Back to the basics: How to budget

This post comes from Jim Wang at partner blog Bargaineering.

April is Financial Literacy Month and, as part of this month of financial education, I thought I'd go back to the basics with this edition of the Foundation Series. This post explains something I think everyone should integrate into their personal-finance routine -- budgeting.

Budgeting is one of those activities that sound like a hassle, even if you're a numbers person. But I guarantee that you will benefit tremendously from learning how and implementing your own budget.

• Bing: Find free budget forms

What is a budget?

Merriam-Webster Online defines a budget as "the amount of money that is available for, required for, or assigned to a particular purpose." Whether you keep record of that money in a little notebook or in a complicated Excel spreadsheet, your budget is an allocation of your money to your monthly expenses.

I'm saving money each month, and I'm spending less than I earn. Why do I need to budget? Anything you track, you can improve. If you're spending within your means (kudos!) and saving money each month, that's very good. If you use a budget and plan everything out, you'll save even more. We all have our unknown leaks, and budgeting will reveal them so you can plug them.

Budgeting has three parts. The first part is setting up your budget, the second is sticking to your budget, and the third involves adjusting it as needed. We'll discuss techniques for all three so you can easily establish and stick to the budget on your way to financial prosperity.

Setting up your budget

The basics of creating a budget are quite simple. Simply take a look at all your expenses, categorize them, and then assign a budget to each. When you add them all together, you have your monthly budget. How you go about this will vary based on how well you understand your spending.

The first step is to determine your categories of spending. You want as many categories as you need but you don't want to make it too complicated to track. I like to have about eight to10 categories, but my first budget started with seven:

• Housing/utilities. This included my rent or mortgage, my utility bills (electricity, water, trash), and anything related to those. These were typically fixed, with some variance in the utility bills.
  
• Groceries. I have groceries separated from restaurants because I wanted to know how much I was spending on "raw materials" for food and how much I was spending to eat out.
• Restaurants. It's important to know how much you're spending at restaurants because you can spend a fraction of it cooking at home. Restaurants offer amenities you don't get at home, such as ambiance or preparation skill, but knowing how much you spend can help you reduce it if it's out of line.
• Entertainment. This is one of the broadest categories, covering everything I did that was considered fun. For example, if I rented a movie, it was included here.
• Car. If it was related to transportation, from a car repair to gasoline to Metro tickets, it was included here. I simply called it "car" because it was easier than writing out "transportation," which sounds nebulous.
• Savings. Each month I would set aside a certain amount for the "savings" expense, which was putting money into a 401(k) or IRA or whatever savings goals I had set. I think having a "savings" expense is crucial. It makes saving money an active activity, rather than a passive one where you "save whatever is left over."
• Miscellaneous. The catch-all "everything else" expense. If something went into "Misc." too often, I would make it a separate category.

You can begin with those seven and expand as needed. Those were merely the ones I started with and they served me well.

There are two ways to create your budget's spending limits:

• Guesstimate your expenses. Even if you have never done a budget, you might have a general idea of how much you're spending in each area of your life. Use that guess to create your spending limits.
• Track your expenses. If you don't feel comfortable guessing, record your spending habits for a month and use those as a guideline.

Tracking your spending

This is Step 2 of budgeting, and you can make this step as simple or as complicated as you want. I've looked at five budget systems in the past, and the one you end up using should be the one you're most likely to stick with. The five I wrote about are envelope budgeting, reverse budgeting, tracking to the penny, tracking to the dollar, and doing nothing.

Don't be afraid to try different ways to track your spending and don't feel constrained to use the ones I listed. Tailor them to fit your needs and your tendencies.

When I started budgeting, I tracked my spending to the penny. I'm a bit of a statistics junkie, so I knew I could stick with it and make games for myself. If you don't think you can track your spending to the penny, don't. Track it to the dollar or try envelope budgeting, where you don't track anything. Do what works for you.

Create statistics about your spending. Just recording the numbers isn't exciting for a stats junkie like me. I turned it into a game. I started calculating the percentage of my budget each expense category was. I figured out how my expenses compared with the targets and played with the targets some more. I created "zero-spend" days (as in $0) when I didn't spend any money whatsoever and tried to maximize the number of zero-spend days I had in a month. I created sub-$5 days and sub-$10 days and no-restaurant weeks and all sorts of crazy metrics as a competition for myself. It became a game and the game helped me save.

Adjust your budget

This is sort of Step 2.1 of budgeting, not really a third step but not really part of tracking, and it refers to how you should be looking at your budget as an evolving entity. As you progress through the year, your expenses will change slightly. Your electricity bills tend to be lower in the temperate months of spring and fall, compared with the extremes of summer and winter. You may drive more in the summer, so your car expenses will increase in those months.

Regardless of the reason, each month you should adjust the budget as you need to and account for changes. You can still play the statistic games (if you're into that); the underlying numbers will just be different.

In the end, whatever you decide to do, by starting a budget and sticking to it, you'll have a better idea of your spending and a better chance at boosting your savings. 

What are your favorite budget tips and tricks?

Related reading at Bargaineering:

• 5 money-saving bank hacks
• Buying municipal or state bonds
• Computer training software

Published April 21, 2009