Income + expenses = budget

In this installment of the Finance 101 series, we'll take a deeper look into the basic concept that makes up personal finance. Getting a good understanding of the flow of your money is essential for anyone. It doesn't matter if you make minimum wage or you're a lawyer, if you spend more money than you make, you'll be in trouble. Very few people track where their money goes, they simply spend what they have.

To reduce these concepts to the simplest expression, you have money coming in (income, yay) and money coming out (expenses, boo). Together, they form a budget. Few people have one, which is a shame since it would help so many get their finance on track. In the end, money is useless if you don't use it to build the life you want, and realize your dream. People are sometimes afraid of making one because they'll have to face the realities of their financial shortcomings. Others just don't see the point and go through life without realizing how much they spend on stuff that doesn't make them happy. Making a budget forces you to make choices, and allows you to spend money where it matters the most to you.

While you may not track a budget yet, you can't escape the reality of the money flow: money comes in and money comes out whether you notice it or not. What making a budget allows you is to take control of the process and make conscious decisions towards building the life you want. What you'll get out of this exercise depends on the situation you find yourself in currently. Someone in debt could be looking at escaping the hole they're in, while a young family could be interested in buying a house. If you have no current plan, saving for both rainy days and retirement are good starting points that everyone needs. Remember, the earlier you start saving, the more money you'll have through the power of compounding interest!

Income

If you're an employee and receive a salary on a set schedule, this should be easy to do. In general, when we talk about salary we focus on the gross amount, but in this case what you need is your net pay, which is the amount after you've paid your taxes. You can use your pay stub to figure this out.

Very important, regardless of which category of worker you are, NEVER include future salary expectations into your income. Plans change, the market evolves, promises get broken. The only thing you can count on is your salary now, not what you expect to make in a few years. Spending as if your plan will come true is a sure way to live outside your mean and lose wealth instead of building it.

Paid monthly or bi-monthly

If you're paid monthly, then the amount will be just there! And in the case you're paid bi-monthly, just multiply the amount by 2. This will give you your monthly income, which makes the (smallest) half of your budget.

Paid bi-weekly

If you're paid bi-weekly, it gets a bit more complicated. You end up receiving 26 pay over the year, so one way would be to multiply one of your pay stubs by 26, then divide by 12. The problem with this approach that glosses over an important fact: most months, you only receive 2 pays, so your actual monthly income will be lower than your estimate, while in 2 of those months, you'll receive 3 pays, receiving much more money than your estimate. It could still work, if you're very diligent and divide up your 3rd pay equally to stretch it across the months you only get 2 of them, but this is complicated and rely on you being very diligent and tracking all of this.

A much better approach in my opinion is treating your 3rd pays as extra, and completely ignore it in your budget. If you have emergency debt, use it to pay it down. If you don't, put it all into savings. By putting in toward savings, that would equal a 7.7% saving rate right away. This simplification will allow you to build a budget that models your monthly cash flow a bit more, as you'll live on 2 paychecks every month while doing something useful with those extra pays.

Self-employed or on commission

If you find yourself in this category, your salary probably fluctuates month-to-month and/or year-to-year. This makes it harder to accurately estimate your monthly income, rendering this exercise much more difficult. My advice to you would is two-fold.

Be conservative in your estimate

Plan as if it was a rough year, even in good times. As it's hard to predict the future, underestimate the amount of money you make. If you're a seller, making a 2000$ monthly salary + a bonus of 1000$ based on performance, don't go all out and plan your budget around a 3000$ monthly income. This will leave you no wiggle room for the months when you don't receive the full bonus, or the bonus at all, for whatever reason. You probably don't need me telling you this, but bonuses and performance pay do get cut at times for varied reasons, sometimes unrelated to us.

Since your budget doesn't account for that extra money, when you do receive it you can put it directly towards debt or savings, leaving your budget intact. When you don't receive any, it won't matter one bit and your lifestyle will continue unscathed.

Keep a bigger emergency fund

In step 4 of this Finance 101 series, we'll explain the concept of an emergency fund. The gist of it is that you keep some savings on the side to support yourself would you happen to lose your job, because of a pandemic for example, so that you can continue to pay your bills and eat. Since your salary is uneven, especially if you make your money in a few concentrated months, it could be worth increasing the size of your emergency fund, replenishing it when you make money, and depleting part of it when you're not. This will allow you to make a budget and stick to it all year long.

