How to Plan Your Budget

So it’s all nice that you want to plan your budget. But how do you do it? Having a tool is often not enough. There’s a step before that. You first need a method or a model.

In this article I’m going to show some general key principles that I keep seeing in most personal finance courses and models. From my experience I saw clear results by applying these principles. That’s why I use them as pillars for planning my budget.

The 50/30/20 per Cent Rule

This is a simple principle for how to split your monthly budget. You start by looking at your net income per month. So make sure you exclude all the mandatory state contributions and taxes. With what is left you should split it into 50% for what you need, 30% for what you want and the remaining 20% for savings or paying off debt.

50% what you need – this includes things that are critical for your survival. For me this is the rent or the mortgage (because I need a roof over my head), groceries (because I need to eat and stay clean) and health insurance.

30% what you want – this is for “nice to have” items. Things that make your life more comfortable even though you could live without them. A few examples would be: eating out, going to movies, traveling etc.

There’s some grey area between need and want. Sometimes you might just need to have a holiday or an evening out with friends to relax your mind and keep yourself efficient. Nevertheless, I keep a critical eye on this grey area because there’s a lot of things that I think I need and it turns out I can happily live without them.

20% for savings or paying off debt – this part should be self explanatory. There’s a question as to how much savings should you accumulate. The answer highly depends on your goals – maybe you want to reach financial independence at 40. However, as a minimum you should think about having enough to get by for 3 to 6 months without an income or to be able to handle common types of unexpected costs (e.g. medical expenses not covered by your insurance, something needs repair etc.). You should see your savings as a way to keep your independence and freedom sufficiently long so that you have enough time to act if something unexpected happens.

The 50/30/20 per cent rule is explained in detail by this guy:

My final note on this topic is that the ratio actually depends on your situation. Especially the country you’re in and your age. For example, in a country with a strong social security system you will need to rely on your savings a lot less than in countries which don’t have that. On the other hand, if real estate and food prices are relatively low compared to your income you might get away spending less than 50% on your needs. Related to your age, if you’re at the beginning of your career you might want to invest more in education than to keep money blocked in a savings account.

The bottom line is that you should judge this ratio critically as well. It’s one of the elements you can use for fine tuning your budget, similar to the grey area between want and need as explained above.

Defining Goals

This is a simple change in how you look at things. Instead of seeing your expenses as things that simply happen because everyone else does them, look at them as objectives that you set consciously while keeping in mind your needs and your values.

To give a few examples, the amount of savings that we discussed above can constitute a goal. You can calculate the sum you want to get to given your current income and spending needs, plus other risks and factors you want to take into account. Other examples are your next holiday, a car you want to buy or a new house you want to move into.

Once you have a few of these goals defined you can look at them side by side and realistically determine what is feasible. You should also be setting priorities using such goals and most importantly you can make adjustments in your budget.

Here’s a simple example to make this very practical. Assume you earn 2,000 EUR net per month and you have 12,500 EUR in savings right now. This year you want to go on a 3,000 EUR holiday and you want to reach the point where you have a 6 months buffer in savings. That means you’ll need 15,000 EUR in total and you still need to save 2,500 of that. We’re now in July, so you have 5 more months to get to your goal by the end of the year. This means you need to save 500 EUR per month which is 25% of your income.

Calculations like these are the way to plan your budget rationally. This is only possible by making that first step of setting goals. Although all of this might look obvious, putting it into practice takes a change in your habits and self-discipline.

Rational Decisions

This is a point that extends the previous two. I’m going to explain it by giving an example first.

Assume you want to buy a new car that costs 25,000 EUR. What is the underlying need you’re trying to solve by buying it? If it’s meant to solve a transportation need, consider these next questions. For how long will I be using it? What are the other costs for maintenance, fuel and parking? What would roughly be the costs of using public transportation in this period? What if I rent a different car every time I need to take longer trips in this period? What are the costs for buying a used car and then selling it after a shorter period? After considering all this it might turn out that buying the car is not the right way to solve your need for transportation.

The list of examples can continue with things that range from your next holiday to the vacuum cleaner you want to buy. The point is there are often multiple ways to achieve something you wish for. Being rational about this involves understanding the underlying need that determines your wish. Once you know that you can find a few different ways to get what you ultimately want. For each of those ways you can then make clear calculations. Your decisions should be based on those results.

Conclusion

None of the principles above should come as groundbreaking news. To some extent we probably all have an “instinct” that tells us when to apply this kind of measures. Nevertheless you should reflect honestly how disciplined you are when applying these principles. My argument is that relying on that “instinct” is often not enough. You can get better results by making budget planning a focused activity and by consistently using guidelines like these.

Have a look at My Resource Planner to find out if a tool like that enables you to apply this kind of principles. Also, please let me know in the comments below what are your ideas about the ways for planning your budget.

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