Introduction – How to build a budget

The purpose of this article is to provide a clear and simple process for how to build a budget for the average household. This article will provide some strategies and tips aimed both at those new to budgeting, as well as those who have tried this out before and are looking for some guidance to perfect their strategies.

Here are some quick links to various sections of this post if you want to jump around.

Budgeting is too hard! How to get started

Managing a budget can seem like a daunting task at first. I studied Finance and Accounting in college and even I have had trouble setting up and managing a budget, so believe me, I understand.

Even a simple budget is going to have dozens of expenses each month to account for and many ways to potentially categorize and track those expenses. Deciding on a strategy without some sort of guidelines on what to think about and how can make this whole process seem impossible to tackle.

The goal of this article is to provide a process for how to think about a budget and start planning your spending, which is the hardest part of any budget. As we go, I will also point to articles I have on similar topics that can help with getting started, such as how to select budget software as well as how to further simplify budget maintenance through outsourcing and automation [coming soon!].

My goal is to provide tools for those new to budgeting to understand how to build a budget, as well as to provide some helpful tips that may help experienced budgeters improve upon their strategies.

Why do I need a budget?

Even with my finance education, I did not see the value in planning out a budget when I first entered the workforce.

Instead of addressing this challenge head-on, I tried to live frugally and put as much money into savings each month as I could. But I did this without tracking my spending or planning how much I wanted to save each month.

I found some issues with this strategy, however, early on. For one thing, no matter how responsible I had been during the month I always felt guilty when I spent money on myself, like at lunch, while out with friends, or when I wanted to buy something fun for me. There was no amount of money I could spend on myself without feeling guilty, and that was even though I was working for a salary and did not have many monthly bills to worry about at the time.

The first problem was that I never knew with certainty what expenses were coming later in the month. This meant that surprise expenses could potentially show up at any moment and I never knew if I would have the cash available to cover them without having to dip into savings to stay afloat.

This led to periods of extreme frugality alternating with splurge purchasing whenever I began to resent the fact that I shouldn’t ever spend money on myself. This resulted in very inconsistent savings patterns.

And secondly, in part due to the first issue, I found that over time my savings didn’t seem to be growing – even though I told myself I was living frugally and saving, the reality didn’t seem to match up.

Ask yourself some tough questions

Because of these challenges, I started asking myself a series of tough questions. Questions I would recommend you start asking yourself as well:

Is it ever going to be acceptable to spend money on something fun, or spend money to have fun with family and friends?
If I do spend money to have fun, how confident am I that I won’t need to dip into savings to pay the bills as a result?
How sure am I that my savings will be enough to cover any emergencies that will come up in the next 6 months?
Thinking about emergencies – I also owned a car at the time, so what about new tires or other maintenance costs? How are these going to be paid for consistently without having to use savings?
What about my other long-term savings goals? How do I plan to pay for a vacation, or plan to replace that car when needed? What about buying a house someday?
And finally, do I ever plan to stop working? If so, what is the plan to be able to retire?

For me, these were all hard questions to answer – and for the most part, I had to admit that I didn’t have plans ready to address them with my current budget strategy. If I was ever going to address these questions, I would need to have a solid plan.

These may not be challenges for everyone. If you have the willpower to live simply and frugally without needing to monitor spending to keep to your goals, then maybe you don’t need a budget.

For the rest of us, a budget is a good way to ensure you can answer the questions above and at the same time provide the accountability to yourself that is required to ensure you stick to your plans, at least more often than not.

How can a budget help?

The purpose of a budget is not just to make sure bills are paid each month; a budget also exists to ensure you can achieve your long-term financial goals. Here are some of the goals a budget can help you accomplish:

Ensure bills are paid on time to avoid late fees and interest
Covering maintenance and replacement costs for your home and other assets, like cars, so the tools you use to live your life can stay in good working order and be replaced when needed
Building an emergency fund
Saving for regular vacations
Planning for college tuition
Investing for retirement
Investing in yourself (more on this below)

The great benefit of having a plan in place is the peace of mind that comes from knowing your day-to-day work is bringing you closer to financial freedom. How much better would you sleep knowing these are taken care of?

