How to create a basic budget in 6 steps

Creating a budget is an important step on the road to financial independence. A budget is a plan of your income and your expenses. You create a budget typically for a 1 year period. You don’t need to start in January, you can start right now.

I’ll help you in this article to collect all incomes, collect all expenses and give you advice on how to use your new plan.

1. Collect data about your income
2. Collect data about your expenses
3. Categorize your data into buckets of similar expenses
4. Set planned levels for each category
5. Reflect if you pay yourself
6. Set up a tracking mechanism for the year

Keep it simple

Before we start with the details of how to create a budget, let me tell you that you should keep it simple. This is a plan and as Dwight D. Eisenhower famously said “Plans are worthless, but planning is everything.” Don’t spend too much effort on planning. Rather put your energy into sticking with the plan or adjust it flexibly when your situation changes.

You can round all historic numbers to the full dollar and all planned numbers to 5 or 10 dollar values. Ideally, you round down incomes and round-up expenses.

Tools for creating a budgeting

You don’t need to buy anything or sign up for fancy services to create a budget. You can write a budget on a few sheets of paper. However, as you are online, you can as well use a spreadsheet to make your life easier. I mention a few more tools along the way, but they are merely speeding up creating a budget.

Step 1: Collect data about your current income

If you are employed write down your paycheck. You have two choices, you can copy the take-home pay or the gross pay and items like social security and taxes withheld as expenses. Whatever is easier for you.

If you have other sources of income, a second job, social security, or other government payments, add them in additional lines.

You want to record these values for at least 6 months, ideally 1 year. If your income is smooth and steady, then 6 months would suffice. However, if you have varying income, because of a job change or seasonal work, or a business, then you want to collect 12 months’ worth of data. Besides, it does not matter if you do the budget bi-weekly or monthly as long as you are consistent with how you record the expenses.

Step 1a: Quarterly or annual income

If you receive quarterly payments or annual payments, such as bonuses, then write those down too. Take note if they are guaranteed or depend on factors you can not influence directly.

If the non-monthly payments are guaranteed, you can either calculate them as monthly payments (not recommended) or you can leave them at the dates where they’ll come in.

If the irregular payments depend on things outside of your direct control, such as overtime pay or company success bonuses, then it is best to keep them on a separate sheet. We’ll return to them later.

Bonus tip: Tax refunds belong on this annual income sheet.

Finally, sum up the payments.

Step 2: Collect data about your expenses

You want to collect data about your expenses as detailed as needed but no more. Remember, keep it simple!

A good source for this data is your bank statements and your credit card statements. Make sure you review all of them.

Also make sure that you don’t count transfers from one to the other, such as paying your credit card balance off in part or in full. However, you need to account for the interest payment charged to your credit card.

Again you want to collect at least 6, better 12 months of expenses. The more your expenses fluctuate, the more data you want to collect. If you can collect 2 or three years’ worth of data easily, go ahead and do so.

Step 2a: Quarterly, annual or one-off expenses

Take note of expenses that occur quarterly or annually, such as insurance premiums, car inspection, or estimated tax payments, or other tax payments.

Put these irregular payments on a separate sheet.

Also take note of one-time payments, such as moving costs or the purchase of a car. Put these on a separate sheet.

Step 3: Categorize your data by similar expenses

In this step, we want to find out, where your hard-earned money is going. We want to determine, which expenses you can plan for and which expenses you need to prepare for as they will be coming up.

We further want to understand which are the big expenses and which are the smaller expenses that add up to substantial amounts. We want to get an idea of which expenses can be reduced/eliminated to achieve our financial goals, such as getting out of debt or saving for retirement.

Here tools like Mint, Clarity Money, Wally, or You Need a Budget (YNAB) come in really handy. They can categorize your outflows from your checking account into neat categories. They guess many recipients automatically. Further, the good tools learn from you, when you change a payment that was not correctly classified.

Many banks do offer such tools now integrated and free of charge. In any case, I’d not overpay for the tools, as any expense will hurt your goal of saving for your future self.

Finally, sum up the expenses in each category and sum up all categories per month.

Step 4: Set planned levels for each category

Now it is time to look at your expenses in the past. Make a list of things that surprise you. Write down what expenses you had forgotten. Add to it the expenses you do not remember to be so high.

In this step, you want to pay special attention to the changes from month to month in the income you have as well as the expenses. Find out what causes these variations. They may be perfectly normal. However, if they are more than 5% from the average over the year, you should take special measures to set aside an amount every month to cover those irregular payments.

You might also review your categories and if they are really small, merge them with something similar.

Step 5: Reflect on if you pay yourself

By paying yourself, I mean paying your future self. This can be the amount set aside for uneven expenses in the year. It can also be amounts you set aside for specific spending goals, like buying a car or making a once-in-a-decade or lifetime trip.

More importantly, are you contributing to your goals to become increasingly financially independent? Ideally, you make those payments not with what is leftover. You will be much better off if you make them first, in an automated fashion. Send this money to a different account, that is destined for paying irregular payments or another separate account to save for medium-term purchases.

Step 6: Set up a tracking mechanism for the year

Now that you have a plan, you want to sit down every month to gather the data in the same manner as above. Gather the income and the expenses. Categorize the expenses into the same bucket or open a new one if an expense does not fit.

With the data gathered, you want to assess if you are staying within your budget or if you are underspending or overspending.

Take actions to create a budget NOW

Now that you know if you spend money according to plan, or not, you can take action to correct any expenses or misses in income.

If you are overspending, note down actions you’ll take to correct this. Deferring medium-term planned purchases can be a good idea. Skipping contributions to your goal for financial independence may be as well if you have room to stretch it. If the goal is tied to the regular retirement age, then I’d prefer you find other ways to live within your means.

If you are underspending, then pad yourself on the back for this achievement. You planned very well. Now you have to decide what to do with the extra money. You can put it towards the medium-term purchases funds and reach those faster. Or you can put it towards long-term retirement savings and become faster financially independent.

There are more advanced topics to budgeting, such as dealing with not foreseeable payments like success bonuses. For now, you can treat them like any other underspending.

Furthermore, there is the case of serious overspending or zero payments to yourself. These are serious issues, you might want to correct. I’ll discuss those in future posts on this blog.

There are other methods to create a personal budget: Check out this comprehensive guide.