Side hustle

Do you have a side project? Moonlighting as a freelancer? Bootstrapping your own business while having a job? All of these have the possibility of adding to your total income. Again, you should only count consistent income within your budget. But if your side hustle provides consistent income, there's no reason not to include it in your budget. After all, you worked hard for it.

Next step

Now that you have the income part figured out, half of your budget is done. That was easy right? We'll now look at the other half of a budget, expenses. Remember to update your budget anytime your income changes, to make sure you can still afford the life you want.

Expenses

There are a lot of ways you can categorize expenses. The hard part here is that you need to include every single one of your expenses in this budget. It's not good enough to put a line item saying "fun time" for 400$ or "shopping" for 800$ per month. You need to break it down and find where your money is going. It's perfectly fine to have big expenses (so long as you can afford it), but it needs to be tracked. One of the biggest reasons people overspend is that they don't realize where their money is going. By listing them all (and when I say all I mean it), you can make better decisions for yourself. Focus on what makes you happy. The goal is not to shame your expense patterns, but to realize where your money is going. You will be surprised to know once you do it. Is that 300$/month you spend on food delivery making you happy? If so, keep it! Otherwise, move that money to something that will make you happy.

It may seem obvious, but if your expenses exceed your income, you'll be in for a world of hurt... and debt. On the other hand, if you manage to create this budget and realize that you could save a few extra bucks to put towards your savings, you'll be in a better position as you get older.

What matters is that it reflects the reality of your spending habits. There's no point in doing a barebone budget if in reality, you spend tons of money on discretionary things like concert tickets. Just be honest with yourself and include them. Again, the goal is not to make yourself miserable, quite the opposite. It's to allow you to spend on what brings you happiness, and do it in a guilt-free fashion as you've already accounted for it.

The following is not an exhaustive list, but it's a good starting point. There's a very good chance you'll need to add to it to get a complete picture of your situation.

• Housing

  • Rent/mortgage

  • Insurance

  • Condo fee/HOA

  • Taxes

  • Maintenance (very important, people often overlook this, but if you own your property you're going to have to repair it as time goes on)

• Transportation

  • Car payments

  • Insurance

  • Maintenance (repairs, tires, oil change, etc.)

  • Gas

  • Registration

  • Parking

  • Public transportation

  • Car rentals

  • Uber/taxi

• Food

  • Groceries

  • Restaurants

• Utilities

  • Electricity

  • Water

  • Garbage

  • Internet

  • TV

  • Phone (both the cost of service and the cost of the device itself)

• Insurance (health, death, disability, etc.)

• Clothing

• Health care

• Household supplies

• Daycare/babysitter

• Gym membership

• Salon services

• Debt servicing (personal loan, credit card if any, etc.)

• Savings (retirement, emergency fund, big purchase)

• Education

• Gifts/donation

• Entertainment

  • Alcohol

  • Games

  • Movies

  • Concert/sport/amusement park tickets

  • Vacation

  • Netflix/Spotify

  • Books

  • Hobbies

• Pet

• Annual fees (credit card, group membership, etc.)

That list should be enough to get you started. You can use your bank account and/or credit card statement to help you compile this list, or write things down every day for a whole month. There is no one-size-fits-all, the most important part is to just do it. Even if your list is not perfect, don't worry. You can improve it with time, as you become more conscious of your spending habits.

Your turn

We've seen that a budget consist of both income and expenses, and I've shared a starting list of expenses that should give you a few ideas on how to start your own. Now it's your turn to reflect on your own life and build your budget. It doesn't have to be perfect, just start somewhere and iterate on it. You can use paper, notes, a spreadsheet, anything you're comfortable with. In a future post, we'll look at tools that can help you keep track of your budget as it evolves and to make sure you're sticking to it.

That's all for now. Stay tuned for the next step in the Finance 101 series, or go back to read the previous one if you've missed it!

• Step 1: Introduction to personal finance

• Step 2: Income + expenses = budget (this)

• Step 3: Debts (upcoming)

• Step 4: Savings (upcoming)

• Step 5: Make a plan (upcoming)