Financial planning is a must to get your financial life in order, and any financial plan is incomplete without a solid budget in place. While budgeting is quite simple to understand, following and maintaining a budget on a regular basis is important to keep your finances in control. You will come across hundreds of articles and books on budgeting, but how you go on to create your budget depends entirely upon your understanding of the term ‘Budgeting’. In layman’s language, budgeting is how you allocate your monthly income towards your savings and expenses, which includes your house rent, food, utility bills, clothing, entertainment, insurance, car maintenance, debt repayment, etc.
The simplest way to understand budgeting is by elucidating the 50/30/20 rule where the three numerical components depict the percentage of your income that shall go towards your needs, wants and savings & debt repayment in that order. In order to have a deeper understanding of the 50/30/20 rule, let’s have a look at each of its three components in detail:
The Needs – 50% of After-tax Income: This component of the budget comprises the absolute necessities that your life depends upon. It includes:
- House Rent
- Basic Utilities that include Electricity, internet, water, natural gas and cell phone bills
- Transportation which includes fuel & maintenance if you own a vehicle, and cab charges & bus/metro ticket costs if using public transport
- Insurance includes your health Insurance, Life Insurance & Vehicle Insurance
- Monthly loan installments towards your car loan, home loan, student loan or any other loan you might have taken
No more than 50% of your after-tax income shall be spent on necessities. If your after-tax income is low or your necessities are eating away more than 50% of your after-tax income due to any reason, the amount of necessities over the 50% mark shall be counted in the 30% portion reserved for the wants until you are able to control your spending. Even if your needs fall under the reserved 50%, it’s always good to try and reduce your spending to save money wherever possible.
The wants – 30% of After-tax Income: This component of the budget includes all your wants that allow you to lead a better lifestyle. It includes:
- Dining out with friends and family
- Entertainment includes watching movies or live shows, partying, or going out for a sporting event
- Vacation Or Travel expenses
- Other expenses like shopping, expenses incurred on hobbies, gifts given in cash or in kind, etc.
Your wants shouldn’t consume more than 30% of your income and should be absolutely taken control of if exceeds the said percentage. While you can’t postpone or do without your needs, your wants can wait until you pay off your debt or build up some significant savings.
The Savings – 20% of After-Tax Income: Your savings should be the first thing to get addressed as soon as you receive your pay check. As per the 50/30/20 rule, at least 20% of your After-Tax Income should be saved and it’s always good to automate your savings to strictly maintain the said ratio of savings to Income. Your savings should provide for the debts that you have to repay and your life post retirement. If the amount of debt is higher or debt repayment forms your number one priority, you can cut down on your wants to save extra money every month until your debt gets repaid.
The 5 steps to creating a budget:
1. Calculate your expenses: Your expenses shall include everything spent on essentials (like groceries, utilities, housing, transportation, insurance, minimum loan repayments, etc.) as well as your wants (gym membership, shopping, dine-out with friends and family, club membership or travel expenses). Your expenses should also account for any sudden or unplanned spending, like a field trip for your child, electronic replacements, fines, etc.
In order to get a clear picture of your expenses, you may have to refer to the bank account statement or the receipts collected during the month. If you have lost the receipts or don’t remember the exact amount of expense incurred, record the approximate amount. To eliminate the hassle of saving the receipts, I have always had this habit of recording the expenses in the Notepad of my phone as and when they are incurred. You can even develop a habit of recording your expenses every day after you come home as it’s easy to remember what you spent today than trying to recall what you spent during the last 30 days.
2. Figure out your income after taxes: Your budget must record your income as the one that remains after you’ve paid taxes as it forms the actual amount you can spend or save. Your income must also include your rental income, interest received and any unexpected amount received during the month in the form of gifts, or reimbursements.
3. Automate your savings and set debt payoff goals: “Don’t save what is left after spending; spend what is left after saving.” In order to control any excessive spending, it’s important that you automate your savings. By automating your savings, a specified amount of your salary will be directly transferred to your savings account as soon as you receive your salary, rest of it being available for spending. You can decide on the amount of income that you would like to save depending upon your income and debt repayment goals.
4. Record your spending and track progress: Recording and monitoring of your spending is important to be able to control it. There’s no use of creating a budget if you are only calculating your expenses without doing anything to bring them down. Even if your spending is under control, there can be a huge scope for saving more money by cutting on any extra expenses. Tracking your progress and continually working to save money is exactly what forms the essence of a budget.
5. Revise your budget as needed: As your income increases, you might want to raise your standard of living or start saving additional amount of money to buy a home or for your child’s higher education. Your budget should be flexible enough to make way for any change in financial situation or financial priorities. You may need to revisit it every few months to improve it or to make any required changes.
While you can think of many ways to create a budget, sticking to it depends upon your level of motivation to improve your financial position. Budgeting isn’t something you can’t do without but having it will definitely guide you in managing your finances properly.