How To Set Up A Personal Budget

how-to-set-up-a-personal-budget-522549__180Everyone should know how to set up a personal budget, because it help you incorporate financial discipline into your life.  As I explained in my previous post, What Is A Monthly Budget?, anything you do to apply discipline to control your spending will help you in your financial journey to retirement.

Putting together a budget can be very easy – after all, it really is just a list of spending categories with dollar limits attached to each category.  So you could just sit down with pencil and paper and make your best guesses as to how much you should be spending per month, and on what categories of expenses, making sure that the total of each of those spending categories doesn’t exceed your total income per month.

However, I would argue that the less effort you put into it, the less success you will have with it.  You will see what I mean as I explain further how to build a budget.

The Hardest Part of Budgeting

The first and the hardest step in putting together a budget is to identify the right spending categories to track your money against.  Believe it or not, I feel that this is more important than identifying the dollar amounts in each category that you will try to live under.  This is easiest seen in the extreme: if you try to track too much or at too low a level, then you will consistently have trouble staying within your budget (staying under your spending limits) because one or two expenses in a month will greatly exceed the average.  This is a problem because if you are always being warned that you are over-budget, you may stop paying attention to what your budget is telling you.  At the other extreme, if you track to little or at too high a level, it will be very easy to stick to your budget, but you then might find yourself wondering why you aren’t able to save any money, or (worse) wondering why you are running out of money in the middle of the month!

I discuss more on how to determine the appropriate level of monitoring for your budget below.

A Software Tool To Make Budgeting Easier

If you have been tracking your expenses using Quicken (as I recommend – see my Personal Spending Tracking page) or another financial software package, and have been making an effort to put mark your expenses in categories that the software suggests, or that are applicable to you, then you have a leg up on this process.  Quicken has a tool that will create a monthly budget for you (although I don’t necessarily recommend you blindly use this tool – see below).  The video below explains how to do this (at a very high level).


 

However, I don’t recommend you just take Quicken’s recommended budget at face value as your monthly budget (I wish it were that easy, but …).   Although it sounds so easy in the video, it does take effort to adjust what Quicken gives you in seconds into something usable.  Unless you have been tracking expenses from the start with the purpose of generating a budget, and have been intentionally cleaning things up along the way with this in mind (good for you!!) you will run into trouble.

Budget Level of Detail

You will also need to determine how deeply you want to monitor your spending – that is, do you want to monitor categories at the level of “All Auto Expenses” or do you want to monitor “Auto:Maintenance” and “Auto:Fuel”.  Or, do you want to monitor even lower – for example, do you want to monitor all Auto:Maintenance:Repair and Auto:Maintenance:Regular_Expenses, to differentiate between repair costs and regular oil changes and checkups?  This is a completely personal decision, and should be considered carefully.  You can choose to monitor at a high level in one area (for example, Household Expenses, and at a lower level in another area (for example, Clothing:Randy:Work_Uniforms).

Monitoring at a higher level is quicker to set up, but may not provide you with enough information to avoid making spending mistakes month after month.  Monitoring at a lower level takes a lot more time to set up, and unless you have been tracking your expenses pristinely so far there will be a lot of re-categorization of your existing expenses to do to get it set up correctly.  The solution for you may be somewhere in the middle.

Remember that the goal here is to be able to keep track of your spending monthly, and to stay within your own spending limits.  And also remember that there will be a learning curve to get over, so plan to re-visit your budget and make adjustments for the first few months until you get to something that works for you month in and month out.

Review and Re-Categorize Your Recent Spending History As Necessary

To start, I recommend that you simply make a report of your expenses over the past year (i.e., last 12 months) by category, subtotaled by month.  Most banks allow you to export your spending by account (i.e., checking accounts, credit cards, etc.) into text files or other formats that you can then read in another program such as Microsoft Word or a text editor, and print out reports to paper as necessary.  If you are using Quicken, from the Quicken Reports menu, you would use the “Spending by Category” report.  If you have spreadsheet skills, I recommend exporting your report to a file that you can then import into a spreadsheet, so you can move things around, add category totals into other categories, etc.  However, you can definitely do this by hand as well, using printouts, or the on-screen reports from Quicken.

