Personal budgeting is the best way to pay off your debts. But make sure you are using the best type of budget.
Making a personal budget is the first thing a financial planner will tell you to do to stop accumulating debts and regain financial stability. It has a significant impact on your budget and also your spending patterns, so it’s vital to be aware of the types of budgets and to choose the type that suits your needs. Wait a second, there are different types of budgets? There are indeed and they differ in their purpose, simplicity and flexibility.
Simplicity is large determinant of how closely a budget is adhered to. Don’t at all disregard it in budgeting no matter how many maths subject you’ve studied, budgeting is a continual chore that creates the temptation to not be bothered doing it if it is complicated and finicky.
Flexibility determines how closely a budget can be adhered to. Sometimes expenses come up or you just really want something that would make you happy and improve your life. That’s ok, life goes on despite budgeting, so it’s beneficial to choose a flexible budget if you can and if it is ok for your finances. A mental side to this is that the demoralisation that comes with breaking the budget (even if you have to) creates a slippery-slide effect in the brain with the attitude of: ‘well I’ve broken it once so it doesn’t matter that much if I break it again’.
Purpose: to avoid accumulating debt during the month.
Our rating ★★
The debt-free budget is one of the simplest budgets there is. It has the single-minded goal: to avoid debt. But, it doesn’t help you to pay off your existing debts, save money and accumulate wealth. Hence our low rating of this budget. It is better than nothing but still not much.
The basis of this budget is the essential basis of budgeting in general, so it’s a good example to use to make sure you know how budgeting works. This budget is calculated as so:
Income - Expenses = Profit/Loss
If your income is greater than your expenses, you make a profit that month and gain wealth. If income is less than expenses, you make a loss and accumulate debt. The aim of the debt-free budget is to make the outcome of this equation ≤0.
Purpose: to save a proportion of your income each month.
Our rating ★★★★
The percentage-of-income budget is a big improvement on the debt-free budget with not much added complexity. The equations for this budget are:
Income × (1-Percentage) = Expenses Income - Expenses = Profit/Loss
The percentage is the amount of your income that you decide to save each month. For instance, if you make $2500 this month and you have decided to save 20% of what you earn. Then this equation would look like:
$2500 × (1-0.2) = $2500 × 0.8 = $2000
Therefore, you would be allowed $2000 in expenses each month. And your profit each month would be:
$2500 - $500 = $500
That’s not bad.
To ease the effort in calculating this budget, we recommend using last month’s total income as the basis for the calculation of your allowed expenses for this month and etc.
Fixed Expenses Budget
Purpose: to keep expenses to a predictable, manageable, unchanging amount.
Our rating: ★★
A fixed expenses budget is where you set the amount of money you are allowed to spend per month and then it stays the same each month. This is extremely simple but has some major drawbacks which accounts for our meagre rating.
Firstly, it doesn’t allow for one-off expenses. What if you need a car repair one month? This would blow out the budget.
Secondly, if you are on a varying income, it doesn’t account for this either. Your income may drop to on-par or below the allocated expenses amount one month, and then it becomes difficult to motivate yourself, after all this time getting used to spending a fixed amount, to spend less than this.
For both these reasons, this is a budget that can create problems for your motivation and self-control yet if you can handle this, it can be a great tool to avoid debt.
Purpose: to ensure that each area of your life gets the right amount of funds.
Our rating: ★★★★
The allocated budget is one of the more complex budgets that are useful for personal finances, but if you have a multi-faceted life coupled with some financial troubles, then this extra effort may well pay off.
This budget involves portioning your income into the various facets of your life that need financing. You start with 100%, representing your total income for the month, then allocate it according to the various aspects of your life that need funding. It’s a bit like the government budget. Here’s an example:
That example is just an example, you can portion your funds any way you like. Though of course, some ways are better than others. Hence there are various rules of thumb for how you should allocate your spending. In fact that example was the 60% Solution of Richard Jenkins.
Another famous allocation principle is the 50/20/30 guideline. It is:
These kinds of budget allocation guidelines have been criticised by many for being inflexible and overly optimistic. The best response to these criticisms and the reason why we still rate this type of budgeting 4-stars is that you can alter these proportions to suit your own needs. You can start your first month of budgeting with the 50/20/30 guideline for instance, then realise that your fixed costs are greater than 50% of your income, so you modify it to your own 60/15/25 rule.
Calculating this budget seems complicated, but actually after you set up a spreadsheet with the algorithms, it is as simple as inputting a single monthly value each month (your income), and this should make the spreadsheet calculate your next month’s expenses.
Purpose: to try to spend every dollar in the optimum way.
Our rating: ★★★★★
The zero-sum budget is the most complicated yet highest rated budget type on this list. We are very fond of the zero-sum budget, as are countless people on the internet who write articles acclaiming this budget and how it changed their financial situation and their life.
The zero-sum budget is based on the principle that every dollar must be spent.
Income = Expenses
This doesn’t mean more spending on random things just to make the budget balance. It means that every dollar must be spent in the best way possible and that means more saving and less spending on non-necessities. In fact, it is much like the Allocated Budget above, yet uses a more sophisticated method of allocation. This is the process:
You spend the first 1–3 months tabulating all your expenses to find out how much you spend on each category of goods and services. The final result will look something like this:
Analyse this list you have created. It will probably be a bit of a shock to discover how much you spend on certain things. Use this shock to rearrange your list into a new list which is what you would like to be spending on the different parts of your life (think: less non-necessities, more saving). This list becomes your budget.
Follow your budget in the following month.
Review your budget near the end of this month. Did the budget improve my finances? Did my revenue change and I need to adjust my budget accordingly?
Repeat steps (3) and (4).
The zero-sum budget is a powerful tool for managing your budget that you can be refined over time into a highly efficient and customised money manager. This is why it is our top choice for budget types out of these options, yet keeping in mind that the best budget for you depends on your own particular situation.