Budgeting Basics - What, Why, and How? (1/3)

Hi, everyone!  This is Lara Hammock from the Marble Jar channel and in today's video I'll go through the basics of budgeting -- what is a budget, why do you need one, and how does it work?  This is the first of a three part series on budgeting.

I have been keeping a budget since I was in my early 20s.  I grew up in a frugal family and I like numbers, so it was a natural fit for me.  A couple of years ago, I started volunteering as a financial mentor.  What I realized is that not everyone has a good sense of what a budget is, why it is important, and how it works.  This video is my attempt to break it all down.

What is a budget?

People absolutely hate the notion of a budget -- it make them feel very constrained.  But a budget is really just a plan.  It is a plan detailing how you want to use your income.  It can certainly feel constraining, but it is really just an agreement that you are making with your future self about your financial behavior.  This plan, or budget, can be really detailed or it can be quite simple.  So,

Why budget?

People generally know the answer to this question.  You budget so that you can make sure that you have enough money to save for the future or pay down debts.  Everyone has some big and some small financial goals.  Budgeting is the nitty gritty tactics that make sure you have enough money to achieve your goals.  

But I actually believe that there is another reason for budgeting.  Freedom.  Generally, people think of budgeting as being constrictive and limiting.  That may be true in the short-term, but once you are able to put some money away -- it can be incredibly freeing and liberating.  You are free to live now since you know you are saving for your future.  You can feel good about this big purchase since you have diligently saved for it.  It is a way out of your financial prison and the anxiety that goes along with that.  Okay, so

How does it work?

The third video in this series will cover this process in much more details, but here is how a budget works at it's most basic: you have money coming in, or income.  A certain part of that income will be spent on living expenses.  What is left over can be either saved for short or long-term goals or used to pay down debt.  Simple, right?  The issue is right here -- sometimes our living expenses are so erratic or large that there is either nothing left over OR, even worse, it exceeds our income creating even more debt.  If you've racked up a bunch of consumer debt, you are probably turning to budgeting to help you get things under control.  The four components of successful budgeting are:

• Goals - figure out what your financial goals are
• Current - collect data to determine what your current financial graph looks like
• Make a budget - figure out a plan to change your current behavior in order to meet your goals - this will usually involve either increasing your income or decreasing your expenses or both and finally
• Monitor progress - checking on a regular basis to see how your actual behavior matches against your planned behavior to ensure your budget is on track

Let's go through these briefly one at a time:

Goals

Everyone is different, so everyone has different goals.  However, some goals are more or less universal.  Everyone needs to save for retirement, everyone needs to save for an emergency (like losing a job), and everyone needs to save for unexpected expenses -- like a down payment on a car, fixing your roof, or kid's orthodontia.  Retirement, if at all possible, should be taken out of your paycheck before you even see it.  After retirement is taken out, you have this hunk of income.  30% should be used for savings.  You can slice and dice this any way you want, but one way is

• 10% absolute emergency (hopefully you'll never have to tap into this) - this should be 3-6 months of living expenses
• 10% slush fund (new bedroom furniture, surgery, etc.)
• 10% other (some people give to charity, some save this for college education, this will be different for each person)

If you are in debt, you should build up a bit of a cushion, but otherwise, use all of this 30% money to pay down your debt.  Savings is not worth much if you are paying a bunch of interest on outstanding debt.  Once you have paid off your debt, you can start to work on goals.  Okay -- so now you have 70% left to pay for expenses. Well -- first let's 

Determine your current graph

If you are in a fairly steady state and your expenses are fairly predictable, you only need about 3 months of financial transactions to figure this out.  Go back through bank statements, credit card bills, etc. and gather all of the information that you can about how you spent your money in the last 3 months. Then work out your income and your living expenses.  If your graph looks just like this, you might not even really need to create a budget -- you are saving well already!  Unfortunately, that's usually not what this exercise shows you.   Does it look like this?  Or even worse, like this?  If you want to be able to save at all, you need to

Create a budget

You have 2 options if you want to create savings -- increase your income or decrease your expenses.  For most people, working on controlling expenses is much easier than trying to find ways to bring in more money.  In order to do this, we are going to have to break down your expenses right here.  I'll go into all of the different types of budgeting in another video, but basically, you need to group expenses with other like expenses to figure out what you are spending your money on and limit the spending that is unnecessarily.  Basically, you are going to end up with a sense of how this big block of expenses was split into categories.  I like to think of them as buckets.  Some buckets have a bunch of money in them, some not as much.  Budgeting is the process of determining how much money goes into each bucket.  If you've been spending $1,000 on groceries a month, maybe you can shave that down to $800 instead.   If you can reduce the amount of money you have to put in a bunch of buckets, you can decrease your expenses and start saving.  Your eventual goal should be to get to 70% expenses / 30% savings.  Or even lower expenses if you can swing it.  That said, here is what I would recommend.  If you aren't at 70/30 yet, DO NOT immediately create a budget that is so unrealistically low that you will never meet it!  That is a good recipe for quitting this altogether.  Budgeting is almost exactly like dieting.  You have to make small changes over time that are realistic and achievable.  Put yourself on a plan to cut expenses little at a time over 6 months.  You will need to give yourself time to make adjustments.  And finally,

Monitor Progress

It's all well and good to put a budget in place, but if you never check to see how your actual expenses are doing against your plan, it won't be very useful.  Regularly monitoring helps to keep you on track and making good decisions.  Write down your expenses, compare them against your plan or budgeted number, and make adjustments if needed.

So, that is the big overview on budgeting.  What a budget is, why you would need one, and how it works.  Join me in my next video where I discuss a bunch of popular budgeting methods.  Comments are always appreciated and thanks for watching!