10 Steps to the Perfect Budget

Creating a budget was one of the best decisions Megan and I have made. We’ve used a budget to enhance our lives and strengthen our relationship. We have built in a process that defaults awareness. We don’t have to go out of our way and spend an enormous amount of energy to get on the same page. We are on the same page because our needs, wants and goals are literally on the same page.

Before we get into the actual steps, there are a few ground rules that must be addressed. First, the budget should be a Zero-Based Budget. A Zero-Based Budget is proactive – you tell every dollar where to go. Don’t expect it to stay around if it’s not given a job.

Second, a budget does not work if you cannot delay gratification. I want you to get whatever you want…it just may not be right now. We get it when we can. We’re adults.

Finally, for the married folks, both spouses have to contribute and compromise. One of them cannot do it as the other just signs off. This will not work. Not only will you not have a successful budget, money will be another topic of contention.

Considering only 32% of Americans prepare a detailed written plan, budgeting is a formidable foe. I have outlined the steps Megan and I took to create our first monthly budget.

Do we go through these exact same steps every month? No. After a couple years of practice we (at most) make small updates at the beginning of the month, and most months we don’t change anything. The hardest part is starting. It only gets easier and more beneficial as time goes on.

10 Steps to the Perfect Budget

Step 1: Income

At the top of the page write down all sources of income (net of tax). Every dollar is accounted for! It might only be paychecks from your day job, or it might be from eight different sources. Regardless of its source, it’s always included in the budget.

Step 2: Brainstorm All Monthly “Expenses”

Below your income, write down all monthly expenses. Don’t put a dollar amount just yet; only brainstorm the various expenses you are expecting to incur during the month. Expenses include things you have to do and things you want to do! Add anything you can think of; from a mortgage payment to a latte to a savings account. There is always a time to consolidate with similar expenses or remove all together if it doesn’t make the cut.

Step 3: The Rule of 12

Write down all other expenses that occur throughout the year, just not on a monthly basis. These are annual or semiannual expenses such as Christmas, birthdays, insurance, Homeowners Association fees, professional dues, clothing, property taxes, car repairs, house repairs, school supplies, school clothes, etc.

I call this the Rule of 12 – trying to budget for every expense incurred during the year on a monthly basis. Some expenses apply the Rule of 12 for us, by requiring monthly payments. We have to apply it ourselves for the other expenses paid once or twice a year.

12We still pay these expenses monthly, but instead of paying someone else we put that money into a designated sinking fund. A sinking fund is established by setting aside current income to pay a specific future expense. It does not require opening a new bank account or any extra work. All it does is tag that dollar with a liability that will be satisfied in the future. The key point is that money is earmarked for a specific purpose. Although one might be highly sophisticated, it is not allowed to be “mentally noted” because it will be used for something else 100% of the time.

The January budget should include Christmas shopping. How much money are you going to spend in December on gifts? $1,000? Then your January Christmas “expense” is $83 (1,000/12 =83). By the time December comes you have $1,000 while doing no extra work!

If we have four months until an expense is due, we split the expense into four monthly payments.

This rule also applies for unexpected expenses that (hopefully) occur once every couple of years, such as car repairs. We cannot accurately anticipate these unexpected expenses. We can just expect them. We know they will occur, but we don’t know when or how much it will cost us.

A sinking fund simply hedges these expenses. We bring the terrible to bad, and the bad to “oh well”.

Has the fund grown enough to cover the unexpected expense? Great. But what if we come up short? We started budgeting $75 a month in March for “Car Repairs” but in November we needed a $1,000 repair. We only have $675! That’s okay too! That’s why we have an emergency fund – to cover actual emergencies; one’s in which we tried to prepare for.

It’s the behavior that matters most. By creating a sinking fund for unexpected repairs, we show our ability to not only NOT spend “available” money but also our willingness to save for something completely opposite of fun. And we aren’t even sure when it’s going to happen!

The ultimate goal is to tell every dollar where to go before that dollar even exists. Is this going to happen perfectly? Probably not. But it does eliminate “fake emergencies” like Christmas shopping and car repairs. The secret to reducing financial stress is to remember Christmas is in December and cars are not indestructible. These are the “emergencies” that most often put people into debt. Now that excuse is gone.

Step 4: Categorize Expenses

Categorize all expenses into larger buckets. Although everyone’s specific expenses will be different, the buckets are often very similar. Buckets include giving, shelter, utilities, food, transportation, clothing, debt repayments, retirement savings, personal expenses, savings, etc.

