The first part of putting any financial plan into action requires you to control your flow of money.
A budget tracks your income and expenses, and helps you direct the flow in the way you want it to go.
To construct a budget, first account for all your income. This includes your paycheck, plus any income you might have from other sources such as rental income or government benefits, interest on money you have in the bank, or investment income.
From that, you’ll need to subtract your expenses. Expenses can be broken down into two categories. Fixed expenses are those you pretty much have to pay, such as rent or a mortgage payment, car payments and insurance, utilities, groceries, and basic clothing. Discretionary expenses are more optional items, such as eating out, entertainment, gifts, and vacations.
It can be difficult to get a handle on many of these numbers, especially the expense items. You may want to keep track of them for a while, either with a paper and pen or on a computer software program, to find out how much you’re spending. And remember that not all your expenses occur on a weekly or monthly basis. Some are seasonal, like holiday gift expenses or home heating costs. Others are occasional, like car repairs or getting a cavity filled. It may take several years of tracking some expenses to get a good idea of what you spend on average per month or year.
Now, subtract your average expenses for a given period (a month or year) from your income for the same period. Is there a positive number left over? If so, you’re “in the black” or running a surplus. A surplus can be converted into savings or an investment for the future.
But if you get a negative number, that’s bad; you’re “in the red” or running a deficit. You’re spending more than you’re making. The only thing that’s going to change that equation is either increasing your income (perhaps a second job) or decreasing your expenses (and it’s the discretionary expenses—the “fun stuff”—that are easiest to reduce)—or both.
So, let’s look on the bright side: you’re running a surplus. One of the first things you want to do with that surplus is create an emergency fund.