Determining the Right Set of Initial Spending Data to Use

For this report, you need to select data from a recent time frame that you feel most accurately represents your current spending habits; if your spending has been about constant monthly over the past year, then a year is a good time window to use, because there is plenty of monthly data for averaging, and you won’t miss those regular bills that come in only quarterly or annually.  Normally, your more recent spending history is the best guide as to your current spending habits, although if you have some outlier expenses or income recently, an older time window may be more appropriate.  The best strategy may be to start with the most recent year, and review the report to look for significant outlier expenses (those that you don’t expect to recur in the future regularly) and delete them from your annual category totals.

Categorizing Transactions for Budgeting

Review these categories to determine which ones you want to track monthly, and which you want to fold into other categories to track at a higher level.  You might even find that you need to re-categorize some of your spending in order to correctly track things the way you want to (you should do that now – Quicken will remember your categorizations for future transactions with the same payee).

You should plan to budget ALL of your spending by category, even if you have a category like “Miscellaneous” – this will tell you how big your un-categorized spending is, and you can then take action to start getting a handle on these items.

The on-screen Quicken reports allow you to “drill-down” into your spending categories by month to get to the transactions that are mis-categorized, and to more quickly re-categorize them.

Add Your Income To Your Budget

Budgeting is not all about what you spend.  What you earn, and what income you bring in from other sources is just as important.  You need to be able to look at what you are spending in light of your income – this allows you to set spending levels that assure you an amount of free money each month that you can apply to savings and investment or to new spending (that in light of your budget is appropriate!).

Income is often overlooked in personal budgeting because for many people it remains pretty consistent every month; however, this may not be the case for you. Therefore it is critical that you keep just as close an eye on your income as on your expenses, and include a budget line item and expected income amount for income source for each month.

Finalize Your Budget

When you have finished moving your transactions into the categories you want to track in your budget, re-print your itemized categories report complete with monthly sub-category totals.  Create a single list of only those categories that you will include in your budget, listing them in order by descending value (cost or dollar-value), and keeping all Essential and Discretionary expenses together.  If you are using Quicken, you now have a couple of choices; you can either:

  1. Re-print your Spending By Category report from Quicken (using only those categories and subcategories that you have determined will be monitored in your budget) and include average monthly totals over the last 12 months (or over the most recent number of months for which your data was taken) as your monthly budget amounts for each of these categories. Adjust these values up or down as you feel necessary, given your knowledge of upcoming life changes that you expect over the next year or so.  Or, leave these totals as is, allow your actual spending to exceed or under-spend these categories and provide explanations for these items as they occur throughout the year.
  2. Use the Quicken Budgeting tool to build a budget using only your budget categories. Remember that you must include all of your spending, even transactions that have not been intentionally categorized (“miscellaneous” category items).  In the Planning tab, select Budgets, and click the “plus” sign at the bottom of the page to Select Categories to Budget.  The Budget tool will then automatically generate the budget for the month, showing the expected spending, the budgeted amount for each category, and whether each category is over- or under-budget so far this month (green = under budget, red = over budget), and by how much.  A total for the month (all spending) is also identified at the top of the screen.  You can edit the Quicken-generated budget amounts up or down as you feel necessary, given your knowledge of upcoming life changes that you expect over the next year or so.  Or, leave these totals as is, allow your actual spending to exceed or under-spend these categories and provide explanations for these items as they occur throughout the year.

Continue to compare and refine your budget as necessary until your spending is being accurately reflected in your budget and your budgeted spending is mostly consistent with your actual spending.

Adjust Spending to Achieve Your Goals

When your budget has been refined to where you can trust the results are correct, it is time to start making decisions about where changes need to be made in order to align with your individual retirement plan, which is based on fulfilling your retirement and life goals (see my pages The Best Retirement Advice and Retirement Goal Setting, respectively for more information on these topics).  You may find that, after working with your retirement calculator and plan, that you are right on course to meet your life and retirement goals.  However, you may find the opposite to be true.

