How to Build a Better Budget in 3-steps

A budget is your financial compass!

How do you decide who to pay after you get paid? 

Some may say: “Well, I have a budget.”

Sure, a budget may be the obvious answer.

Before that, though, what was your thought process leading up to creating your budget?

If you don’t have a budget, the same question still applies: How do you decide who gets your hard earned income and why?

Whether you have a formal process or a simple flexible mental exercise (aka no process), the only right answer is the process that works for you.

Just the thought of doing a budget can seem tedious. The goal is try different methods until you find one that sticks, and eventually make your own.

I’m personally not a fan of the traditional idea of a budget. It’s tough to keep an eye on spending for every line-item in a category. Even though I use Quicken to automate the process and track spending, it still can be overwhelming and discouraging when trying to keep up.

Instead, I prioritize my expenses and I have a less restrictive budgeting process. I group my expenditures into buckets—savings, recurring expenses, and everything else. Yes, I consider savings an expenditure this way I always pay myself first.

Then, I take each bucket and budget specific dollar amounts to each savings vehicle (401k, IRA, CD, etc.) and all known recurring bills (monthly or yearly bills).

With the cash I have left, I use it freely for my discretionary spending.

How do I track discretionary spending? I use a credit card for everything and track it in Quicken. I pay my credit card balance in full every month. A budget makes it easier to pay your bill off every month if you stick to it. 

3-Steps to a Better Budget

“Mr. LifeMoneyFire, that’s great and all, but you still didn’t answer your own question: How do you prioritize your money?” Well, glad you asked.

I want to share with you a simple 3-step method I created. It’s a framework to help you prioritize your money and expenses, and a guide to starting or building a better budget.

In the end, you’ll be able to make better decisions about your money with more control and visibility into your spending, with the flexibility to easily cut back.

If you have a budget already, great, this process may still help you reconsider your priorities.

If you don’t have a budget, that’s even better, since this process will help you create one.

Okay, let’s get started…

  • Step 1: Identify & List Expenses (including Savings)
  • Step 2: Prioritize Using the Need & Want Matrix
    • Step 2a: Distill Matrix out into Buckets
  • Step 3: Decide to Eliminate or Reduce: How to think about the Matrix
  • Lastly, I’ll show you how to do what-if scenarios with with two examples.

Step 1: Identify

The first step is to identify and write down your expenses. To keep it manageable, let’s start by focusing on recurring bills.

Find and list all known expenses that are recurring—any monthly, quarterly, yearly bills that you pay on a regular basis.

If you have the dollar amount, great, keep it close, but don’t worry about the dollar amounts for now. Just list every recurring bill.

Here’s an example of an expense list like the one you would create. We’ll use this list (below) in each step of the process to illustrate:

 

example-expense-list
Example 1: List of expenses

 

Step 2: Prioritize

Now, for the best part…

On a piece of paper or spreadsheet (Excel), draw the image below (example 2).  Include all four quadrants (sections) and the labels at the top and left.  Give yourself enough room in each box.

 

Example 2: Four quadrant with labels

 

Now, using the list of expenses from step 1 (example 1), we need to determine which quadrant each one will fit into—A, B, C, or D. 

This part might look deceivingly easy, but be honest with yourself; consider each section and your expenses carefully before placing it—section B and section C are the toughest.

If you’re doing this exercise with your spouse, first try to do this step separately, then come together and compare your results. Openly discuss any differences in results.

Here’s a quick guide for how to think about each quadrant:

Section A: Essential Spending + Personal/Family Need (EN)

  • No questions about it. This is an essential (required) spend, and it’s a personal/family need which can impact quality of life. For example:
    • Electric Bill: open and shut case… can’t live or work without power.
    • Savings: this should always be #1, besides your future self would be pissed if you didn’t have enough money saved. Plus, if you have 401k and company match, this is a no-brainer.

