“You cannot get ahead financially until you make a habit of spending less than you earn.” Columnist Rob Carrick calls this the most basic rule of personal finance, and yet it’s one that many of us struggle to follow. One vital tool to help you get on top of things is the simple old-fashioned budget. But what are budgets, how do they work and how do you start making one? Here’s the basics, and some simple rules to follow.
What is a budget?
For a company, a budget is a financial plan and a record of credits and debits. For an individual, it’s much the same. It’s a monthly tally of your income and expenses that lets you track where your money is going and be sure your spending and saving match your financial goals.
People also use the word “budget” to refer to an amount of money allocated to something specific. For instance, you might have a budget of $2,000 a year for vacations, or $100 a week for eating out. But in truth that’s just part of a budget.
Since many of us receive paycheques twice monthly, and a lot of expenses occur on a monthly basis, many people set up their budgets month by month. Your monthly budget would include your income as well as your expenses organized by category: everything from rent and mortgage payments, to tax-free savings account contributions and other savings, to music subscriptions, food, clothing and donations to charity. The goal is for the expenses to be lower than or equal to the income.
Why is budgeting important?
Budgeting is an essential tool for meeting your financial obligations and goals. If you are trying to get out of debt, or pay off student loans or credit card balances, it’s far easier if you have a budget that includes those things and you stick to it. And if you have a hard time coming up with the money for big purchases, a budget can help you get there by encouraging you to put away a bit at a time.
It forces you to pay attention, in other words, and avoid trouble. Jenna Young in Halifax, for example, used to avoid looking at her bank balance and just hope she had the money to cover automatic bill payments. But she was having difficulty paying off her student loans and was racking up credit card debt as well. She created a budget one year as a New Year’s resolution, and stuck to it religiously, checking her budget spreadsheet every payday and keeping track, on her phone, of money available for spending.
“It was terrifying to see the total amount owed,” Ms. Young says. But she could also see real progress: She started spending within her means, saving up for unusual expenses, and paying off debts. “Emotionally, it made me feel way less anxious about money because I knew I was in control.”
What role does budgeting play in our personal finances?
We all have different financial goals, but for the most part, there are three places to put your money: paying for necessities, buying things (and experiences) that are optional, and saving for the future. The latter might mean putting aside cash for a down payment on a house, saving up for big-ticket items like vacations or cars, or investing for your kids’ education or your retirement.
If you have a hard time saving, or if you often find yourself in debt, then a budget can help you get back on track. “If you regularly have nothing left over to save from paycheque to paycheque, then track where your money is going,” Mr. Carrick suggests. “Use the information you get from this and look at your spending to find areas to cut back.”
Smart budgeting can help you be ready for emergencies and changing expenses. If you keep an eye on what you’re spending, for instance, you’ll see how much more expensive groceries have become, and you won’t accidentally slip into the red because you haven’t adjusted your budget to accommodate.
A budget will also help you plan for the future and make informed decisions. Buying a car, for instance, has gotten more expensive, not to mention the price of gas. If this is something you’re considering, experts recommend assessing all the associated costs to figure out how much the new vehicle will really cost you, and how that will affect your overall budget.
The same goes for buying a house. Mortgage payments are only one part of the puzzle. A thorough budget that also looks at insurance, property tax, utilities, repairs and maintenance will help you decide what purchase price you can really afford. How much should you budget for maintenance and repairs? Mortgage broker Sean Cooper suggests 1 per cent of the home’s value per year.
And then there’s children. “Never-ending costs for parents require never-ending saving and planning,” Mr. Carrick writes. “Figure out what your priorities are as parents and prepare as required.” Having a budget will help you understand how to cover costs such as daycare, contributions to a registered education savings plan, and activities.
Can a budget help with your credit score?
Achieving a high credit score is straightforward, Mr. Carrick says: Pay what you owe on time, and never borrow even close to the maximum amount lenders will give you. “Do only that and you will not have a problem borrowing at a competitive interest rate,” he says.
Your credit score is your history as a borrower distilled into a number on a scale that generally ranges from 300 to 900. 760 and up is considered excellent, while 660 to 759 is good or very good. Below 660, you may have trouble getting the best rate on a loan or mortgage.
Late payments and running up a big balance on a bunch of credit cards or a credit line can hurt your credit score. Creating and sticking to a budget is one of the simplest ways you can avoid a decline in your score. (There are also little things that can reduce your score, like adding a new credit card or cancelling a credit card you’ve had for years and replacing it with a new one – though your score should rebound quickly from such activity.)
Outstanding credit card balances can hurt your score when they’re more than 30 per cent of a card’s borrowing limit, according to a big U.S. credit reporting company. Using a budget can help prevent that from happening as well. “Maintaining a zero balance by paying off all purchases in full each month is the best of all.”
What else you need to know about budgeting
The best budget is the one you’ll actually use. Be honest with yourself about what habits you’ll really stick with when it comes to managing your budget and changing your spending and saving routines. Just like with fitness, consistency is key to success.
One trick is to set a date with yourself in your calendar for when you’ll review your budget. Treat yourself and try to make it fun – maybe budgeting review night and pizza night coincide, or you simply blast your favourite motivational tunes while you work.
To stick to your budget, it also helps to flip things around. Instead of focusing on spending reduction and sacrifice (so tragic), start from zero with an “I get to” approach. You didn’t cut your restaurant budget; you get to eat out X times a month. You didn’t reduce your clothing budget; you get to spend X dollars a month on clothes. Think of yourself as the kid in the candy store with a whole dollar (maybe five dollars with inflation) to spend on sweets. You’ll be much more selective, and enjoy your purchase that much more, than the child who has no limits.
And if you can’t track every penny, there is a middle ground. Gregory Karp of personal finance website NerdWallet, for example, confesses that he thinks budgets are overrated. “But if you’re not going to create a household budget, at least regularly examine your past spending and categorize it,” he adds.