Budgeting Basics: How to Calculate What You Can Afford to Buy

Know What You Can Spend

Creating a budget is one of the single best things that you can do for your finances. If you do not know where your money is going, it is impossible to make it work for you and it is difficult to ensure that your money is going to the right places. While a variety of budgeting techniques are available, the key is to ensure that you are not spending too much and that you are saving enough of your hard-earned money.

Do you know what your take-home pay is after taxes? This is the amount you will need to keep track of coming into the household and then tracking where or how much of your money is going out. By putting everything down on paper, you can visually see how much you spend. You may not have to cut out your morning coffee with friends at your favorite restaurant or taking a week-end vacation to the beach.

1. Budgeting Basics

When setting a budget, or if you prefer to say personal finance planning, start with your income and required expenses. Your income is the amount of money that you make from all sources over the course of the month. Required expenses are things that you absolutely must pay for such as:

Food
Shelter
Insurance
Transportation costs
Medical needs
Clothing
Child care
Taxes

Determine your required expenses and make a list of those costs. Required expenses generally fall into two categories: fixed expenses also known as, ” Hard Costs” – are the same costs every month, and the variable expenses also known as soft costs. which are costs that can fluctuate over time. For example, mortgage or rent payments usually remain the same on a month-to-month basis while food costs may vary.

It is typically difficult to cut fixed expenses like the cost of your mortgage, but, you can refinance. Read more about the cost of refinancing your home to determine if it makes sense for you. Refinancing your home could help reduce your monthly payments and save thousands in interest over the lifetime of the loan on this fixed expense. Rent, car payments, car insurance, house insurance and loans, to name a few, will likely stay the same unless you refinance or move to a new location.

On the other hand when you budget you can take control over variable expenses such as: food, clothing, recreation etc. Therefore, when you consider your expenses, consider your true net-worth. Knowing what you own (real estate, investments, income and savings) compared to what you owe, (bills, debt) are necessary when you are developing a budget. Need help? Check out this resource.

You shouldn’t assume that you have to budget the amount that you have been spending to date. If you are spending a lot on food, for example, couponing can come in handy to help save money on your groceries. Using this resource you could budget a smaller amount for this category and make a commitment to stick to your smaller budget. Although you need to be realistic, you should also set goals that allow you to save more money as a part of your budget.

2. Budgeting for the Other Costs

After you have determined how much you should spend on a monthly basis for your required expenses, add up all of your essential costs and subtract that amount from your income. You can use a simple spreadsheet to track weekly, monthly and yearly expenses or the cash envelope system, which uses cash only.

If you have money left over, then you are in a good position and can move on to the next step of budgeting. If you end up with more expenses than income, you need to make some changes, either by increasing your income or cutting expenses. Otherwise, you’ll be in the red each month and will quickly sink into debt.

Any money left over after you pay your required monthly expenses is your disposable or discretionary income. You should not just spend this money freely – you should make a plan for how that money is going to work for you. There is a free computer program that is easy and simple to use to help you make a budget plan for your extra monies. It is called the moneyclip. It’s a program based on the envelope system.

Several strategies for what you can and should do with your disposable income include:

Emergency fund. Save for an emergency fund or a rainy day. Set a goal of placing three to nine months of living expenses in an emergency fund. You should also save for expenses like home and car repairs or the purchase of a new car so you don’t end up going into debt to meet these costs.

Retirement. Put aside money for retirement by placing it in a 401K, IRA or other investment vehicle.

Large Expenses. Save for occasional or periodic expenses such as buying a new car, making home improvements, going on vacation or shopping for holiday gifts.

Entertainment. Set aside money to spend on entertainment and fun activities.

You should prioritize your savings when deciding what to do with your discretionary money. This guide should help. However, you also should set a little cash aside to spend on fun stuff in order to have the best chance of sticking to your budget. Experts recommend saving around 15-20 percent of your income for retirement, but once you meet or exceed this goal, you can decide how much you want to spend on fun activities and how much you want to allocate towards other goals.

Sometimes, we lose site of the value of money. It’s so easy to just go to the ATM and swipe. You could do that several times a day. You don’t see the money that is gone until you write those receipts down in your checkbook. That is when overspending becomes a factor in your budgeting goal.

By setting a budget, you should easily be able to see how much you can afford to spend on all aspects of your life. About.com’s Jeremy Vohwinkl, recommends Try using cash instead of your debit or credit card. Sticking to the budget is important to helping you meet your financial goals, and adjusting the budget periodically is necessary to address changes in your life. John Rohn (1930-2009) motivational speaker once said, “if you fail to plan, you plan to fail.”

Additional Resources

The Envelope System, by Dave Ramsey categorizes envelopes for budgeting using cash only
Defining Discretionary Income, by Referenceforbusiness.com is an article on “The Definition of Discretionary Income.”
Mint.com is a computer program (you have to create an account) that organizes your spending into categories using simple charts.
Account Book +Simple Money Management, by Nutractor is available on iTunes. This app keeps track of your money and manages your expenses for a minimal purchase price.
Mistakes to Avoid When Preparing a Budget, by Amy Fontinele from Investopedia

Video & Books

How to Save Money, by howcast.com. Make do with money you have or do without.
“The Official Guide to American Incomes”2^nd ed., by Thomas G and Cheryl Russell, Ithaca NY Talks about household incomes, personal incomes and discretionary incomes. Book can be purchased at Barnes & Noble for $35.00 (ISBN-13: 9780962809224).

Education

Save and Invest is an educational government website that teaches American financial education. The site has many Federal Agencies and Bureaus to help you make smart choices.
Money Smart Podcast Network is a financial education portable audio (MP3) version for people on the go.
Budgeting Basics Course is a training course that teaches the basic principles of budgeting, which can be done online, on your PC, iPad or your iPhone. The cost is $29.99.

Apps

Budget, by Deskescape is available for .99 on iTunes
Capital Budgeting, by David Karlsson