What are the steps to prepare a budget?
How many times have you heard the statement, “live below your means” or “Spend less than you take home”? The concept is simple enough although It will take discipline and planning to implement it. You will need to know your estimated expenses to develop the budget on a paper. However, the execution of the plan on paper will take discipline and effort.
The Benefits of Budget
Creating a budget and tracking expenses is not fun and is at times painful. However, there are many benefits of a budget such as:
- Know where each dollar is going
- Makes it easier to make financial decisions
- Helps in developing short-term and long-term goals
Does budgeting protect you from disaster? No, but it will help you navigate through it. Additionally, there could be unexpected / non-routine expenses that may derail your budget. Therefore, building an emergency fund of three-six-twelve months of expenses (depending on your financial situation) should be part of the budget.
What are the steps to prepare a budget?
By defining “wants” and “needs”. That is how our budget development process started.
The basic necessities such as the following are in the “need” category.
- Food (groceries)
- Shelter (rent, mortgage, property tax, home insurance)
- Clothing
- Utilities (water, gas, etc.)
- Health Insurance
- Taxes
After taking care of our “needs”, we focus on savings.
- Retirement Account (401ks)
- Roth IRA
- College Savings (if applicable)
After “needs” and savings comes the “want / flexible” category such as:
- Travel
- Dining Out
- Phone, cable, internet (although internet and phone are becoming necessities now)
- Automotive
- Entertainment
- Home repairs
We made a spreadsheet (engineers, right!) to track our spending every month for at least a couple of years. Nowadays, there are a number of tools available to track your budget such as Mint and Quicken.
Budget Categories and Trends
We use credit card(s) for almost all purchases and pay in full every month of course! It helps us track our spending as most credit card companies provide end-of-year spending reports. The following graph displays our spending by category. The spending table from the year 2000 is based on manual tracking with excel spreadsheet.
| Category | Need or Want? | % of Income |
|---|---|---|
| Mortgage | Need | 18% |
| Income Tax | Need | 15% |
| Tax Deferred Saving | Preferred/Need | 25% |
| Saving | Preferred/Want | 14% |
| Property Tax | Need | 6% |
| Travel | Want | 5% |
| Insurance | Need | 3% |
| Health and Wellness | Need | 2% |
| Utility | Need | 2% |
| Groceries | Need | 2% |
| Dining Out | Want | 1% |
| Personal | Flexible | 1% |
| Phone, Internet, etc. | Flexible | 1% |
| Automotive | Flexible | 1% |
| Entertainment | Want | 1% |
| Home repairs etc. | Flexible | 1% |
| 100% |
The two years of tracking gave us insight into our spending habits. For example, we realized that after mortgage payment, income tax is the second largest spending category followed by property tax. The next highest spending category was travel which was a “want” and not a “need”. All the rest of individual “need” categories were under 5% of our expenses. Fast forward to 2019, income tax became the largest spending category as our income grew over 20 years.
Don’t forget about income tax!!!
In nutshell, we were spending
- 50% on essential (needs)
- 40% saving (two earners household helped)
- 10% discretionary (want / flexible)
The general guideline is to save at least 20% to 25% of your income on a consistent basis or start with what you can initially. It could be 5% or 10% or a fixed dollar amount. Consider getting in the habit of saving a certain portion of your income on a consistent basis. Wealth building is heavily dependent on your savings rate.
Household Finance Policy Statement
After a couple of years of tracking and data analysis, we made macro-level goals in order of priority as follows:
- Fully fund all tax deferred accounts (401ks and Roth IRAs)
- Save one person’s salary to build an emergency fund (3 Years expenses*), mostly invested in Bank Savings Account and/or CDs
- After the emergency fund is fully funded, invest the rest in equity / bond / real estate (depending on set allocation) in a taxable account(s)
- If one of us lost our job, we would start making adjustments in the “want / flexible” category such as travel and entertainment
*We are risk averse and wanted to keep a large cushion in the event that both of us lose our jobs. It could be a different number for you.
We stopped making budgets after a couple of years and concentrated on fulfilling aforementioned goals. It was our initial household finance policy statement, although we did not name it at the time. Our recent household financial policy includes a lot more detail as we gain knowledge about investing. That is how our wealth building journey started, with budgeting, tracking, and data analysis. Budget was our guide to living below our means.
Peter Drucker
“You can’t manage what you can’t measure”
In summary, creating a realistic budget and tracking spending for at least a couple of years will help you establish the baseline and set up short-term and long-term financial goals. The budget will kick-start your wealth building journey.
How do you track your spending? What does your household financial policy statement look like?