Section B: Essential Spending + Personal/Family Want (EW)

  • Spending here is essential (required), but this is more of a personal/family want that doesn’t really impact quality of life.
    • Car Note: for people who want a reliable car to get to work.
    • Auto Insurance: by default

Section C: Non-Essential Spending + Personal/Family Need (NEN)

  • Spending in this section is not essential (or required), but it is a personal/family need that could impact quality of life at this time.
    • Cell phone: it’s not absolutely necessary, but it’s the only way you have to keep in touch with family, work, etc.
    • Internet Bill: need this for entertainment or school research for kids

Section D: Non-Essential Spending + Personal/Family Want (NEW)

  • No questions about it, everything in this section is purely a luxury and expendable. It isn’t essential and nor needed.
    • Gym Membership
    • Cable TV
    • Costco

After you go through each section, this is what it should look like:

 

Example 3: Prioritize & Place

 

Get your dollar amounts for each expense item ready.

Step 2a: Buckets

Now, create four tables that correspond to each of the four sections from the exercise above (Example 4). List the expense and the monthly amount you spend on each recurring expense.

Here’s what it looks like with our example list:

 

Example 4: Four buckets of expenses

Total recurring expenses after adding each section = $1,405/month.

As you can see, each section now becomes more manageable. We now have four buckets of expenses. We’re now prepared for the next section.

Step 3: Decide

In this step, I’ll give you general guidance on how to make decisions to reduce, eliminate, or substitute expenses using the buckets you created in step 2.

By the way, your net-income (after tax pay) plays a significant role when considering what to eliminate or reduce. For example: if you notice that your total recurring expenses is more than you make, you need to eliminate immediately… this section will show you how.  However, for now, let’s assume your income is sufficient.

Since you’ve already gone through thinking about which expense is essential or non-essential based on a need or want, this next part is relatively easy.

What you’ve done so far is prioritize your expenses into sections (or buckets) that allow you to focus your efforts and money on the essential expenses that really matter, while easily eliminating the expenses from the categories that don’t, as needed.

How do you do that? Here’s the general guide for each section:

  • Section A (EN): Keep
  • Section B (EW): Keep, but evaluate regularly to reduce
  • Section C (NEN): Reduce, but eliminate when possible
  • Section D (NEW): Eliminate (find free alternative)

 What-If Scenarios…

Two quick examples of what-if scenarios:

  1. What-if you want to save more money for a down payment on a house but you need to cut expenses:
    1. Instantly, go to Section D and eliminate these non-essential expenses since you know it won’t compromise quality of life. You also know, from the example above, that you can save an extra $135 a month by doing so. 
    2. If you need to save more than $135, go to Section C to find a way to reduce more expenses in this non-essential bucket. Then to Section B if you have to.
  1. What-if you just learned about financial independence and you want to accelerate your progress by increasing your savings-rate and decreasing your expenses:
    1. First thing you do is eliminate everything in Section D, and use the money to increase your ‘Savings’ in Section A by $135.
    2. Next, Section C: change cell phone carriers; reduce internet speeds. Use the money saved to increase ‘Savings’ in Section A.
    3. Section B: Sell your car. Find a cheaper car. Take public transportation–which will help to reduce or eliminate your auto insurance. Try to increase your deductible on your home insurance, etc. Send the extra money to Savings in section A.

What-if scenarios allow you to plan ahead before making any decisions that impact your money or budget. You can also make decisions faster since you’ve already gone through the process of prioritizing your expenses into buckets. Give the process a try with your own information and create your own what-if scenarios.

In Closing

In an idea world, you would do this budget exercise once, and then adjust and reevaluate as your situation changes. You can also run what-if exercises as often as you like to see the impact on your budget before making the changes.

Remember, this is a general framework. Feel free to adapt this method in your own way.

If you have questions or ideas on how to improve it, please share your ideas in the comments section below. I’d love to hear about it.

I’ll update the content regularly if things change. I hope this was helpful to some of you.  Good luck.

Also Check Out:

  1. Couples Budget: How to budget for Income & Expense with two people, or more
  2. Cut the Slack, Pocket the Savings: How I eliminated $3,380 in unwanted bills from my yearly budget
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