Here’s how you can make this happen.

Step 1 - Define your budget strategy

So how do you set up a budget? The idea is very simple – make sure your expenses are less than your income, and that the excess is enough to meet your savings goals. But while this is simple in concept, the steps to make this happen can seem a bit challenging, especially if you don’t have a strategy.

Set your savings and spending targets

First, set a guideline for how much of your income you want to save every month. This can be defined based on set dollar targets you might already have in mind. For most people that are new to budgeting the best way to start is to set some targets for budget categories based on a percentage of your income.

My ideal budget strategy that uses this approach is a modification of some other popular budget strategies. Most people know about the 10/10/80 plan, with 10% for savings, 10% for spending money, and 80% for everything else. I prefer 10/10/10/70. The key to this plan is to take out 10% upfront to pay yourself first.

Whether you use this strategy or have others in mind, it’s important to set these targets up front. Pick something that sounds appealing and go with it – you can always modify the exact figures as you go.

Step 2 - Turn those targets into real numbers

Now that you have some targets in mind, start looking at your current income and calculate how much to allocate into each of the categories you defined previously – these would be investing in yourself, savings, spending, and everything else, if you’re using the 10/10/10/70 plan.

Look at your take-home pay from all sources for the past few months to understand what your starting point will be. Look at deposits to your bank.

Your total pay at the top line of your paycheck is important for tax purposes, but for your budget, all that matters is the net amount that is deposited each month. Remember to include your pay from all sources – multiple jobs, interest income, and anything you have coming in each month.

If your pay is variable, such as from working varying hours or working seasonally, make sure to average out your pay so you have a consistent value to plan for each month. Eventually, you may want to set up specific budgets for each month depending on how much these factors impact your month-to-month income. I would recommend looking at this later, however, as the average will be of most use when planning a budget strategy and monthly values can be adjusted up and down as needed after the initial setup is complete.

Write down the amount going into each category. If you make $3,000 per month on average, the budget framework would look like this:

$3,000 x 10% = $300.00 for Investing in yourself
$3,000 x 10% = $300.00 for savings
$3,000 x 10% = $300.00 for fun
$3,000 x 70% = $2,100.00 for everything else

Is 10/10/10/70 realistic?

Quick statement on these budget strategies. The 10/10/80 and similar budget strategies are easier to set up if you’re someone who does not have a lot of bills, especially someone new to the working world that hasn’t taken on a lot of obligations (like a mortgage, student debt, car loans, etc.).

For everyone else, these strategies will take time to adopt. Current obligations will likely mean you can’t just set aside 30% of your income today for savings and other long-term plans, almost nobody just has an extra 30% of their budget laying around!

This is ok. Even after years of budgeting, while our family aims for 10/10/10/70, our actual budget split is something closer to 10/6/2/82. Having the goal of getting to 10/10/10/70 means we’re less likely to use the extra money from a raise frivolously; we don’t just take on a new internet plan or more TV channels like a lot of families do precisely because I know where I’d like us to be long term.

While I’d like to allocate more towards long-term plans, we just aren’t able to with our current obligations, and the money we have allocated already is making a difference in getting us to our long-term goals.

This sort of strategic thinking helps you be the master of your finances, instead of being stuck in a perpetual cycle of making more money only to take on more expenses, and then feeling just as poor the next month (but now with HBO, or something else you probably don’t need).

If you don’t have a strategy today, there’s no reason to wait! If you want more ideas on what strategy to pick, NerdWallet has an article explaining how to budget using the 50/30/20 approach: Your Guide to How to Budget Money – NerdWallet.

Plan how to use these categories

Now that you have a strategy, the next step is to build out how you plan to use the money in each of these categories. Below I’ve broken down this process into a few easy-to-follow steps. These steps will use the 10/10/10/70 plan with the example numbers above but substitute your numbers when building your budget.

If you already have a budget tool in mind, you can start by adding up the different categories in the tool directly. Otherwise, a spreadsheet tool is just fine for getting started. Defining the strategy and budget categories & buckets is the most difficult step in the budgeting process. Once these are defined, inputting the data into a tool can easily be done later on.

