How to Create a Basic Budget in Three Simple Steps
- Everyone needs a budget, including individuals, families, and companies.
- As you create a budget that fits you and your lifestyle, it’s essential to find your basic budget ratio.
- Your basic budget ratio will give you a clear picture of how much you can put toward certain categories in your budget, like food, housing, and savings.
Everyone needs a budget, including individuals, families, and companies. A budget that can last through the ups and downs of a challenging economy is important. Developing the right budget is especially important during periods of inflation. A budget that meets your basic needs can reduce your stress around your finances in case economic uncertainty strikes.
As you create a budget that fits you and your lifestyle, it’s essential to find your basic budget ratio. The basic budget formula is a tried and true method for developing a recession-proof budget of sorts. The basic budget formula helps you determine your critical must-pay expenses, compare them against your income, and identify any shortfalls.
How to Determine Your Budget Ratio
There are three steps to finding your basic budget.
Your first step is to add all of your basic monthly expenses. Basic expenses are necessary to keep you sheltered, fed, healthy, and in good standing with your creditors.
Examples of basic monthly expenses include:
- Rent or mortgage payments
- Utility payments
- Basic groceries to meet your nutritional needs
- Car or transportation expenses to get to and from your place of employment
- Required prescriptions or medical care
- Minimum debt payments
Importantly, your basic budget does not include ‘wants,’ only basic living expenses. For example, dining out and shopping sprees are not part of a basic budget. Instead, these are replaced by homemade meals, shopping only when necessary, and finding shopping deals at thrift stores when possible.
Unfortunately, the line between needs and wants is not always clear-cut. You may ask yourself questions like:
- Are spa visits that restore you, body and soul, a want or a need?
- Are organic or locally-sourced groceries an important part of your baseline healthcare, or something less fundamental?
These decisions vary from person to person, and there’s no one-size-fits-all approach. A basic budget is less flexible than your daily living budget and is meant to provide you with a plan you can readily implement should an emergency arise.
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Next is to calculate your after-tax income. Your after-tax income also referred to as your take-home pay, is your pay after required deductions come out, such as federal and state taxes and any garnishments, and after voluntary deductions, such as 401k contributions.
If automatic contributions to your 401k plan are being taken from your paycheck, these should be added back in when calculating your basic budget. While savings, emergency fund contributions, and 401k investments are an absolute must under normal circumstances, these deductions will be paused under a basic budget scenario when every penny is critical.
Once you have your basic expenses and take-home income, you will divide your total basic monthly expenses by your take-home pay. For example, if your basic monthly expenses are $1,800 a month, and your income, after adding back 401k deductions, is $2,000 a month, then your basic budget ratio is 0.90, or 90%. Let’s see the basic budget in action with an example.
An Example of a Basic Budget
Let’s imagine that you have a monthly take-home pay of $2,600 and you don’t receive any retirement benefits. Even though no automatic retirement contributions are coming out of your pay, you find yourself still coming up short each month and want to understand why.
Your first step is to use the basic budget formula to investigate the budget deficit. In our example, your basic expenses comprise the following:
- Rent: $900 – Your rent is thankfully lower than most of your friends because you have a roommate.
- Utilities: $200
- Monthly car note: $250
- Monthly car insurance: $200
- Gas: $300/per month – Given the still too-high gas prices.
- Student loan payments: $200 – You are paying the minimum amount.
- Monthly grocery bill: $200
- Monthly hair care maintenance: $100
- Monthly credit card payment: $50 – You are paying the minimum amount.
Since this is your basic budget, the extra payments you normally make on your credit card, dining out, and cable subscriptions, weren’t applied.
Now that you have a handle on what your basic expenses are, your next step is to divide these expenses, which total $2,400, by your take-home pay of $2,600 (example: $2,400 / $2,600). Plugging this into your calculator yields a ratio of 0.92, or 92%.
Normally higher percentages are good, like at school when a 92% on a test translated into an A. But in this case, higher percentages are bad news. A high percentage means more of your income is going toward basic expenses. In this example, 92% of your income goes towards covering your basic overhead, leaving only $200, or 8% of your income, for savings, fun, and any unplanned expenses.
Recommended Read: Am I Spending Too Much on Rent? Here’s Your Answer.
After letting this sink in, you realize that $200 will not cut it. A basic budget goal is to ensure that no more than 60% of your take-home pay is going towards taking care of your basic needs. You will need to decrease your expenses or increase your income to hit this goal.
A basic budget, by definition, means that you’ve already trimmed all or most of the fat. Yes, it’s possible to cut back on your housing costs through more roommates or cut your automobile expenses by selling your car and buying a cheaper one.
However, if your apartment doesn’t have room for more beds—which would require approval from your landlord to add a tenant to the lease—or selling your reliable car risks taking your chances with a cheaper and likely older unreliable one, then your main lever is adding another income stream to your budget.
To determine how much income is required to achieve a 60% ratio, divide your basic budget by 60%. Use this example, $2,400 / 0.60 = $4,000 in after-tax pay.
With $4,000 a month in take-home pay, $1,600 would be left over after funding your basic overhead. Now expenditures like saving for a house, creating an emergency fund, making extra debt payments, and even investing in a business idea or in the stock market are more feasible.
How to Develop Your Basic Budget
In an ideal world, a basic budget would not be needed, as both needs and wants could be easily met with your income. This isn’t always the case; developing your basic budget will involve increasing your income, finding opportunities for trimming expenses, and monitoring your budget in good times and bad.
Increase Your Income
Opportunities to increase your income in a hurry include side gigs like ride-sharing, food delivery, and part-time income from talents you may have in areas like arts and crafts sales, haircare, and tax preparation. What’s key is that you renew licenses or refresh skills before the need for a basic budget arises so that you are ready to implement them on Day 1.
Reduce Your Expenses
Avenues for lowering your expenses include adding a roommate, lowering car insurance payments through a higher insurance deductible, and reducing gas costs by limiting driving to essential travel. As with income, you will want to identify potential opportunities for reduction ahead of time before they’re actually needed.
Monitoring your budget becomes a habit with practice. Aim to review your budget quarterly so that you can see spending spikes or income dips before they become problematic.
The Money Wrap-Up
A basic budget provides you with a parachute to don should a financial emergency strike, and you must limit your spending only to your most basic needs. The basic budget formula allows you to calculate how much of your take-home pay is absorbed by your basic expenses.
A lower percentage means your basic budget costs are taking a relatively small bite out of your take-home pay, and as such, it is better than a higher percentage. Your aim is to have approximately 60% (or less) of your take-home pay needed to cover your basic expenses.
If you find yourself far from your target goal of 60%, don’t worry. Instead, congratulate yourself for taking the brave step of learning exactly where you stand and committing yourself to make small, steady improvements.