How do I make a budget?

There are 5 key steps to making a budget: 

1. Figure out how much you have to pay in fixed expenses
2. Figure out how much you expect to pay in variable expenses
3. Figure out how much money you will earn 
4. Check if your expenses equal your earnings (i.e., check if your budget “balances”) 
5. Change your budgeted spending or your earnings to balance your budget

It’s helpful to think about the time period for our budget. Many large and recurring expenses are due on a monthly basis, so many people choose to make their budgets based on monthly income and expenses. 

Let’s break this down step by step. 

Figure out how much you have to pay in fixed expenses

Fixed expenses are the costs that you have to pay no matter what. Anything that has a contractual obligation to pay is a fixed expense. You need to budget the full amount of these because they are predictable and you know what they will cost. Common fixed expenses include:

• Rent / housing
• Student loans
• Car payments
• Utilities
• Gym memberships
• Streaming services

You should make a list of all the recurring expenses that you have and how much each of them costs per month. If you have some costs that you only pay once per year or at a different schedule, you should divide that cost into the implied monthly cost and include in your monthly budget to set aside for later (e.g., divide annual property tax expense into 12 months so you account for the cost in your monthly budget). This way you can spread the cost of large predictable expenses over multiple months. 

Remember, some costs are fixed right now but you can still change them. You cannot change the amount of money that you owe for rent whenever you want, but you can choose to move and find a less expensive home when your lease expires. You have to make your car payments right now, but you can sell the car and stop making payments in the future. You can cancel any streaming service, gym membership, food delivery service, or other recurring expense – it just might take a little time before you can stop paying. 

Figure out how much you expect to pay in variable expenses

Variable expenses are those spending categories that are not a set amount. Some examples of variable expense include: 

• Food
• Entertainment
• Hobbies
• Clothing
• Savings
• Transportation
• Vacations

As you can see, not all variable expenses are equal. For example, you cannot cut out the cost of food completely, but you have a choice in how much money you spend on food. You can spend $400 on groceries per month or $2,000 on takeout per month. In the process of creating your budget, you should include how much you expect you will spend on these variable expenses and be prepared to change these as needed. 

You should brainstorm what spending categories you haven’t covered in your fixed expenses and then determine how much you usually spend for each. Look at your credit card statements from the past few months and any receipts you have. The more accurate you are in your budget amounts, the better your budget will be. 

Figure out how much money you will earn 

A budget needs to be balanced, so you have to account for both the money coming in and the money going out. When you are accounting for your income, you should be focused on just the money that you have available to spend – that is, your after-tax spending power. 

You should total your average monthly earnings from all your sources of income (paycheck, side jobs, etc.). If your monthly earnings are inconsistent and can change, you should use an average of several months of income. You should only budget around the money that you expect you will have. You don’t want to be forced to cut back on your spending because you didn’t reach a sales commission goal or didn’t get a raise. 

Check if your expenses equal your earnings (i.e., check if your budget “balances”)

This is a simple step – do the math! Check if your estimated spending is more or less than your estimated income. 

The takeaway from this step is very clear: if your budget balances, you are done! If your budget does not balance, you have to move to the next step. 

Change your budgeted spending or your earnings to balance your budget

An unbalanced budget can mean one of two things: you are planning on spending more than you make (you are “over budget”) or you are planning on spending less than you make (you are “under budget”). 

Being under budget is a great problem to have because you can spend more money than you expected. At this point, you should re-evaluate your spending categories. Were you too conservative with how much you expect to pay for something? Were you too generous with how much you thought you would earn? Are you putting enough money away for savings or retirement? Tweak your budget amounts and check again if it balances. 

Being over budget is a tougher problem because it means that you cannot meet your spending goals with your expected income. In the short term, this might mean that you have to reduce your expected spending. If you have savings then you can dip into that and spend accumulated savings for the budget overage. In the longer term, this might mean that you have to find ways to increase your income in order to support your desired spending levels. 

Regardless of the causes, you need to tweak your budget amounts, make some tough choices about where you can carve out some expected spending, and check again if it balances. You have to keep repeating this step until your budget is balanced.