Step 3 – The first 10%, Investing in yourself

Most people start the process of building a budget by looking at their income, adding up expenses, and then saving whatever they can with what is left over. I prefer the reverse – I want to pay myself first, then use the rest on savings goals and expenses. The point of paying yourself first is to invest in your financial freedom.

The reason this isn’t part of a standard savings category is that most savings goals center around larger projects or vacations, or at best planning for retirement at 65 or older. These should be planned for as part of your budget, but at the same time these are all one-off events, and they don’t change your financial situation.

This essentially means you are constantly working to pay for your next vacation or home project, with an end goal of retiring only when you have reached a late stage of life. If you are happy to work in a career towards this goal eventually and don’t feel any specific urgency to try to retire sooner, then maybe this category can be used to further build your savings and retirement fund.

If you’re like me, however, then this is a good backup, but not my primary plan. A career is a great way to get benefits and learn certain skills, but for me, the most interesting pursuits seem to fall outside of an office job. Because of this, the first 10% of the budget is set aside for investments that develop me as a money-making machine that I can design and control.

The goal here is to build toward financial security, by whatever means. There are a few options you can consider for how to make this happen listed in my other article on Investing in Yourself.

Step 4 – The second 10%, Savings

This category is standard for all budgeting strategies. There are a few goals for this category that I like to prioritize:

Creating an emergency fund
Paying down debt
Retirement savings
Long-term savings goals that don’t fit into the ‘Everything else’ category below

Long term, this category would ideally be focused entirely on saving for retirement. This would happen once you are out of debt, have an emergency fund, and your ‘Everything else’ category is set up to account not only for regular monthly expenses but also for costs for maintenance and saving for large purchases (like home projects, new cars, etc.).

The reality is this won’t happen quickly for most of us, so the savings category can help account for these goals while you are getting the rest of your budget in order. For some more ideas on how to prioritize and store your savings, see my other article on how to prioritize savings.

Step 5 – The third 10%, Whatever you want!

What more is there to say? If everything else in the budget is covered, go nuts!

This is one of my favorite parts of this exercise. There’s no need to justify purchasing a new toy or fancy shoes if that purchase won’t impact your savings goals. Having this bucket separate gives you the freedom to know that spending within this category is guilt-free!

I view this category as essential for any budget. Even if you can’t allocate a full 10% to this category, everyone needs to have some amount of money they can use to have fun today, to provide something short-term to look forward to.

Having something fun to look forward to will also help avoid cycles of saving & splurging that could cause you to break your budget regularly, as I experienced early on.

If you need to determine the amount for this category as a last step in budgeting, do so. But to reiterate, I always recommend you make sure there is something left to allocate for fun after all the other expenses are accounted for.

Step 6 - The remaining 70%, Everything else

This last category is the standard home-budget category. This category is for all expenses needed to keep the family fed, lights on, and house and car maintained.

I do include saving buckets below for known maintenance and home improvement costs in this category as I mentioned previously. This includes expenses like oil changes, paying for landscaping in the spring, or replacing a home appliance that may be showing signs of age.

Not everyone will have the flexibility to account for all their maintenance and short-term savings goals in this category of their budget. This puts a lot of pressure on the budget for most households. The point is to try your best – anything that needs to be moved up into the Savings category means less money saved for retirement or other long-term plans.

Think hard about how to keep maintenance costs in this category to whatever degree is possible for your situation. But if this isn’t possible, feel free to exclude these costs when you’re getting started.

Build your budget buckets

The first step is to look at your expenses from bank and credit card statements for the past few months and start building out the buckets that will capture all your spending. It is important to be honest about where you are spending your money today. A realistic budget is the only way to set up a plan that can be followed consistently, and consistency is key to meeting your saving goals.

These buckets will be used to track expenses going forward, so set up as many as you would like to use. More buckets will make it easier to plan out how much to allocate for each bucket each month and to track how your spending changes over time.

However, more buckets also mean more effort to categorize expenses each month. I would suggest you start with a smaller number of buckets, then if you find a certain bucket is capturing a lot of expenses and is difficult to keep track of, break it down into multiple buckets later.