Categorizing expenses helps you visualize where your money is going. Are you spending a majority of your money on repairing your life (debt repayments and eating out)? Or is it going towards preparing your life (giving and saving)?

Step 5: Put a Dollar to Each Expense

dollarThis is the hardest step in creating your first budget. If you’re like most people, you have no idea how much money you spend in a day, let alone a month or a year. Finding the actual dollar amounts might take some time, but in order to tell our money where to go we have to know where it was going in the first place!

When starting your first budget, it might even be a good idea to simply track your spending for a month or two and forgo a Zero-Based Budget. Simply being aware of your finances can have a have a huge impact. After a month or two you can switch from a reactive budget (tracking expenses) to a proactive budget (Zero-Based).

Some expenses are easy to track, like your mortgage payment. Others are mere guesses, like groceries and gas. It’s impossible to track every penny, so don’t even try. The idea is to get a good grasp on what you used to spend money on. From there we can set parameters that can realistically be followed.

Look through bank statements or receipts and try to make your best estimates. There will be plenty of time to make adjustments in the following months. When in doubt, make sure to over budget.

When you become a true budgeter every cent of your paycheck goes somewhere; from an actual expense to a “budgeted expense”, like savings or a sinking fund. The budget is not complete until you have “spent” all your money. Your monthly expenses subtracted from your monthly income equals zero…before the month even begins.

Step 6: Create a Wish List

Create a short-term and long-term Wish List. Short-term wishes will consist of “big” purchases within the next year. Long-term will be 2-10 years. Anything after that can just be lumped in with “savings”. So what is a “big” purchase? That depends on your financial condition. For some it will be $500; for others $5,000 or more.

Your wish lists will include things such as a car, a piece of furniture, a vacation, a down payment on a house, a pool, etc.

wish listThe benefit of creating a Wish List within the budgeting process is that it gives you a benchmark to compare as to whether or not your budget is aligned with your goals. By using the Rule of 12, you are able to break down big purchases into monthly expenses. The house you want to buy in three years comes from down payment fund you started three years earlier. You do not just “save” that money. It is giving a specific order; “This dollar will pay for my house”! Without that direction it will disappear.

Creating a Wish List forces you to think beyond the present moment. The inability to delay gratification is the most common reason people do not follow a budget. A Wish List makes it easier to delay gratification by purposely writing down what you want. You might not be able to get it this year, but you will be able to get it at some point! It’s really hard to delay gratification if you believe it’s now-or-never.

Buying a house can seem overwhelming. In a matter of minutes our savings are wiped out and we probably have a large mortgage to go on top of that. But spreading that cost over 60+ months doesn’t seem as overwhelming. The day after the big purchase doesn’t bring buyer’s remorse; it brings, well, just another day. This is what we planned for!

A Wish List helps bring things into the proper perspective. Putting something on the list obviously means it’s an important goal. Every day we are one step closer to or further from that goal. Don’t want to follow the budget this month? Then it looks like you don’t want that house either.

You can’t have your cake and eat it too. That’s why I suggest baking several cakes instead! It takes time, but they taste amazing.

Step 7: Start the Budget!

At this point you should have a written plan. But the plan does us no good if it never leaves the kitchen table. For some, implementation may be easy. It could be like pulling teeth for others who haven’t paid attention to their finances in years.

“There are two mistakes one can make along the road to truth…not going all the way, and not starting.” The Buddha said that, not me. So why do we postpone starting something life changing? We are scared to fail. We think it’s better to fail-by-default (because we trick ourselves into believing we didn’t technically fail) than it is to fail-by-trying.

If you hadn’t consistently exercised in years and not a morning person but decided to start exercising every weekday morning for 60 minutes, your chances of success are slim. I know you read in a magazine that it would blast away fat, but they weren’t talking to you.

Instead of 60 minutes in the morning, we change the goal to exercise five (5) minutes – not 60 – in the afternoon. We have implemented a process that makes it impossible to fail. Everyone can walk for five minutes. What happens? We exercise 30 minutes when we said five minutes, but 0 minutes when we said 60. I’d argue it’s actually harder to exercise for five minutes and stop than it is to exercise 60 minutes; thus, 60 minutes is the easier option. This is done by making it impossible to fail, which in turn makes it easy to succeed.

If this is your first time following a budget, don’t do everything at once! You’re setting yourself up for failure. Instead, do ONE thing. Maybe for the first month the only thing you do differently is take an allotted amount of cash into the grocery store and restaurants, and only pay with that cash. Add something else in the next month.

