Budgeting Basics

Putting coin in piggy bankA household budget can help you take command of your money. By following a budget, you become better able to spend within your means, lighten your debt load and save for your financial goals. You can also become more confident about your finances.

Budgeting gives you a clear, objective view of your spending and overall financial situation. And if you're not already in the habit of talking openly about money with anyone else you share your finances with, such as your spouse, partner or children, now may be a good time to start.

You can choose among several budgeting tools, including a paper ledger, an electronic spreadsheet, personal finance software or one of several free services on the Internet. Whichever tool you choose, the following four-step process can help ease you into the budgeting habit.

1. Set your goals

Establishing and documenting financial goals is an important first step, because you want to make sure your budget is targeted at helping you get what you want out of life. Decide on the financial goals you want to achieve either in the short term (within a year), intermediate term (one to five years) or long term (more than five years away). For example, maybe you want to get out of credit card debt within 12 months. Or buy a car or home in a few years. Maybe you hope to send your child to college or retire to a warmer climate farther down the road. You likely to have multiple goals. Once you've listed them all, set priorities on them.

2. Analyze your cash flow by tracking income and expenses

Track all your income and expenses for several months. Also document any amounts you pay toward debt or put into savings or investments. These amounts can go under the expenses column.

Cash flow: the movement of money in and out of your household. Also, a measurement of your financial health: your income minus expenses for a given time period equals your cash flow for that period.

You don't necessarily have to track your cash flow on a calendar month basis. Generally, your initial cash flow analysis—and the budget you eventually base on it—should reflect your pay schedule. For example, if you get paid only once a month on the 15th, you might want to set up your cash flow analysis and budget to go from the 15th of one month to the 15th of the next month. Similarly, you can define the beginning and end of each month based on when during the month you receive most of your bills.

3. Create your budget

Once you're able to look back at your cash flow for the preceding several months, you’ll be able to create a plan for managing your money going forward. Take all the income items you tracked in Step 2 and group them into categories, such as "salary" and "interest and dividends." Do the same for your tracked expenses, using categories like "housing," "groceries" and "clothing." For each income and expense category, calculate the average monthly dollar amount for the period you tracked and then multiply by 12 to come up with an annual average.

Next, adjust your monthly and annual averages based on how much you expect to receive and plan to spend going forward. You want your budget to reflect total expenses (including amounts used to repay debt or to save and invest for other goals), so you can determine how much is left over once all of your financial commitments have been settled.

Be sure to account for seasonal and other occasional expenses that might come up later in the year—things like holiday gifts or a summer vacation. By estimating the total amount you will spend on such an item and dividing by 12 months, you can budget for the item on a monthly basis throughout the entire year.

4. Set it in motion

From this point on, continue to track your income and expenses and compare your actual numbers with the budgeted numbers you came up with in Step 3. Especially when your spending runs higher than your income, look for ways to spend less on items that are more discretionary than necessary. For example, can you cut back on how many times you dine out during the work week? Or could you get by with a less expensive channel package from your TV service provider?

Because life is full of surprises, you might need to adjust your budget now and then. For example, maybe your household will experience a job loss, pay cut, birth, marriage or divorce. You should also take a new look at your budget if your goals change.

With your budget well-established as a control panel for your finances, you will be in a better position to make informed decisions in pursuit of your goals, including decisions about how much to save and where to invest your money.

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