Before we get started take a look at this formula:
I – (E + FG + DE) = FWB
That formula is what budgeting is all about. FWB is an acronym for Financial Well-Being, which is a place that everyone wants to get to. Let’s get into the meat so that you can find out what the other variables stand for!
Would it not be wonderful if we knew exactly how we spend our monthly paycheck? Sure, it would. However, creating a budget from scratch can be a challenge, especially if you haven’t developed such a habit from an early age.
Some of us mistakenly think we don’t need a budget probably because we don’t earn that much money. To help you understand why you need to create a budget irrespective of your income, we first need to understand what budgeting means and why it is important for proper financial management.
What Is A Budget
A budget is simply a reflection of your income and expenses over a given period of time, say one month.
A budget allows you to track and identify where your hard-earned money goes and helps you make necessary adjustments in case you are heading down a slippery path.
Now that we’ve identified what a budget is and what it does, it is time to figure out exactly how we can get started with budgeting. The following step-by-step guide will help you start out on your budgeting journey.
Step 1: Determine your NET income (I)
The first step in budgeting is to determine how much money you have coming in (minus the deductions such as taxes, 401(k), social security among other mandatory deductions).
However, income doesn’t have to come from salary alone, other sources include income from side-hustles such as freelancing or other business ventures. The TOTAL SUM of all such income MINUS the deductions highlighted above is what we refer to as NET INCOME.
Pro Tip: Create a spreadsheet detailing all your sources of income, line by line.
Step 2: FIXED & VARIABLE Monthly Expenses (E)
After you’ve determined your monthly net income, the next step is to add up all your FIXED monthly expenses. These are mandatory financial obligations that you must honor such as rent/mortgage, insurance premiums, minimum monthly loan repayments, retirement fund etc.
Pro Tip: Automate all your major bills and savings, eliminating the worries associated with late payments, associated fines and fees
Next up is the VARIABLE expenses, essentially this are expenses that vary from month to month such as groceries, car maintenance, utility bills, entertainment etc.
When determining your monthly fixed/variable expenses, it is important to identify areas you can cut back on by either switching service providers or finding affordable alternatives, leading up to the next step.
Pro Tip: Download an app and religiously record your daily/weekly/monthly spending, even on the smallest of items
Step 3: Establish your FINANCIAL GOALS & Develop a Plan (FG)
Yeah, yeah I know what you are thinking; we haven’t budgeted for Pay TV yet, but don’t worry that will come in the next step. For now, let’s pause and establish our financial goals.
This is such a vital step because it allows us to reflect on our spending habits and shift our focus from aimless spending to prioritizing important financial goals that we’ve identified for ourselves.
To achieve this we need to write down our financial goals; this is not as hard as it sounds, in fact, it is a very pleasurable process once you’ve got the hang of it.
Your financial target can be anything ranging from paying off your student loan, getting out of debt, saving for your MBA, paying off your car debt etc. Once you’ve identified your financial goal/target you have to determine how much money you have to set aside in order to achieve that goal.
Pro Tip: Getting out of debt should be at the VERY TOP of your financial goals list
Step 4: Discretionary Expenses (DE)
We all indulge in activities that are NOT essential; but that provide pleasure and relaxation, these are referred to as discretionary expenses.
Examples include entertainment, impromptu shopping, personal care, gifts for self/others among other discretionary expenses.
These expenses come last on your list of expenses because they don’t add any value to your long-term financial health BUT play a vital role in your overall well-being.
Pro Tip: Funds for discretionary expenses should be the leftovers after we’ve catered for steps 2 and 3
Step 5: Determine your FINANCIAL WELL BEING
This step involves taking stock of our financial well-being using a SIMPLE mathematical equationI – (E + FG + DE) = FWB
If the FWB is POSITIVE, then you should be celebrating, because it means you are living within your means. The larger the positive number is the more you can invest in your future!
If the positive number isn’t very large, then you should be looking for opportunities to better manage your finances.
Pro Tip: Just because you appear to be in perfect financial health, doesn’t mean that you should sit pretty. The secret here is to use the surplus amount towards attaining your financial goals as opposed to increasing your discretionary expenses.
If the number is ZERO, then it means that you have just enough to cater to your needs and not an extra coin to cater to unforeseen emergencies.
Pro Tip: Though this scenario might seem ideal, it isn’t. You might need to find ways to increase your income so that after deducting your expenses you are left with a margin in the event of unforeseen occurrences.
If FWB is a NEGATIVE number for you, then you are in a financial mess and you need to take steps to correct your situation. But realize that your situation is NOT hopeless, with some adjustments you can turn it around.
Pro Tip: In this situation, you have two options:
First, you need to examine your budget carefully and be honest in your analysis; alternatively, you can decide to get help from a family member, friend or colleague who has your best interests at heart and can honestly review your finances and identify loopholes that need to be sealed.
Secondly, after you’ve identified the loopholes, you can look for ways to seal them by either increasing your sources of income or reducing your expenses by eliminating unnecessary/discretionary expenditures.
Regularly Review and adjust your Budget (to fit your changing situation).
After you’ve conducted steps 1 through 5 for the very first time, it is time to make a point of doing it on a regular basis preferably weekly.
The reason for repeating this process is the simply fact that situations change from time to time necessitating a corresponding change in spending habits.
For instance, you can find a better paying job, apply for a mortgage or refinance at a lower interest rate, start a family, buy a new car, enroll in higher education, etc.
Major life changes like those will require financial and lifestyle adjustments.
Pro Tip: Make a point to prepare and plan for important lifestyle changes and to adjust your financial goals accordingly.
The initial months of budgeting can be tough, especially if you were used to aimless spending. However, with the aid of mobile apps, payment automation services and online budgeting tools and software, budgeting can be an enjoyable every day process that is looked forward to rather than being frowned upon.
I hope with the help of this step-by-step guide you can get out of your comfort zone and make a conscious decision of creating your budget today.