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Introduction – Why Budget?
Budgeting is a fundamental aspect of personal finance management. This article shows you seven effective ways to budget.
A lot of people focus on the income and wealth-building sides, but budgeting is an essential component of building your wealth. 1 in 4 people in the UK with an income of over £100,000 live pay cheque-to-pay cheque.
What this reveals is that many people have stretched budgets that do not properly account for their daily expenses, and leave enough room for saving and investing. For those with lower incomes, it is even more crucial that an effective budgeting strategy is put into place.
Dave Ramsey has a brilliant quote about budgeting: “Having a budget gives you permission to spend—guilt-free!” If you are afraid of budgeting, reframing the process as giving you room to spend, can help you develop a better mindset towards the skill.
Zero-Based Budgeting
Zero-based Budgeting is simply making sure that every penny/cent is accounted for in your budget. A budget that accounts for everything, and leaves nothing to chance, gives you a thorough understanding of your expenses and income.
Ultimately, with zero-based budgeting, you gain control over your finances. This form of budgeting is particularly useful when you start, and when your financial situation is particularly challenging. As I own my own business, I find that a critical component of managing the business finances well is understanding expenses and income flows within the business deeply.
If you want to create your zero-based budget, use my free Google Sheet:
Budget Spreadsheet Template
$0.00
This budgeting tool is what I use to track my spending and income month-by-month. It’s a great tool for understanding your personal finances.
Category: Google Sheet
Tags: Personal Finance
With a business budget, you have to use projections to understand how much cash will flow into the business, and how much will flow out. Personal budgets tend to be less complex, especially if you’re an employee, and it is often easier to cut expenses. If it is your first time making a budget, definitely sit down for an extended period and be as meticulous as possible.
It is worth carrying out zero-based budgeting in the first month, implementing changes to positively impact your savings and investments, and then reviewing it the next month, to understand whether your budget can be improved.
Envelope System
The word, “budget”, has its roots in the French “bougette”. “Bougette” means a little purse, so it is a charming little word. These little purses did not necessarily have to contain money, but the association with money stuck.
The second way you can budget more effectively is by utilising an envelope system. In a meta-analysis carried out by Davydenko and Peetz (2021), it was found that people spent less with cash than they did using card.
The reason why people spend less with cash is probably owing to it being easier to “mentally account”. Mental accounting is a branch of behavioural economics that deals with how we attach beliefs and emotions to our financial decisions.
Spending with cash makes us more aware of our finances and hurts us more when we part with money.
The envelope system is a 6-step process involving:
- Identifying Categories: List your spending categories.
- Assigning Budgets: Allocate funds to each category.
- Creating Envelopes: Physically or digitally designate envelopes for each category.
- Allocating Cash: Place or assign funds to the envelopes.
- Tracking Spending: Deduct purchases from the corresponding envelopes.
- Adjusting as Needed: Reallocate funds if necessary to stay within budget.
Digital Options
In our increasingly cashless/digital world, there are also other ways of implementing a similar system.
Many banks such as Monzo and Starling Bank, have pot and envelope systems in their apps which allow users to divide their money up. I use both banks, so I know how useful they can be.
This facility has enabled me to create an emergency fund, holiday fund, house maintenance fund, etc.
Monzo
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Starling
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50/30/20 Rule
If you’re stuck on how to divide your budget up, consider using a simple rule of thumb like the 50/30/20 rule as a starting point.
The idea is that 50% of your expenses go towards needs, 30% towards wants, and 20% towards savings and investments.
Your first port-of-call is to decide what your needs are. These really should be defined as your four walls:
- Food
- Transport
- Shelter
- Utilities
Wants vs Needs
People tend to struggle to see the difference between a want and a need. Also, people tend to overestimate what they need. You could say that true needs are often disguised as wants.
For instance, some people spend a huge proportion of their budget on a luxury car and would define this as a need. The car can get you from A to B, but spending a huge proportion of your salary on a car is the result of paying for what you want. People, however, tend to justify spending a huge amount on a car because they need “a reliable vehicle”. There are, however, a lot of costs to owning a vehicle: petrol, tax, insurance, fuel, maintenance and depreciation (the car decreasing in value).
Also, taking an Uber or other taxi service is a want, not a need. You can take public transport or walk in a well-connected city.
As owning a car is expensive, it can take up a large proportion of this “needs” budget, so expensive car payments, can become an issue if you have expensive rent or a big mortgage payment. If you live in a well-connected city such as London, consider just using public transport.
Playing around with the ratios
The 50/30/20 rule is a simple starting point for anyone building a budget, but of course, it can be adjusted. Some people have to naturally allocate more to needs or can allocate more to investments and savings, but it is crucial to keep the ratio for savings and investments at around 20% if possible.
