Budgeting 101
What is a Budget?
When people hear the word “budget,” they often think of boring excel spreadsheets created by accountants or unrealistic spending restrictions limiting them from living freely. However, a budget does not have to be boring, unrealistic, or limiting. Instead, think of it as a financial game plan to help become financially free.
A budget will show precisely how much money you make, what your expenses are, and if you are overspending. Without this information, it will be impossible to become financially secure or achieve your financial goals. Understanding your current financial situation and comparing it to your goals is the easiest way to improve your spending habits and hit your financial goals.
Create a Budget in 4 Easy Steps
Step 1: Calculate Your Monthly After-Tax Income
Your after-tax income is the amount you make each month, minus taxes, CPP, and Employment Insurance (EI). This number will be the final number on your paystub and will be deposited into your bank account. When creating a budget, it is crucial to use your after-tax income instead of your gross income because taxes must always be paid. Suppose you model your expenses on your gross income. In that case, you will end up overestimating your available cash, leading to improper budgeting.
Step 2: Create a List of Your Expenses
Create a list of all expenses you expect to have each month. This list may include:
Mortgage Payments
Rent
Utilities
Transportation
Childcare
Insurance
Groceries
Personal hygiene
Haircuts
Clothing
Eating out
Entertainment
Internet
Gym Membership
Loan Repayment
Forced Savings
Step 3: Split Your Expenses into Fixed and Variable
Fixed expenses are the bills that MUST be paid each month and DO NOT change. For example, fixed expenses may include rent, mortgage payments, internet, car payments, and childcare. Each of these expenses is the same amount each month and will always need to be paid. While many more fixed expenses are not on this list, just remember that fixed expenses are the ones that must be paid each month.
Variable expenses are the costs that DO change each month. For example, variable expenses may include groceries, clothing, entertainment, and haircuts. These are the expenses you choose to pay, and their value will change depending on how much you spend.
Once you have written down your fixed and variable expenses, assign a value to each one. For the fixed costs, this number will be the amount on your bill each month. Remember, it should be the same each month.
For the variable expenses, you must estimate how much you will spend. Initially, use your credit card and bank statements to determine what you have typically been spending. This will be a good starting point. Once the budget is complete, these numbers can be changed to the amounts required to meet your financial goals.
Step 4: Calculate Your Net Cash Flow
Net cash flow is the amount of money you are left with after all your expenses are paid. In a budget, this value should be positive. Conversely, if your net cash flow is negative, it means that you are spending more than you are earning, and you are losing money.
To calculate your net cash flow, add up all your expenses. Then, with this total, subtract your expenses from your income. For example, if your after-tax income is $2,000 and your expenses are $1,500, your net cash flow is $500. This $500 can then be saved and invested to achieve your future goals.
If you have negative cash flow, it means that you are spending more than you are earning. To fix this, you will have to do one of two things; increase your income, or reduce the amount you’re spending. As increasing income usually requires adding extra shifts or switching jobs, it takes extra time. Therefore, the fastest way to balance your budget is almost always to reduce your spending.
The easiest area to cut spending is by reducing variable costs. These are the costs that change each month and are usually the result of your choices. For example, if you have three streaming services, consider ending two of them. If you eat all your meals at restaurants, consider cooking at home. In addition to your variable costs, it is also possible to reduce your fixed costs. For example, if you have a phone plan that costs you $100 per month, see if there is a cheaper plan. Or, if you have an apartment that you cannot afford, consider moving or adding a roommate.
Regardless of whether you increase your income or reduce your spending, it will be impossible to become financially stable if your current budget has a negative cash flow. However, by creating a budget, you are making a game plan to get on track financially. At the very least, it will show you where you require improvement.
How to Know if You Are on Track
Once you have calculated your monthly income and collected all your expenses, it can be challenging to know how much you should be spending on each category. One easy way to allocate your income to your expenses and know that you are on track for your financial goals is to use the 50/30/20 rule. This strategy was coined by Senator Elizabeth Warren in her book, All Your Worth: The Ultimate Lifetime Money Plan. The 50/30/20 rule says that you should spend 50% of your income on needs, 30% on wants, and 20% on savings and debt repayment.
Spend 50% on Needs
Your needs are the items that you must spend each month to live. Needs may include:
Rent
Groceries
Utilities
Minimum Payments on Debt
Spend 30% on Wants
Your wants are the items choose to spend money on, but you could live without. Wants may include:
Entertainment
Eating out at restaurants
Netflix and other streaming services
Spend 20% on Savings and Debt Repayment
Generally, 20% of your income should be allocated towards getting out of debt and saving for your financial goals. Prioritize getting out of debt and setting up an emergency fund before saving for retirement accounts or major purchases. Once your debts have been paid, it will be much easier to contribute the full 20% to savings and investments.
How to create a 50/30/20 Budget
Step 1: Calculate Your After-tax Income
Your after-tax income is what’s leftover after your employer deducts taxes, CPP, and Employment Insurance. This number will be the final number on your paystub, and it will be deposited into your bank account.
Step 2: Limit Your Needs to 50% of Your After-Tax Income
Once you have your monthly income, multiply this number by 50%. For example, if you make $2,000 per month, you will have $1,000 to spend on needs. Remember, your needs are what you need to live, such as rents, groceries, and utilities. This category also includes the minimum amount required to pay off your debt each month. For example, include the “minimum payment” in this category if you have credit card debt.
If your needs are above 50%, it either means your income is too low, or you are overspending. On the other hand, if you are working full-time and your basic needs account for more than 50% of your income, it likely means you are living in a place that you cannot afford.
Step 3: Limit your Wants to 30% of Your After-Tax Income
Once you have your monthly income, multiply this number by 30%. For example, if you make $2,000 per month, you will have $600 to spend on wants. These items are things that you could live without, such as Netflix, entertainment, and restaurants. However, suppose you realize that your basic wants are more than 50% of your income. In that case, this is the category that you should cut back on until you have changed your living conditions or increased your income
Step 4: Allocate 20% of Your After-Tax Income to Savings and Debt Repayment
The remaining 20% of your income should go towards paying off debt and saving for your future. Since the minimum debt payments were included in the “needs” category, focus on building an emergency fund at the same time as you pay down your debt.
If you build an emergency fund and lose your job, you will have enough money to pay your bills without having to go into debt. Remember, you want to eliminate your debt so you don’t accumulate interest. Therefore, build your emergency fund slowly and prioritize paying off your debt.