Oxford Dictionary

Budgeting — [noun] An estimate of income and expenditure for a set period of time.

ELI5

Many people associate budgeting with something that needs to be done when money is tight – which is true. However, there are many people including those making more than the median income that choose to budget as well. Lifestyles will vary based on your job, your family, and other needs and budgeting is a useful way to help maintain that.

A budget, for personal finance, is setting a limit in spending in various categories of life expenditures – whether short-term, mid-term, or long-term. A monthly budget, for example, would include an expected spending limit for rent, food, utilities, insurance, etc. Another budget could be a savings budget for the downpayment on a house. The term is used quite flexibly, but it’s really a method to help someone gain more control of their finances and understand what’s coming in and what’s leaving.

Even though building a budget seems like an added burden – keeping track of income and expenses closely, it can provide greater freedom and flexibility in the future. Preparing to purchase a new car, house, or putting a child through college are events that generally require patience to save for — and something a budget can help expedite. In addition, by ensuring you have money in the bank, i.e. an emergency fund, you can spring back from sudden mishaps or unforeseen accidents such as a hefty medical bill, car maintenance, etc.

 

Detailed Definition

There are some basics steps to budgeting that include: understanding what you are saving for, estimating income and expenses, building an emergency fund, and growing a nest egg.

Like mentioned before you can have different types of budgets – a monthly one to understand how money is flowing in and out of your account or a long term budget to help save for a car or child’s college tuition. Depending on what you are saving for and the timeline, the strategy for how aggressively you budget will vary.

For a medium term item, such as saving up for a downpayment for a car, building a budget will help an individual think about what expenses can be pared down to facilitate the savings growth. After reviewing the last couple months, you might notice that a great sum of money is spent on eating out. By switching to a home-cooked diet you can shave off a couple 100 dollars and be able to get that brand new Tesla that much sooner without breaking your wallet!

Now that you’ve thought about what your budget is for, the next step is to do a deeper dive into the money flow. Hopefully, you have a good idea of how much money you are bringing in per pay period — this counts as income. Disposable income is the money left over after taxes. There are typically two types of expenses in personal finance – fixed and variable.

Fixed expenses are recurring costs such as rent, insurance, and subscriptions that you can expect on monthly or annual basis. These payments are useful while budgeting cause they stay constant, but also inflexible since most individuals have little control over them once they are set.

Variable expenses are dynamic costs that tend to change month-month and these include food, utilities, entertainment, and discretionary spending. Given our gig-economy with great services such as Grubhub, Doordash we quickly can find ourselves overspending on delivery for example. Unchecked variable expenses can quickly place people in tight financial situations. At the same time, people have more control over variable expenses — instead of doing delivery every night, they can save some money on groceries without too much added effort.

It’s a useful exercise to review the last couple months expenses to figure out what your fixed expenses and variable expenses are. There are fantastic services such as Mint and YNAB that enable people to quickly gain an understanding of their finances by connecting bank, investment, and retirement accounts in one centralized location — so you don’t have to keep track of receipts and credit card statements.

In the world of budgeting, a critical concept is being ready for unforeseen, mandatory expenses — i.e. a hospital bill for an injury or a sky-high car repair. An emergency fund is generally agreed to be 3-6 months of living expenses saved in a highly liquid account (checking or savings) so it can be withdrawn almost immediately. Having this allows an individual to not take out an emergency loan with high interest which can quickly place a person in a tricky financial state.

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