I’ve generally been able to find myself able to reduce my wants below 30%, so I can allocate more money into investments.
Another consideration is how much you want to allocate to savings and investments. I prefer to pay more into investments, as it makes sense for a young person to take advantage of the critical component of time to compound growth early.
Pay Yourself First
You cannot miss the money you never see. A core principle of budgeting is paying yourself first. Once you have worked on establishing your budget and
It is easy to automate your savings and investments by setting up direct debits with your brokers and savings banks. Before you know it, you will have created a cushion of savings and a large investment portfolio.
It is truly an incredible feeling when you allow your savings and investments to grow without you paying much attention to it, and then checking. You usually find that you have made a lot more money than you expect.
Paying yourself ensures that you’re consistently building your financial reserves, and not dipping into them.
Track Your Expenses
Thanks to many of these new banking apps, it has become easier to categorise your spending every month. Budgeting is only a worthwhile task if you understand whether you are sticking to the budget.
Setting a budget is just the start of managing your money well. It’s also important to keep track of what you spend. Without tracking, it’s hard to know if you’re sticking to your budget or spending too much in certain areas.
Tracking your expenses helps you understand your spending habits. You can see if you’re spending too much in one place or if there are any surprise expenses you didn’t plan for. Plus, it helps you catch any mistakes in your transactions so you can fix them quickly.
Also, tracking your expenses makes you more aware of your money decisions. When you regularly check where your money is going, you can make smarter choices about how to spend it. This helps you prioritize your spending, cut out things you don’t need, and work towards your financial goals better.
So, while making a budget gives you a plan, tracking your expenses is what helps you stick to it. Together, they’re a powerful duo for managing your money and staying on track towards financial stability.
Use Budgeting Apps
Budgeting apps make it easy for you to keep track of everything. There are so many budgeting apps available.
I generally just use a Google sheet to work out my initial budget, as I’m comfortable with that approach, but there are lots of apps with friendly interfaces such as Weekly, Everydollar and YNAB.
Another reason why I like using a Google Sheet is my ability to do anything I want to the sheet and the formulas. If I were based in the US, I would probably side with Everydollar, as Dave Ramsey runs his company with no debt, so there is a good chance that it will stay operating.
A lot of people used Mint before it was acquired by Intuit, but using something like Everydollar or a spreadsheet allows you to stay confident that your budgeting tool won’t suddenly disappear.
Emergency Fund
The purpose of an emergency fund is to deal with expenses that are unpredictable, non-recurring, and that cannot be formally included in a budget.
According to Hargreaves Lansdowne and Oxford Economics, one in three people do not have enough cash for an emergency. This statistic underscores how precariously people live on the bread line and the difficulty in building up retained savings.
Dave Ramsey suggests building up to $1000, or £1000, as an initial emergency fund. Once you reach that level, you can aim to create a larger emergency fund.
To establish the size of your emergency fund, you need to have a good understanding of your monthly outgoings, so building a fully-funded emergency fund of three to six months requires you to do some zero-based budgeting beforehand.
The 7 Key Characteristics of an Emergency Fund are:
- Easy Accessibility—keeping it in a liquid account for quick access
- Separation from regular savings to prevent non-emergency use
- Three to six months’ worth of living expenses
- Kept in stable investments or cash
- Used only for genuine emergencies
- Regularly replenished
- Adjustable to accommodate life changes
By maintaining these characteristics, an emergency fund ensures financial stability during unforeseen crises. Some people think that utilising a credit card in these situations is an alternative to an emergency fund, but I disagree.
Conclusion
In conclusion, budgeting is an essential tool for managing your finances effectively and building wealth over time. By implementing budgeting strategies like zero-based budgeting, the envelope system, and utilising digital options, you can gain control over your expenses and prioritise your financial goals. Understanding the difference between wants and needs, playing around with budgeting ratios, and paying yourself first are key principles that can help you achieve financial success.
Tracking your expenses and using budgeting apps are also crucial for staying on track and making informed financial decisions. Additionally, having an emergency fund with the key characteristics of accessibility, separation, adequacy, stability, and adjustability provides a financial safety net during unexpected crises.
By incorporating these budgeting techniques and principles into your financial management routine, you can take control of your money, reduce financial stress, and work towards achieving your long-term financial objectives. Remember, budgeting is not about restricting yourself; it’s about empowering yourself to make smart financial choices and build a secure financial future.
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Bibliography
- Davydenko M, Kolbuszewska M, Peetz J. A meta-analysis of financial self-control strategies: Comparing empirical findings with online media and lay person perspectives on what helps individuals curb spending and start saving. PLoS One. 2021 Jul 8;16(7):e0253938. doi: 10.1371/journal.pone.0253938. PMID: 34237109; PMCID: PMC8266115.