For each category, you want the amount spent during an average month. If the amount stays the same each month take that amount for the bucket. If it varies, add up all the charges over the last few months then take the average. For example, if you spent the following amounts for fuel over the last few months:

$75 in July
$120 in August
$60 in September

Then the average would be $75 + 120 + 60 = $255.00 / 3 = $85.00 per month to put in the fuel category. If you want to be safe, budget a little more to have a cushion for months with a lot of travel.

Check for less-frequent charges

Remember to also look for any expenses that may occur less frequently, especially any spending that only happens a few times a year or less. In these cases, you still want the average monthly cost for the budget. Here’s an example of how to account for auto insurance if paid in a lump sum:

Assume you pay $500 for car insurance every 6 months.
The average monthly cost would be $500 / 6 = $83.33 per month.
Again, I prefer to round up (probably to $100 a month in this case) to help account for rate changes that may occur on the next bill.

This budget bucket would grow slowly over 6 months and when the bill comes due, will be large enough to cover the insurance bill outright.

Repeating this process will save you the extra premium cost that comes from paying certain bills monthly, meaning you’re saving yourself money long-term by using this budget strategy. With some checking accounts, you may even earn a little interest on the money in this bucket while you’re waiting for the next bill to come around.

Thinking long term, or, Budgeting for more than groceries and electricity

The buckets above are mostly focused on regular monthly and yearly expenses that you will need to pay to maintain a household. But budgeting goes beyond just paying the bills.

We all know that our cars or refrigerators will not last forever. Most appliances, and definitely cars and homes, need regular maintenance. But even though we know these are coming, most of us don’t have a plan for how to pay for these costs when the time comes. The only way to make sure your savings can grow is to plan for these as well, so you don’t need to raid your savings each time one of these situations occurs.

This also includes saving up for future projects or costs that may go beyond maintenance. As noted previously, this could be part of your savings category, but whenever you use savings to cover these expenses, that will mean less money for other long-term goals and retirement.

Here are some of the items to plan for:

Vacations
Gifts for the holidays and special occasions
Replacing any large ticket items, like cars, refrigerators, TVs, or home computers
As many long-term home maintenance projects as you can fit into your budget – like replacing a roof, windows, furnace, etc.

List out each of these as a separate bucket and calculate the average monthly cost, like how we accounted for the auto insurance example above. Calculate the time until this expense is expected to occur, the best estimate for the total cost, and average that into a monthly figure:

For example, assume that your car may need to be replaced in 4 years
If you have $3,000 saved up for this already, but expect it will cost $10,000 to replace, that means you will need to save $7,000 in 4 years, which is 48 months from now
The monthly average cost would be $7,000 / 48 = $145.83 per month which needs to be set aside for this future purchase
After the next car purchase, redo this calculation with new estimates for cost and time to update the monthly allocation going toward this bucket

Plan for as much as you can think of today but know you probably won’t remember everything.

The number of buckets I use to track these maintenance and replacement costs has grown over time. Whenever possible, if I make a large purchase for something that doesn’t have a savings bucket already, I’ll set one up. This way, as time goes on, I am slowly building up the number of long-term expenses covered in this portion of the budget.

My reliance on savings is reduced by this practice, which helps me focus more of my savings category on retirement and long-term goals over time.

Step 7 – Build your first budget

List out all the budget buckets you identified for each category and compare those amounts to the targets from your budget strategy (defined in Step 1 above).

How are you doing so far?

Add up all your buckets. How does it look so far? Can you cover your expenses with 70% of your budget? What about your savings, do you have a full 10% to allocate to retirement and long-term goals? Do you have anything you can put towards investing in yourself, or your spending money (whatever you want)?

I would imagine at first this doesn’t good. At least that was my experience. All those small expenses can add up quickly! This is where hard decisions may need to be made. Now you have all the information you need: you set a strategy and goals for your budget, you know what you’re spending money on, and you know what you need to plan for large expenses that may be coming your way.

Your money, your choice!