Megan and I are extremely strict in following our budget, rarely deviating from it. And we live a normal life! After two years we’ve learned what works and doesn’t work; where we get a lot of benefit and where we waste our time. But we didn’t start out this way.

The number one rule in changing something is to not change everything. There are some things that are nonnegotiable – they just have to be done (like meticulously counting every penny that can be put towards the Debt Snowball). But others have the wrong asymmetrical risk/reward, where implementation would have some benefit, but if it fails we risk derailing our entire plan. I want the right kind of asymmetrical risk/reward – doing something and it fails hurts a little bit, but doing that same thing right makes a huge positive impact.

If starting a budget seems overwhelming, just do something of financial mindfulness. That something will at least make you aware, and awareness is half the battle. You will quickly realize it’s not as daunting as you had once thought.

Step 8: Track Your Expenses

It’s up to you to decide how you are going to track all your expenses throughout the month. There is a plethora of ways to do it. From apps, websites, and fancy excel files all the way to a pen and paper.

Whichever method you decide, make sure it’s easy! The first couple months we budgeted we made it about as complicated as possible because we were motivated and would do anything to make sure we were perfect. Then we realized we were going to be budgeting the rest of our life, and there was no way we were going to continue at this pace. We were so motivated that we made it hard to stay motivated. Not exactly what we’re looking for.

The Envelope System is BY FAR the easiest and most efficient way to track expenses (and stay within your budget). I feel so strongly about this opinion that I no longer think it’s my opinion. I accept it as fact.

This is how the Envelope System works:

envelopeGo through your normal budgeting process at the beginning of the month. Once the budget is final, go through each expense and mark which ones are going to be paid for with cash. Examples include groceries, entertainment, restaurants, clothes money, tithe, pocket money; basically anything except payments that would have to be mailed (i.e. mortgage payment, which should automatically come from your checking account).

Sum these expenses. This is the amount of cash you need for the month. You can withdraw the entire lump sum at the beginning of the month, or break down into weekly withdrawals.

Once you have the cash, put it in individually marked envelopes (or Ziploc bags or whatever you want). When you go grocery shopping, you bring that envelope. If you bought one too many frozen pizzas and don’t have enough money in the envelope, you put it back or steal it (not suggested), because we know you’re not paying for it.

The envelope system gives you instant and constant feedback with the added bonus of actually seeing and feeling money. There are many great software tools to use, but they don’t let you feel the pain of spending money on pointless items. Is there a difference between seeing a bank statement say $20,000 or actually holding $20,000? Of course there is!

Another benefit of the Envelope System is that it gets us away from using credit cards. You spend 12-18 percent more when you swipe your card than when you use cash. I don’t care about your points. I don’t care that you pay it off each month. Have you ever considered why every store accepts credit, even if they have to PAY for that option? They know they will make more money! It’s easy to swipe a card. It’s hard to give up a Benny Frank.

[You are not going to get robbed! And if you do, it’s not because they knew you were using the Envelope System. If you’re still uneasy I suggest you put all the cash on your night stand with a paper weight on it so the fan doesn’t blow it away. Oh, and the paper weight is a gun.]

Step 9: Balance Your Expenses

This is where flexibility is a must, and it’s much easier to practice this flexibility while using the Envelope System. A budget essentially guides us to the amount of money we are going to spend in total for the month. We then break it down into actual expenses to make it more manageable. But remember the main goal – stay within our TOTAL amount of expenses.

There will be time when we spend too much money on groceries and we have to take it out of, say, our pocket money. It is simply a tradeoff. Instead of getting a latte at 8am using my personal pocket money, I used the money to get a frozen pizza at 8pm.

balanceSometimes expenses come up that you didn’t budget for, but would still like to do. Well go do it! Just find the money from somewhere else. As an example, Megan’s has been in several weddings and, of course, needs her nails done. We could budget for “wedding nails” like any other expense, but it’s not necessary. When that comes up we just spread the money around and balance the others. It might come from various envelopes; a little bit of her pocket money, a little bit of our entertainment money. I think I have even given her a little bit of my pocket money, but you will need to fact check me on that.

Does this happen every month? Then maybe we need to change something in the budget. But if it’s not a reoccurring theme, balance the budget and move on. Balancing expenses allows us to stay within our goal while living a normal life.

Step 10: Tweak and Re-Tweak

Your budget is not set in stone. It will take several months before your budgeted expenses start to consistently match up with actual expenses. Does something need to be changed? Then change it.

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