5 Simple Steps to Creating a Personal Budget

May 4, 2017

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Creating a budget is one of those items that always falls to the bottom of our to-do list. Perhaps because the mere term "budget" elicits a bitter sense of restriction. The problem is that we’re going about this all wrong. The right kind of budget should empower us rather than confine us. It should equip us to achieve our long-term goals rather than deprive us of enjoying the present. We should be allowed to spend money on things that make us happy, without guilt. These 5 steps will help you build a personal budget that does just that.

Pro tip: Creating a personal budget just got easier. At the bottom of the post, sign up to download my free personal budget template.

Step 1: Know your monthly after-tax income.

Before building a successful budget, it’s important to evaluate your current position. First, calculate how much money you bring home every month after taxes. If you have a steady monthly paycheck, reference your most recent pay stub to calculate exactly what you earned. If your employer deducts 401(k) or IRA contributions, add those back into your take-home pay (we’ll categorize them elsewhere). If you are self-employed, a freelancer, or have a variable paycheck, average your earnings over the last few months to come up with a fair number.

Step 2: Calculate your living expenses.

Your living expenses represent your basic needs and don’t fluctuate much. These are bills you are committed to paying and items you can’t delay purchasing. A few examples are your rent, mortgage, car payment, utilities, and phone bill. I also like to include basic food and groceries in this category because—well, it's a necessity. Just note that any dinner splurges or wine-and-dine nights belong in the next section.

Step 3: Tally your discretionary spending.

Next, focus on where you spend money for fun. Think fitness classes, Kindle books, manicures, Netflix, and date night drinks. Ok, that was just an inside peek into my spending habits. But you get the picture. These are discretionary purchases that you could eliminate or delay if things got tight. Spending on “wants” can be difficult to estimate because each month is different. I like to use Personal Capital, a free budgeting tool that tracks my spending by category. That way, I know exactly how much I (over)spend on cappuccinos.

Step 4: Examine what's left and prioritize financial goals.

After subtracting your living and personal expenses from your monthly income, how much is left? Ideally, this is cash you will put toward financial goals. These might include:

Paying down debt. If you have high-interest credit card debt or student loans, paying these off should be a top priority. The longer you delay, the more your interest expense will snowball. To get you started, here is a guide to paying down debt once and for all.

Setting up an emergency fund. I recommend keeping three to six months of living expenses in a savings account separate from your checking. If your car breaks down or you're in between jobs, this emergency fund will save you you from dipping into retirement savings or taking out a loan. For more details, check out my complete guide to setting up an emergency fund .

Contributing to a retirement account. If your employer deducts 401(k) or IRA contributions from your paycheck, this is where you’ll categorize them. These retirement plans offer an array of tax benefits and typically include an employer match of up to 3-5% of your salary. To avoid leaving money on the table, try to contribute at least as much as your employer will match.

Starting an investment account. If you’re debt free, have an emergency fund, and contribute to a retirement plan, then it sounds like you’re in great financial shape! To take things to the next level, consider opening an investment account. Interest rates on savings accounts are 1% or less, which isn't too compelling. However, you can boost your long-term returns by investing in the stock market. Note that this is a risky short-term strategy because the markets fluctuate daily. However, if you have some cash that you don’t plan to withdraw for decades, the stock market is a great option. I don’t have the time or desire to pick stocks and manage a portfolio, so I use Wealthfront to do it for me. You can get your first $15,000 managed for free by signing up with this link.

5. Consider the 50/20/30 budget.

You’ve already done the heavy lifting. You painstakingly laid out your monthly finances. Now, how do you know if this represents responsible financial behavior? Enter the 50/20/30 budget. This is a guide (NOT a rule) for managing your income in a way that allows for both saving and spending. Here’s how it works:

50% of your monthly after-tax income should be spent on needs. These are the living expenses we tallied in step 2. Rent, food, utilities, transportation, etc.
20% should be allocated toward financial goals. Paying down debt, saving, investing, etc. This is what we discussed in step 4.
30% can be spent on wants. This is the discretionary spend that we calculated in step 3. Cable subscriptions, gym memberships, travel, shopping, etc.

Review the amounts you tallied in steps 1-4, and notice how your spending aligns to the 50/20/30 budget. If your discretionary spend is 50% of your monthly income, that may be a red flag. Download Personal Capital, review your spending habits, and determine how to cut back. Maybe you didn’t realize you spend $100 a month on almond milk lattes. Perhaps your annual cable promotion ended, and it’s time to request more discounts. On a similar note, if your living expenses are 70% of your monthly income, maybe you can negotiate your phone bill or shop around for lower insurance bids.

Remember that everyone’s budget will look different. Someone who lives in an expensive city may pay more than 50% in living expenses. Someone with a lot of student loan debt may need to allocate more than 20% to their financial goals. So don't be discouraged! You don’t have to match your spending exactly to the rule. It is meant to be a proportional and directional guide.

The 50/20/30 Budget

The Bottom Line

I firmly believe that a successful budget is a flexible one that gives you space to spend money on the things you value. I use the 50/20/30 budget to guide my spending because it allows me to enjoy the things that make me happy and still grow my net worth. Many of us procrastinate putting a budget on paper because it's a daunting task. But building a budget doesn't have to be painful or intimidating! Plus, I'm making it even easier with my personal budget template. Sign up below to receive your download link. I hope it's helpful!

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