Before you begin planning your budget, it’s important to understand the different categories that need to be included in your budget. There are two main categories, which are Income and Expenses. There will likely be only 1 or 2 sources of income for most people, however, there can be many different categories of expenses in everyone’s budgets. Let’s begin looking at these different types of income and expenses.
INCOME
It’s important that you know exactly how much money you are earning or bringing home each month, so you can accurately determine how to allocate your dollars each month to expenses and savings. To make things simpler, it is best to calculate your after tax or take home income, which is usually your net paycheck. Most people generally get paid a salary or hourly wage, which means their income is typically a fixed amount each month. Some people may get paid bonuses or commissions. When you’re calculating your average monthly income, you can typically take your yearly salary and divide by 12, or take a weekly paycheck and multiply by 52, because that’s how many weeks are in a year, then divide by 12 to get a true monthly average. Some people may get paid every 2 weeks, so you would multiply by 26, then divide by 12. This is simple to calculate if you make roughly the same each paycheck.
When it comes to earning commission or bonuses you may make a different amount each time you are paid, so there are a few different ways you may want to calculate for budgeting purposes. If you typically do not need your commission for your living expenses, then you may choose not to count you commission for budgeting purposes and allocate that money to specific items when you receive them like savings or paying down debt. If you do rely on commissions or bonuses for your living expenses, then it’s very important that you be conservative with your calculations. You don’t want to over estimate for your income, then come up short if you do not receive as much as you calculated for in your budget. A very conservative approach to take would be to look at the lowest commission amount you made in the last year and use that as your monthly commission for income purposes on your budget. Another way you could calculate your monthly commission would be to take the average of your last year or two of commissions. Simply take 12 or 24 months of total commissions earned and divide by the number of months you totaled up and that gives you a good average to use for you budget. There are other types of income people may collect such as passive income from real estate or other investments. You can choose to include that in your monthly budget as income if want. Again, if you want to be conservative, it would be best not to use this income. Maybe you make all of your income from passive activities such as real estate, then you would definitely include that in your monthly income budget.
EXPENSES
Once you know your average monthly income then you can start looking at your expenses and allocating them appropriately. There are two main types of expenses that you can allocate almost everything towards in your budget, Discretionary and Non-Discretionary. Each month you have costs that you have to pay to maintain your basic needs which are considered non-discretionary. That includes housing, utilities, food, clothes, insurance, etc. These are expenses that should have priority to be paid each month. Other items that could be included in the non-discretionary expenses are fixed installment payments, student loans, or child support. Discretionary expenses are things that you don’t need, but they usually provide a level of enjoyment, like vacations, shopping, entertainment, specialty coffee, etc. It’s important to categorize your expenses into these two different categories because if you know what you have to pay for each month to live on, then you can know where you can cut back if you had to on the discretionary items.
Another subcategory of Non-Discretionary expenses should be Savings. Wait, why are savings considered an expense? For budgeting, you are choosing where you allocate your dollars each month. If you take it from you income and transfer to a retirement account or savings account, you are taking it from your income, so you are expensing it to that savings.
It’s also important to note that just because an item may fit in the non-discretionary category like clothes, if you buy a $500 brand name outfit, that may be a discretionary item since you don’t have to spend that much to meet an average outfit you would typically purchase.
Now it’s time to start putting the numbers to work. The best way to understand your own monthly expenses are to take the last 3 months bank statements and/or credit card statements, and start categorizing everything on those statements. Once you have everything categorized, total up each line item of those categories and transfer them on a spreadsheet, accounting software like QuickBooks which may be free with your bank account, a budgeting app, or you can just write them down on a sheet of paper. It would be a good idea to total each month up for each category, then take an average of the 3 months to get a good number to work with on your budget. Remember you need two categories, discretionary and non-discretionary. Put all the items under each category and subtotal your discretionary and non-discretionary. When you take your monthly income, less your total expenses, you should hopefully have some left over or be close to net zero. Yes, you should be close to zero. Why? Your goal should be to allocate all of your dollars somewhere each month. If you have a surplus each month, then you can allocate those extra dollars to paying down higher interest debt or saving more.
This covers the basics on how to get your monthly income and expenses for your budget. There are several strategies or guidelines to utilize that will allow you to make your budget for effective and help accomplish your financial goals quicker. We will discuss those shortly.