Before I started work in this profession I used to think of budgets as only being useful when someone is struggling to make ends meet. Over time I realised that a budget is the bedrock of any financial plan, whether you have relatively little wealth or are very wealthy.
In this post I will explain the importance of setting a budget and some budgeting tips.
Why you need a budget
I think the word “budget” has negative connotations, primarily because they are normally created if you want to cut back and spend less. However, in my eyes, a budget is primarily a way of correctly allocating each and every pound of your income to the best place. This is why they are an essential requirement regardless of how much you earn each month.
Simply put, without a budget, it is highly unlikely you will know where you spend your money. You also won’t know if you are spending more than you were a month ago or a year ago. Without knowing this essential piece of information it is impossible to know if you are on track with your finances.
As you will expect, there are plenty of financial benefits of setting a budget. However there is also an emotional well-being benefit: creating a budget will help you feel organised and more on top of your personal finances. It will also change the way you think about money and about your spending choices.
Best of all, you will know exactly how much spare income you have and you can freely choose how to spend this. For example, if you allocate £100 per month for holidays you won’t feel guilty if you spend £1,200 a year on holidays because you know you are sticking to your budget.
There are several ways to create a budget and you may need to experiment with different options until you find the best fit. If you find a method that works for you, you are more likely to stick with it. If you start thinking of your budget as a chore and an annoyance, you will stop working at it.
Before you can create a budget you need to consider how much you spend currently. Clearly there is no point in choosing to allocate £100 per month for utility bills if you already pay more or less than this on average.
To do this you will need to look back at your previous spending, ideally over the last 12 months. This is the most time-consuming part of setting up your budget, but unfortunately it is unavoidable.
If you are comfortable using a computer be sure to create a spreadsheet, even if it is only basic. Your bank might allow you to download your transactions into a spreadsheet which will speed up the process. If you use a pen and paper you might find the ongoing monitoring of your budget will become an onerous task.
Once you have this information you need to categorise it appropriately. These categories will vary from person to person.
If you set the categories too broad (e.g. if you use “Household bills” to cover everything from your mortgage/rent to food shopping) it will be fairly useless. If you set the categories too narrow (e.g. if you split “Supermarket shopping” into individual supermarkets to see which shop you spend the most in) it might be too time consuming.
I normally advise clients to categorise their spending based on the table at the foot of this page, but you should personalise this as much as possible and set the categories as narrow as possible.
Creating your budget
Once you have categorised and analysed your past spending, you are ready to set a budget for the future.
At this stage it is important to remember that everyone has over-spent on things they wish they hadn’t. The best way to overcome this feeling is to avoid dwelling on the past. After all, you can’t go back and un-spend your money but by starting the budget process you will be on the way to making positive changes for your future.
At this stage you can create a traditional budget or a reverse budget. The reverse budget is more useful if you are able and willing to make significant changes to your spending habits. If not, a traditional budget will be better.
I have covered the traditional budget in this post but I plan to cover reverse budgeting in a future post.
Essentially you need to plan out how much you intend to spend on each category over the next 12 months. Some of this will be a choice (e.g. you can choose how much to spend on gifts for your family) but some will be mandatory (e.g. you can’t pay less council tax unless you move house or ask your local authority to re-assess your council tax bill).
At this stage it is worthwhile considering where you can cut back. The trick here is to think both big and small. Most personal finance websites might encourage you to cut back on things such as a daily coffee habit because of how much this costs over a year or over a decade.
However you also need to think carefully about bigger outgoings, such as any car finance and your rent or a mortgage. For example, can you pay less by getting a cheaper car or a used car? Are you willing to consider downsizing into a smaller home? Changing any of these bigger outgoings will, of course, have an impact on your standard of living but it will have an even greater impact on your future personal finances.
There are also plenty of ways in which you can cut your spending without changing your standard of living. The easiest way of doing this is to check for better deals on all your regular payments including gym membership, TV packages, utility bills and so on.
If you are lucky, your ideal budget will leave you will some spare money. Importantly, do not consider this “spare money” and available for spending. Instead allocate it to one or more of your spending categories. For example, if you expect to earn £100 per month more than your budget suggests, allocate this to your retirement savings or to reducing any debts.
Doing this ensures every penny you earn is doing something useful, which in turn stops wasteful spending.
Make use of standing orders and direct debits
Once you have your ideal budget, including allocating any “spare” money to savings or debt repayments, you need to ensure your income will cover each outgoing when it falls due. To do this you should automate your outgoings as much as possible.
Most people in the UK are paid monthly (either in retirement or in work). However, plenty of people are paid more or less frequently than this. Also some expenses might occur every day whereas others occur once a year. Both of these factors present a slightly greater challenge to ensure you always have enough money available to cover everything.
The easiest way to allow for this is to take your total planned annual expenditure and divide it by your income frequency. For example if you are paid once a month and your budget for the year is £24,000, your monthly budget is £2,000. If you are paid weekly it is £461 per week.
You then need to set up standing orders or direct debits to ensure each of your spending categories are covered. You also need to set up a separate savings account (or multiple accounts) for any relevant spending categories. For example, if you plan to spend £500 on Christmas gifts you need to set up a standing order of £41.67 per month (or £9.67 per week), payable to a savings account earmarked for Christmas spending. (Technically if you start your budget part-way through the year you will need to set aside more than this to start with, otherwise you will come up short in December!).
Once each of these steps are complete you have done the hard part. From then on you need to monitor two things: your bank balance (to ensure it never gets too low); and each spending category (to ensure it does not deviate away from your budget).
Technology can help with monitoring your bank balance because many banks now offer an “alert” facility. This lets you know if your bank balance gets too low so that you can take action before you accidentally go into your emergency savings.
Monitoring your spending should be done as often as possible, so that it becomes a habit. As you might expect, setting aside 2 minutes a day to record your outgoings is better than setting aside 1 hour per month.
Once again technology can help here because there are plenty of budgeting apps available which can help categorise and record your spending. Of course, you need to be very careful here because these apps only work by getting access to your bank account and other personal details.
It is highly unlikely that your first version of a budget will play out perfectly in practice. Instead you will probably need to make changes and adjustments over time.
If you find yourself making negative changes (for example, increasing your social spending while still making debt payments) you should think carefully about how your finances might look in the future if you continue on this trajectory.
Hopefully the only changes you make will be positive changes (for example, if you finish making payments on a debt you can then choose where to allocate this money).
Once you have a solid budget in place (one which you can afford and stick to in practice) you can start thinking more about longer term strategic plans. For example, should you try to increase your retirement savings each month or try to pay down your mortgage sooner?
This is where our company can help. We will recommend the best place for your existing savings and help you choose the most suitable way to save for the future.
If you have any questions about this post, or if you would like to review your investments and financial goals, please call 01642 477758 or visit our Contact page to book a free initial meeting with myself or one of our advisers.
Possible spending categories
|Mortgage or rent|
|Gas and electricity|
|Car loans (or similar)|
|Gym membership (or similar)|
|Loans (excluding car loans)|
|Credit cards/store cards|
|Life insurance (or similar)|
|Other direct debits/standing orders (list each)|
|Gifts (including Christmas, birthdays etc)|
|Other discretionary spending (split into as many groups as possible)|