The term "zero-based budgeting" comes from an accounting practice where companies must justify every dollar spent in every department (rather than just adding a percentage to last year's budget). The advantage of this is that it forces managers to examine where each dollar is spent, allowing them to allocate money based on specific needs. The end result is a lean, cost-efficient budget and managers who are motivated to stick to the budget that they helped create.
Individuals can benefit from this practice when making a household budget. The main difference when it comes to personal finance is that most of us have a set amount of money each month – and it's a lot smaller than a corporate budget. This means that instead of coming up with the total budget amount by adding up each expense category, you have to start with the amount of money you make and subtract from that according to your expenses. Some people call this zero-sum budgeting because it involves balancing all expenses so you never spend more than that fixed amount of money.
Personal finance is never a fun topic, but it is one that no responsible adult can ignore. Making – and sticking to – a budget doesn't have to be impossible. The key is to have a budget that covers your expenses but leaves enough room for you to be spontaneous and flexible.
Estimate Your Income
This is the most important step in any budget. To avoid going into debt, you never want to spend more money that you have. To accomplish this, you have to know how much money you actually make every month. If you don't always earn the same amount every month, estimate that you'll earn something in the lower end of the range of what's likely. That way you know you can pay your bills even if you get a small paycheck one month.
Add Up Your Expenses
Do you know how much money it costs you to live each month? Many of us underestimate our living expenses and end up spending more than we should on optional things. If you know what your fixed expenses are – and you know that your budget accounts for them – you never have to feel guilty about spending the "extra" money.
Living expenses are the bills you have to pay no matter what. This means difference things to each person, but in general this includes:
- Housing: rent or mortgage, utilities, property taxes, home association fees, etc.
- Food and Hygiene: groceries, medicines, haircuts, etc. (just the basics - manicures and dinners out are optional expenses)
- Transportation: car payment, automobile insurance, general maintenance, gasoline, bus or subway fares, parking fees, etc.
- Insurance: health insurance, life and disability insurance, homeowner's or renter's insurance, liability insurance, etc.
- Short-term savings: money that you will need in the next 5 years for vacations, home improvements, holiday gifts, large house or car repairs, etc.
- Long-term savings: 401k or IRA for retirement, savings for a down payment to buy a house, children's college funds, etc.
You can adjust these categories to suit your needs. If you have major credit card debt or have a personal loan, you may want to include those payments as part of your fixed expenses. Since you will be making a monthly budget, do the math to find out how much you have to save every month to pay any expenses that are billed quarterly or annually.
For expenses that are not always the same amount (gas or utilities, for example), plan to pay an amount that is in the high range for that bill. It's better to plan for too much and have some left over than get caught without enough money to pay that month's bill.
Once you have this list complete, subtract all your fixed expenses from your monthly income. The amount you have left over is how much you have for discretionary spending each month.
Use What's Left
This is the fun stuff. If you've estimated your income correctly and set aside enough money to pay your living expenses, you can use what's left to eat out, go to the movies, work on your hobbies, buy someone a gift, or whatever makes you happy. And you don't have to feel guilty about spending that money!
Still, it's not completely mad money. Keep in mind that it may not always be wise to spend every penny. If you find yourself with $80 instead of the usual $60 one week, would it really be so bad to put that extra $20 into the short-term savings account? Your small sacrifice now might mean you get to play another round of golf on your next vacation, or you don't have to rely on credit cards if you blow a tire or have to replace the water heater.
Make it Work
If you're following along at home, you've probably got a paper in front of you with your income at the top, several lines of fixed expenses subtracted from that, and the final amount that is leftover each month. Seems good on paper, but how do you make it work in real life?
The reason why zero-based budgeting is so effective is that it allows you to adapt the budget to suit your needs. If the number at the bottom of your paper is too small or even negative, then it's time to look at those expenses and cut where possible. Raise your insurance deductibles to lower your monthly premium, cut coupons or adjust your eating habits to save at the grocery store, find a part-time job or sell things on eBay to bring in more money. The key is to add and subtract within those living expenses until you are comfortable with those amounts and how much is left each month.
When it comes time to actually enforce the budget, use any method that works for you. Some people can deposit their entire paychecks and, through online banking and self-discipline, stick to the budget exactly. Other people like to cash their paychecks and literally divide the money into different envelopes for each expense. That trick is useful if you are new to zero-based budgeting because it lets you actually see what happens if, for example, you have to take money out of the “Groceries” category one month because the cost of gas went up.
Eventually you might want to use a combination of the two techniques: put your paycheck into a checking account that you use to pay bills, transfer money from that account into other accounts for short-term and long-term savings, and take what's left in cash to divide up for your day-to-day expenses.
Try a variety of techniques until you find the one that suits you. There is not right or wrong way to stick to a budget - just as long as you do it!
Making a budget will not be the most fun thing you do this week, but it could be the most meaningful. Balancing your income and expenses is the key to long-term financial stability. Plus, then you can have guilt-free vacations and shopping sprees knowing that it's okay to spend the money because your bills are paid.