If, for example, at age 55 you have stated retirement goals of being able to retire at age 62, and to leave $250,000 to each of 4 children, and you have a net worth of only $100,000 at that point, then you may need to be putting a lot of money away into retirement savings per month (read – a lot of “leftover” money between income and expenses per month) right now.  Or, you may need to find a way of making additional income – see my page Making Additional Income Before or In Retirement for information on this topic.  Other possibilities may be that you may need to make some significant life changes soon, or re-assess whether your stated goals are realistic.

At this point, your budget is providing you with a lot of information about your spending habits.  That knowledge is likely impacting your habits in a positive way daily, helping keep your finances under control and on course to support meeting your life and retirement goals.

You now know how to set up a personal budget!  Let me know what you think.  Post a comment below – I’ll respond!  Or, check out my Wealthy Affiliate profile page and leave me a comment there.

12 Comments:

  1. Hello there.
    I found this post really informative and useful, thank you.
    I never thought of using software to create and stick to a budget before, but it makes a lot of sense.
    I do believe most people will benefit greatly from this because of the huge amount of debt most carry.
    If anyone wants to ever become financially free or even retire a balanced sensible budget is a must!
    This will also help with monthly savings as well, I want to try it now.

    • Thanks Randy for the comments – using software is just a suggestion. You can keep track of your spending and your budget at the same time. Best of luck with it

  2. Hey Randy, thank you for this information. Reading this I realized I have my budget setup at a high level, its only “fun” all wants or “necessary” all needs, perhaps I should break this down a bit more, it would definitely make things more visible, didn’t think about using quicken I just have some old excel sheet, thank you for helping me realized my mistake, time to redo my budgeting system.

    • Victor, I do recommend you break things down to at least a level where you can actually monitor what you are spending – if you just have a category called “Other” or “Miscellaneous” or even “Food” you will run into obvious problems.

      A spreadsheet is OK and of course very flexible. And if you are used to using them you may like the flexibility for making tables/charts, etc. better than a program like Quicken. The advantage that a program like Quicken has is that it can download your bank statements as often as you want and so you can easily keep things categorized against your budget. It will show your where you are at any point during the month. As I said, I don’t actually use that feature because it does take a lot of effort to initially set up, but once it is set up it would be great. I use the reporting system in Quicken to tell me how much I’ve spent in each category by month/quarter/YTD, etc.

      Thanks for the comments and best of everything to you!

      Randy

  3. Right on! This is information that everyone can benefit from, especially in today’s credit happy environment and “pay it back later” mentality. It is a good pragmatic discussion. Is there some competition out there in software? Is this the only option worth considering? Thanks for sharing and I wish you well in your future endeavors.

    • Thanks for the comments – there are a number of other packages out there that do some or most of what Quicken does, but it is hard to call them “competitors” as Quicken really has the lion’s share of the market – Mint.com is an online version and is probably the best known. I’ll be posting some reviews of these other products, so check back in soon!

  4. I struggle with budgeting my finances. I have tried keeping up a steady budget but soon fail. I have used many methods to help me become better at it.

    I have not looked into Quicken. I am going to have to come back to this.

    Now that I am working on my own small business, I realize how much more important it is.

    This is a great article. Very informative.

    Thank you for sharing.

    • Yes, this “good habit” is difficult for many so of course you are definitely not alone. But, the sooner you can master it the better off you will be with your savings all throughout your life. Thanks for the comments!

  5. Budgeting is one of my weak points. It truly is something that I need to work on a lot more. This software looks interesting. The problem gets worse for me as when I fail to budget and then I move into more debt and things snowball from there. Pre planning when it comes to income and expenditure is a great way to live your life and it can make saving for things like holidays a lot more achievable…

    • Yes, once we actually have some money to spend, the concept of putting limits on ourselves just seems to fall out of the picture – it is a natural tendency that is hard to overcome. However, if we can it is a powerful life skill that will pay off for us in many (unknown) ways. Thank you for your comments!

  6. This is great, lots of info and tools to help kick start my newly found budgeting skills, great site.

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