How do I build an effective budget?
A budget is the roadmap you use to manage your money effectively so you can maintain stability and avoid debt. It can be as basic or as complex as you need it to be. Some people prefer simplicity, while others focus on detail so they can maintain full control.
In any case, these are the basic steps you need to take to build an effective budget:
- Total up monthly income from all income sources
- Divide your expenses into categories
- Fixed – needs with a set cost, such as rent or a mortgage payment
- Flexible – needs with no set cost, such as your electric bill
- Discretionary – wants
- Check to make sure your cash flow is positive – i.e. you bring in more than you spend
- Set priorities for debt repayment, such as allocating extra to reduce credit card debt strategically
- Factor in savings, so saving money becomes part of your budget rather than an afterthought.
As you build your budget, keep the following factors in mind to avoid financial challenges that can lead to debt and financial distress:
- Total debt payments should take up no more than 36% of your monthly income. This ensures debt isn’t eating up your income and leaving you with limited cash flow. You can use a debt-to-income ratio calculator to help assess your personal debt ratio.
- Credit card debt payments should take up no more than 10% of your monthly income. However, if you have extra cash flow then consider spending more than the monthly required payment so you can eliminate your debt quickly.
- Spending targets can be set by taking a 3-month spending average. When you set target spending for things like groceries or gas for your car, look at your transactions in that category from the past 3 months and take an average to set an accurate spending limit target.
- Savings should be a budgeted expense. Don’t leave savings as a nice-to-have at the end of the month if you have cash left over! Instead, plan to set aside 5-10% of your income per month and consider setting up automatic contributions to your savings account.
- Discretionary expenses should be the first to go. If you need to cut back to improve cash flow, look at your discretionary expenses first. You may have “spending leaks” like overlapping entertainment accounts that you can consolidate to save some cash.