With this information, you have the power to choose what you do next. If your expenses are such that you can’t allocate money to all your budget goals, then think hard about your expenses – are all your expenses so important to you that you would choose them over your goals?

We all have some expenses that aren’t negotiable – like mortgage and rent, auto expenses (if we require a car for work), medical insurance, and the like. But what do you have the flexibility to make choices on? TV, streaming services, dining out, and other luxuries – are any of these something you can do without?

Trimming down your expenses to meet long-term goals will likely be an iterative process – it will take a lot of thoughtful consideration to adjust your lifestyle to meet your budget. This may be challenging, but that shouldn’t prevent you from moving forward. Adjust your expenses as much as possible, and if your expenses & goal saving targets are adding up to more than your income, then adjust the amount you are saving towards your goals.

Build the first budget

Take some time to think deeply about what you want and what your options are. It will take time to review those options, but eventually come up with a way to keep your bills paid and incorporate as many of your budget goals as possible into a plan. Get to the point where the total for all of your budget buckets added together, remembering the ‘Investing in yourself’ and ‘Whatever you want’ categories as well, adds up to less than your monthly income.

Write out the different buckets within each budget category, along with your average earnings. This is now the first version of your budget!

Step 8 - Put your budget into action!

Once you have your budget ready, the next step is to put it into action. Even if you can’t follow your ideal budgeting strategy from the start, it’s better to put whatever you can do into practice. This way you can start building good budgeting habits and make more informed decisions about what to do with your money in the future.

Be accountable for your spending

Without a way to hold yourself accountable to your budget strategy, even after making these hard decisions, it will likely be hard to stay on track after you get started. I suggest looking into a tool for managing your budget as you go. See the linked article for some recommendations if you don’t have a tool in mind already: Finding the best budget tool. Most tools will have some instructions and documentation to walk you through setup, which should be a breeze now that you have your budget categories and buckets ready to go.

Once you have created your budget and it is being managed in a way that ensures you are held accountable for your spending, then the next step is to go into maintenance mode. That’s the real benefit of this process. This may take effort to plan and prepare, but once set up the day-to-day management is much simpler.

You don’t need to spend a lot of time adding up expenses to see how you’re doing because you have budget buckets that allow you to quickly see if your spending is within targets each month. You also don’t need to worry about how you’re going to pay your mortgage or other important bills. These bills are accounted for in your budget, so if you stick to your plans these bills don’t need to be thought about at all.

The only maintenance you will need to do is to categorize your expenses as they come in, which most budgeting software will help you do quickly, and if there are any changes to your income or expenses then adjust your budget accordingly.

Conclusion

I hope this process has helped take some of the mystery out of the process of putting together a budget. Budgeting may seem difficult at first, but not having a budget at all can make it very challenging to be disciplined and meet your savings goals. Here’s a quick summary of the steps involved:

Set your strategy – make sure you are setting aside money for investments and savings so you can meet your long-term goals, in addition to paying the rent and groceries today
Calculate the amounts you will have in each of your budget categories, based on your income today
Identify how you will invest in your financial freedom, increasing your earning power however possible
Plan for savings goals, like building an emergency fund and paying down debt, before building a retirement fund
Set aside money to spend on whatever you want, to give yourself near-term goals to look forward to
Identify where you’re spending money today, and what is required to keep the lights on and your family fed. Think about repair and maintenance costs that may be coming your way as well
Build your first budget – comparing your budget strategy to your goals and current spending, and adjusting until the budget adds up to less than your monthly income
Put your budget into action!

Understanding how to build a budget can be a time-consuming process at first. The benefit, however, is an insight into the realities of your financial situation and a clear understanding of what it will take to achieve your goals. This puts the power back in your hands – whatever your situation, you have choices. You get to choose the best way to spend the resources you have available to your family.

Are you doing what’s best for your family already, or is there something you will change now that you have this understanding?

If you want to see some recommendations on how to further simplify and automate your finances, see these other articles on topics that will further equip you to be a master of your finances:

Finding the best budget tool
[Budget automation – coming soon!]

How to Build a Budget

Introduction – How to build a budget

Table of Contents

Budgeting is too hard! How to get started