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What is a Budget and Why is it Important?

Personal Financial Planning

A budget is a summary of your income and expenses over a specified period of time.

Knowing your income and expenses will allow you to make sure your hard-earned money is being put to its highest and best use. For example, maybe you are spending a lot of money at restaurants, but would rather be saving some of that money for an upcoming vacation. A budget can help you identify and reduce the amount being spent at restaurants, allowing you to direct more of your income toward the travel goal.

After you reduce spending at restaurants, your budget might help you identify and reduce spending in other expense categories, freeing up additional monthly income that can be devoted to your goals. As you begin saving and investing a larger percentage of your income, you will see a steady increase in your net worth.

What Type of Budget?

There are a million different ways to budget, and everyone has a preferred method. What’s important is choosing a method that works for you, and sticking with it.

In my opinion, all of the different budgeting methods fall within one of three categories:

1) Hardcore Budgeting

Excel spreadsheets and vanilla white envelopes come to mind when I picture the traditional budget. This form of budgeting typically includes:

  1. Tracking all forms of spending
  2. Creating different expense categories, often divided into necessary and discretionary expenses
  3. Setting a predetermined spending limit for each expense category (such as $300/month on groceries)

For example, if you have $3,000 of monthly income to spend, you might create ten expense categories of your choosing, setting aside a specific dollar amount for each category. Every month, you could fund each category using a white envelope (or another method of your choosing). If you set aside $300 in an envelope for groceries, that is the maximum amount that you would like to spend. When all $300 is spent, you might not replenish the funds until the following month.

The goal is to establish strict spending guidelines within each category. Some people find success with a strict budget, while other do not. I think the main drawback to the traditional budgeting process is the effort required to make it work. It’s exhausting to track every dollar spent.

2) Relaxed Budgeting

This form of budgeting involves keeping a long-run average of your expenditures.

The focus is on the big picture. Instead of worrying about spending exactly $300 or less each month on groceries, your goal could be to keep the annual grocery budget below $4,000.

You might review your spending each month (or every other month) and make adjustments, but you’re not micro-managing each transaction. If you’re happy with your spending in each expense category, very little ongoing effort is required. If you’re spending too much, you might modify your behavioral habits to spend less.

Relaxed budgeting requires little-to-no manual effort. Free tools like Personal Capital will track your income and expenses automatically, in real time, and provide colorful graphs to illustrate your progress.

3) No Budget

The complete opposite of hardcore budgeting is tracking nothing at all. At times, doing nothing might be an appropriate financial decision.

For example, extremely disciplined individuals with established financial habits might not bother with budgeting. If you’re living well below your means and are successfully working towards your goals, a budget might be entirely unnecessary.

Is a Budget Important?

Overspending is one of the biggest problems in America today. Millions of Americans (with well-paying jobs) have almost nothing saved.

If you’re happy spending every dollar of every paycheck, that’s fine. There is nothing wrong with working hard and spending freely, as long as you understand the implications. Without a reduction in spending, you will be forced to continue working indefinitely because your lifestyle depends on your employment income.

But if you have grown tired of the paycheck mentality and would like to use your money to achieve other financial goals, it’s time to revisit your spending habits and consider a budget.

Only you can determine if the cost of traditional budgeting (time and effort) outweighs the potential gain (cutting unnecessary expenses). If manually tracking all of your monthly expenses helps you identify and eliminate “wasteful” spending habits, then create a detailed budget and commit to following it.

If you believe that a traditional budget is too much work (or a complete waste of time), consider a more passive solution like Personal Capital. Either approach will help you keep track of your income and expenses over time.

Budgeting, like any form of financial planning, is about helping you spend money on the things that you truly care about. If you can manage and direct your spending without using a budget, more power to you. If you need a traditional budget to help keep you on track, that’s great too. Figure out what works for you and stick with it.

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