Creating Your First Budget
Welcome back everyone. Its Dr. A, economics professor at Northern Kentucky University and today we are talking about budgets. It would be super helpful if you can like, and subscribe to the channel. If you find this information helpful, share it with your friends. My goal is to hit 2000 subscribers by December! Help me get to that goal so I can continue to make these videos!
In this financial literacy series, I have kinda done this backwards. Start with thinking long term, but your long term goals start with meeting short term goals. The short term goal that we all can start today is developing a budget. To me a budget is a plan. It allows me to allocate every dollar I make to where it needs to go. It gives my money a purpose and therefore it makes the cost of spending it in a different way clear to me. In economics we call that the opportunity cost of spending.
Do you have a budget? Today I want to run you through how I developed my budget, how I think about it. In a perfect world your budget is forward thinking. So get started with a budget as soon as possible.
Let’s start budgeting
My first tips is to develop a budget before you actually start to take on expenses. This is a scenario I see every May. As my students approach graduation, most are lucky to have jobs waiting for them after graduation. However, some start spending once they know they have jobs but before they actually receive their first paycheck. Whether it is buying a car, renting an apartment, wait as long as you can to make large spending decisions.
The first mistake is people mistake their gross pay for their net pay. Gross is how much your stated pay is, and net is what you receive after taxes and withholding. For budgeting we will focus on netpay. How much you have left over is a function of your tax rate, any 401k contributions, or any pre tax spending that might be collected. It is hard to estimate that without knowing more about your personal situation. So calculate your net pay. For today’s example I will assume someone brings home $3,000 a month.
Two Budgeting Styles
There are two main ways to budget. The 50/30/20 rule and the zero- based budgeting. Both are great for different parts of your life. I like the 50/30/20 rule for those starting off with budgeting. It allows you to see the major buckets in which you can easily categorize your spending. However, as your income grows and as your spending becomes more intentional you can start to shift towards a zero budgeting approach. This gives you more flexibility with how you spend your money. It's kinda like learning how to ride a bike. First you use training wheels that stabilize you but also restrict your ability to maneuver. As you learn how to ride your bike, you can let go of the training wheels and start to ride in the way you like.
Whatever way you budget the first and most important step is to
Calculate Your Income
A budget needs to detail all the income you receive. If you are a salaried employee this is to calculate, but for others that have multiple incomes or hours that are inconsistent predicting your take home pay becomes difficult. I recommend taking your last three months of income and finding the average. If you watched the video on tracking spending, you can do that easily using one of those apps, or just going into your bank account and calculating it that way. This is why I recommend waiting before making large purchases, you need time to figure out what normal life as a young professional looks like. You will have new income but you will also have new expenses.
As I said For the purposes of this video, I will focus on take-home pay. However, if you participate in your employer’s 401k, health insurance plans, then this is spending that is usually happening pretaxes. So keep that in mind through this exercise. You wont have these expenses since they are paid pre tax.
I will link to this sheet in the description. You can download it and plug in your own numbers.
I have your income here. Once you enter your income, it will calculate the ratios of spending. Based on someone making 3000 a month, this means that 20% or 600 dollars should be allocated to savings, 50% or 1500 towards needs or we can call this bills, and 30% or $900 towards wants. These are things like going out, entertainment.
The reason I like this approach is it gives you an idea of where your money should be going. Recent graduates usually don't have a reference point on how much they should be spending on rent or housing costs. According to this budget, you have $1500 dollars to spend on housing costs, insurance, car payments, utility bills and minimum debt payments (student loans repayment). Depending where you are in the world, this might be doable or might be unrealistic. If you find yourself in a situation where that is not realistic then getting roomates, a cheaper car, might be necessary. Obviously if you are not spending your total $1500 then this allows you to spend it on the other buckets, savings and wants.
Wants are things that you can go without, they are easily adjustable, and are function of lifestyle. Eating out, clothing, setting money aside for travel...these all go here. You have $900 a month to allocate towards that bucket. I put extra debt repayment here. This is repayment above your minimum payments that we listed in the needs bucket.
Finally, Savings. This bucket stays at a minimum of 20%. That means $600 dollars per month go towards building your emergency fund, investments, after your 401k savings. Remember this is after tax money, so I assume you are already taking advantage of 401k saving which happens pretax. If you reduce your spending on the needs and wants, it allows you to allocate more towards savings. Starting off your life keeping this in mind, will allow you to consider the opportunity cost of your spending. Once you hit your emergency fund goal, you can then start to invest for wealth accumulation. Again this assumes that you have maxed out on tax favored investment or you are investing outside of retirement because you want access to the funds. How to invest is a whole other series of videos. For now, remember that 20% of your monthly spending should go towards savings and investment.
You can start to create your own budgeting approach. A former student of mine, modifies the 50/30/20 rule to the 50/20/20/10 rule. She modifies the 30 percent that goes to wants to 20 percent and separates savings from investment. I like that approach. You can find her on instagram as @thefemalefinancial. I love her content, follow her and join her as she takes on the CFP certification. Don’t forget to follow me too! You can find me at @DrAalbahrani
Budget before your start spending
I recommend doing this exercise before you start off your career, dont make big decisions without making a plan. Having this information gives you ease of mind on how to approach these decisions.
If you have already started working and spending without creating a budget, it is not too late. You can get started. Track your spending and populate this sheet. See where you are off, and what adjustments need to be made. Some changes might be easy, adjusting your wants bucket is much easier than changing the money spent on needs, so start there. Its easier to change how much you spend on clothing than it is to change how much rent you pay.
However, if you find that you have cut out most of your wants but still can't meet the 20% savings target, then a discussion about how to make adjustments around housing and your car might be necessary.
A budget is never final, I revisit mine monthly and make changes every quarter. Life changes, spending patterns change. But this way I know what buckets I can change and which ones I can not touch.
Does this sound doable? I would love to hear from you.