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A budget ― a running account of what you are making, spending, and keeping over time ― is essential to good personal finance and wealth building. But many people don’t have one. Consumer surveys frequently indicate that a good portion of people don’t have a budget and don’t keep track of their spending.
That means many people don’t have a set strategy for attaining their financial goals, be it simple financial security to building independent wealth. Instead, without some sort of consistent system of targeting and tracking money, many people fall into the problem of over-spending and debt.
“From my perspective as a financial planner, if someone has a ‘spending problem’ they generally already know it, so making a budget is really an exercise in prioritizing what is important and what is not, rather than how much is spent on a particular item,” said Douglas Collins, a financial planner at Fortis Lux Financial. “Most often, we aren’t looking to change spending habits, but to make sure they are well defined and realistic. The most important, and most difficult, thing is to be honest about spending habits.”
How to make a budget
The basics of creating a budget are pretty simple:
- Start with how much you earn.
- Subtract necessary expenses.
- Subtract discretionary expenses.
- The result is what’s left for saving and investment.
The first step, what you earn, is usually pretty easy to identify. It’s typically a salary or wage, enhanced by any part-time work or investments that may be involved.
The purpose behind subtracting expenses in two steps is to isolate those costs that you may be able to mitigate in order to have more money left over for saving and investment.
But these expense steps can get complicated. That’s because the definition of a “necessary living expense” and how much should be spent on it will likely differ from individual to individual, depending on their job or living circumstances.
Necessary expenses
These are generally fixed expenses that everyone needs in life. Shelter, food, and clothes ... the basics of survival … are a good starting point. And in today’s modern world, things like a phone and various utilities are considered essential too.
But there are also expenses that relate to the ability to make a living. You might need a car to get to work. Or special tools or an Internet connection at your home to do your job. Perhaps you need to pay for child care.
In this area, what might be discretionary for some, may not be for others. For instance, someone whose personal appearance is an integral part of their work performance, like a salesperson or model, may view hair styling, the gym, and cosmetics as more of a necessary expense than other folks.
And then there are expenses that are necessary for your financial security, like keeping current on credit card bills and setting aside money for an emergency fund. Insurance is also one of those necessary expenses (and, yes, this is coming from an insurance company). But things like auto and health insurance are required to function in today’s society.
And for those looking to protect a family or others who depend on them, life insurance is a necessary expense. The type of insurance and extent of coverage will depend upon the circumstances. Disability income insurance may be necessary too. (Related: Why you need disability and life insurance)
Discretionary expenses
Other types of expenses may not be critical to survival or day-to-day living. Still, for purposes of a budget, they should be accounted for and considered. After all, this is the area where cutbacks can be made to save money and redirect resources for more rewarding goals.
Typically, this would include the entertainment area, like movies, restaurants, and vacations. But this category will likely also include things that people could conceivably live without, but don’t want to, like a pet or regular spa treatment.
Intertwined with these judgments are also questions of quality and degree. For instance, clothes are a necessary expense. Whether they should come from a discount store or designer boutique is discretionary. Similarly, food is necessary. But some people can forego steak and make do with peanut butter sandwiches.
Additionally, for many expenditures there are various “rules of thumb” that get touted, such as “only spend 30 percent of your income on rent” or “your car payment shouldn’t be more than 15 percent of your paycheck.”
Indeed, many financial professionals recommend a 50/30/20 split, with half of your income going to necessary or fixed expenses, 30 percent earmarked for discretionary spending, and 20 percent saved for future needs including retirement and an emergency fund.
But here, too, individual circumstances can dictate differences. Someone living in a big city may perhaps spend more on housing since they don’t need a car.
Budget trade-offs
In determining what is necessary and what is discretionary there will be, for some people, serious questions about what the expense will mean for the future.
Take continuing education. Some would argue that it is a discretionary expense that could be foregone for the sake of improving finances for day-to-day living. Others may argue that sacrificing quality of living in the present in order to possibly improve earning and financial circumstances down the road is a necessary expense.
And many parents would argue that saving for college is a necessary expense for the future of their children.
Similarly, arguments can be made that saving and investing shouldn’t be something reserved for the end of the budgeting process but made an integral part of necessary spending. To that end, many direct some of their pay directly into retirement or investment accounts and don’t even consider it in their day-to-day budget considerations.
Debt will also enter into decision making. Keeping current on debt is important for your credit and financial stability, so that is a necessary expense. But incurring more debt ― and with it typically more current expense obligations ― should be weighed carefully. (Learn more: Good debt vs. bad debt)
Maintain, measure, and modify you budget plan
In the end, what you deem as a necessary expense will be your decision, just as your ultimate financial goal is your decision. Having the discipline to follow your budget will let you see if one will work with the other.
The desire is there. A survey conducted by Harris Poll for the National Endowment for Financial Education concluded that over three quarters (66 percent) of U.S. adults typically will make financial New Year’s resolutions. Setting and following a budget was one of the top goals for 43 percent.1
Achieving that goal essentially boils down to maintaining your budget guidelines, seeing if it achieves your goals, and adjusting your spending (or lowering your goals) accordingly. Of course, some of this may change over time and as financial needs and knowledge may grow more complex and sophisticated.
“It’s important to understand that financial education is a learning process that continues throughout our economic lifetime,” said Paul Golden, a spokesman for the National Endowment for Financial Education.
For instance, you might initially decide that certain entertainment expenses are necessary for your sanity. But, after failing to reach certain savings goals for a time ― like putting together a house down payment ― you may change your mind and modify your habits with less expensive ways to occupy your time and mind.
Conclusion
And life and circumstances change. What might have been a discretionary expense may become necessary should your career or marital status change.
Indeed, what once was a simple budget can become quite challenging when you start to have dependents or a sizeable portfolio. Some people opt to consult a financial professional to get advice on what should be considered a necessary and unnecessary expense.
But in the end your budget, your goals — and your commitment to them — are your decision.
Learn more from MassMutual…
7 things financial planning does for you
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1 Harris Poll/NEFE, “New Year 2020 Consumer Expectation Survey,” Jan. 2, 2020.