helps create financial stability both in the day-to-day and in the long term, making it easier to pay bills on time, build an emergency fund, and save for major expenses such as a car or home.

Components of a Budget

To create an effective budget, it's crucial to understand the key terms and components. These include:

• Income - Any money received from various sources (e.g. wages and salaries, investments, rental income, etc)

  
  

• Expenses - Any money spent on goods or services, including both fixed and variable expenses

  • Fixed Expenses - Regular, unchanging expenses that must be paid consistently (e.g. rent, mortgage payments, or insurance premiums)

  • Variable Expenses - Expenses that fluctuate based on consumption or needs (e.g. grocery bills, utility costs, or entertainment expenses)

  • Discretionary expenses - Non-essential expenses that are optional and can be adjusted (e.g. dining out, hobbies, or holidays)

    
    

• Savings - Money set aside for future use or specific goals (e.g. putting $100 a month into a savings account for a vacation)

  
  

• Debt - Money owed to creditors (e.g. credit card balances, loans, mortgages, etc)

  
  

• Budget Surplus - When income exceeds expenses, resulting in extra money available for saving or investing

  
  

• Budget Deficit - When expenses exceed income, requiring additional funds or adjustments to cover the shortfall

  
  

• Investments - Money allocated to assets expected to grow in value over time (e.g. buying stocks or contributing to a retirement fund)

  
  

• Emergency Funds - Money reserved for unexpected expenses or emergencies (e.g. a fund with three to six months' worth of living expenses for situations like job loss or medical emergencies)

  
  

• Budget Tracking - Monitoring and recording actual income and expenses against the planned budget to assess financial progress

Types of Budgeting

There are several types of budgeting methods available for different financial situations and personal preferences. Here are some of the most common types of budgeting methods, along with their advantages, disadvantages, and practical examples:

• Zero-based budgeting - Requires you to allocate every dollar of your income to a specific category until nothing is left unassigned

  • Advantages:

    • Ensures that every dollar has a purpose and is accounted for (whether it's for spending, saving, or investing)

    • Potentially reduces unnecessary spending with every expense being justified

    • Gives you precise control over your finances

  • Disadvantages:

    • Can be a time-consuming approach

    • Less flexibility available for unexpected expenses

  • Example:

    • If you earn $2,000 per month, you would allocate that entire amount across categories like rent, groceries, savings, and entertainment, leaving a balance of zero

      
      

• 50/30/20 Rule - Divides your after-tax income into 50% for needs, 30% for wants, and 20% for savings or debt repayment

  • Advantages:

    • Easy to understand and implement (especially for budgeting beginners)

    • Flexible as it allows for personal spending within a systematic approach

  • Disadvantages:

    • May be oversimplified for those with more complex financial situations

    • The fixed percentages might not align with everyone's financial reality (e.g. 50% of your income might not cover basic needs like rent and utilities)

  • Example:

    • If you earn $3,000 a month after taxes, you would allocate $1,500 (50%) for needs like rent and groceries, $900 (30%) for wants like dining out and entertainment, and $600 (20%) for savings or paying off debt

      
      

• Envelope System - A cash-based method where you allocate money to different categories, placing the cash in envelopes

  • Advantages:

    • Limits spending to physical cash on hand, reducing the likelihood of overspending

    • Makes spending more real and impactful

  • Disadvantages:

    • May be inconvenient managing and carrying cash

    • Challenging to manage with unexpected expenses

  • Example:

    • With a $2,500 monthly income, you allocate cash into envelopes: $800 for rent, $300 for groceries, $200 for transportation, $150 for entertainment, and $50 for dining out. Once an envelope is empty, spending in that category stops until the next month, helping you stay within your budget

      
      

• Pay-Yourself-First Budgeting - Prioritizes saving or investing by setting aside a specific amount of money as soon as you receive your income

  • Advantages:

    • Encourages saving and investing to build wealth over time

    • Can be set up automatically, reducing the temptation to spend

  • Disadvantages:

    • May leave too little for essential expenses if not carefully balanced

  • Example:

    • If you earn $3,000 a month, you set aside $500 for savings as soon as you receive your paycheck. The remaining $2,500 is then used for expenses like rent, groceries, and entertainment

      
      

• Incremental Budgeting - Involves adjusting the previous period’s budget by adding or subtracting incremental amounts based on changes in income or expenses

  • Advantages:

    • Easy to implement

    • Maintains consistency by making small adjustments

  • Disadvantages:

    • May keep previous budget problems if the previous budget wasn’t well planned

    • Less effective for significant changes in financial situations or goals

  • Example:

    • If your previous year’s budget was $4,000 for monthly expenses, and you anticipate a 5% increase in costs, you adjust the new budget to $4,200

Remember that budgeting is not a one-size-fits-all approach, meaning the type of budgeting used depends on your financial situation, personal preferences, and financial goals. If you are looking at which budgeting method suits you the best, check out the Personal Finance 101 post on budgeting strategies for more specific guidance.

Budgeting Misconceptions

Ever heard the idea that budgeting is only for people with financial problems or that it means not enjoying life? Well, both these ideas are misconceptions that prevent many from effectively managing their finances and reaching their financial goals.

Budgeting is a tool used by anyone who seeks to manage their spending and savings more strategically, not just by those in financial trouble. In fact, some of the world’s greatest investors and wealthiest individuals use budgeting to optimize their financial strategies and achieve their goals. As quoted by Warren Buffet, regarded as one of the most successful investors in history:

"Do not save what is left after spending, but spend what is left after saving." (Warren Buffet)

This quote highlights the importance of prioritizing savings and budgeting as part of effective financial management. In order to ensure financial stability and avoid unnecessary debt, you must focus on saving and manage spending carefully through budgeting.

Next, it's somewhat ironic to claim that budgeting means not enjoying life, as it actually allows you to allocate your money more effectively and ensure that you can both manage your finances wisely and enjoy the things you love. Budgeting gives you the peace of mind when taking a vacation or pursuing a new hobby, knowing that your finances are under control and you can comfortably enjoy these experiences.

But what if I'm not great at math?

Generally speaking, creating and sticking to a budget doesn't require exceptional math skills but a combination of organization, discipline, and the ability to follow instructions. This is because of the increasing popularity of free and legitimate software programs and apps that simplify the budgeting process, making it easier to track and manage your finances effectively. If anything, the basic skill of adding and subtracting income and expenses are all that’s needed to get started with budgeting—making it accessible to virtually anyone!

What if I don't want anything big?

It can feel hard to stow away money each month and deprive yourself of that extra dinner out if you don't have any major savings goals like buying a house or funding a vacation. However, it's important to recognize how your situation and your attitudes likely will change over time. In addition, there is no specific reason needed to budget and save money, as emphasized by New York Times Bestselling author Morgan Housel in his book The Psychology of Money:

"[...] saving does not require a goal of purchasing something specific. You can save just for saving's sake. And indeed you should. Everyone should. [...] Saving is a hedge against life's inevitable ability to surprise the hell out of you at the worst possible moment." (Housel 107)

Ultimately, even if you are not planning on purchasing something big like a car or a house, you should still be saving as a safety net because of the unpredictable and unexpected events life may throw at you. Essentially, saving is about preparing for the unexpected and ensuring you're financially secure.

The Bottom Line

While budgeting might seem like a daunting process, it’s actually a straightforward and essential money management tool that can be used by governments, businesses, and individuals regardless of income level. By using a budget, you can improve your financial decision-making and work towards a more secure financial future.

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Sources

Warren, Karon. “What Is the Average Credit Card Debt in America?” Investopedia, 15 May 2024, www.investopedia.com/what-is-the-average-credit-card-debt-in-america-8622723.

Ganti, Akhilesh. “What Is a Budget? Plus 11 Budgeting Myths Holding You Back.” Investopedia, 17 May 2024, www.investopedia.com/terms/b/budget.asp.

“Budgeting.” Federal Student Aid, studentaid.gov/resources/prepare-for-college/students/budgeting. Accessed 9 Aug. 2024.