Budget Explained

Before we get into specific areas of your budget, let's take a brief look at how a normal household budget works.

Primarily, all budgets are divided into income and expenses, but most good ones now include a third component, savings. Items in the "income" section can include after-tax salary, pensions, investments and tax refunds.

Items in "expenditure" can include rent, mortgage payments, food, gas, utility bills, childcare, entertainment, gifts and holidays. The "savings" section logs how much you put away each month, after satisfying spending requirements. As much as 10 percent of total expenses should be put into this category to allow for unforeseeable events such as dental emergencies.

One way to attack your budget is to use what some debt counselors refer to as "the snowball method". Using this strategy, simply list your debts in ascending order with the smallest remaining balance first, the largest last. Do this regardless of interest rate or payment. You will pay these off in this new order. This works because you get to see some success quickly and are not trying to pay off the largest balance just because it has a high rate of interest.

Once you pay off the lowest balance, take that payment and combine it with the next payment on the list, so that each month you're making a larger payment on that debt. Repeat the process, again and again, so that your payments are getting larger, your debts are being paid off faster, and the process starts to snowball until all your debts are paid.

If you're one of those people who can't sleep at night worrying about bigger bills, go ahead and address those bills first. Just rank your debts in order of highest interest rate to lowest. Then whittle away at them in that order. Make sure you are not comparing apples and oranges. The effective interest rate is often different from the nominal rate quoted by the lender. For example, mortgage rates are compounded semi-annually, while rates on credit-card debt are usually compounded monthly.

Your Budget List
Here are some more tips on building a better budget:

Don't make your budget too inflexible because, like a diet, it's unlikely you'll stick to it.
Use exact costs, not just averages, so you know at any point exactly how much you need or have.
Use a spreadsheet layout with two main sections - income and expenditure.
Categories should be broad so that the budget is not too complex. For example, include doctor, dentist and medicines under Health.
People always underestimate what they spend. Remember extras such as lunches, public transportation and football memberships.
A good strategy is to prepare your budget based on how often you get paid.
Review your budget every month for the first couple of months to make sure you are on track.
When the economy enters a low-interest rate period, as it did in the mid-to-late 1990's - take advantage of low interest rates to refinance a home mortgage and make lower monthly payments. Numerous web sites offer instant calculators that will estimate your new payments, including www.Realtor.com.
Review auto and home insurance rates and comparison shop for better values. Some companies offer discounts you may not be aware of, such as those for senior citizens, multiple policies or autos with anti-theft devices. Consider raising deductibles, too, in exchange for lower payments.
Add up the fees on your bank statements and shop for a better deal or ask your existing bank about lower-cost accounts. While you're at it, find out if your employer will automatically deposit your paycheck to your bank account, to minimize the risk of bounced checks and other mishaps. Consider starting an automatic savings plan that will route some money directly to a separate account before you're tempted to spend it.
Obtain an estimate of your future Social Security income by calling (800) 772-1213. Ask for a Personal Earnings and Benefits Statement request form. The response time is quick, and it's a good opportunity to make sure your employment history is reflected accurately.
Order a copy of your credit report for $8 from reporting agencies Equifax (800-685-1111), Trans Union (800-916-8800) or Experian (800-422-4879). Again, note that you can get one free copy of your credit report annually.
Get rid of clutter and raise extra cash by holding a garage sale or get a tax deduction by donating unwanted items to charities. In that case, be sure to keep an itemized receipt of donated goods in case the IRS has questions.
Make a detailed household inventory to protect yourself in case of theft or disaster. Engrave your name and an identifying code on high-value items, and record serial numbers. Most insurance companies offer guidelines or even workbooks -- call yours or check out the Nationwide Mutual Insurance Company web site at www.nationwide.com.
Taking out one manageable loan to pay off various scattered debts is often a smart way to lower your effective cost of borrowing. Credit-card debt is the prime target for this strategy. Interest rates on credit cards are frequently two to three times higher than consumer loans. Consider the possibility of borrowing on a personal line of credit to pay off credit cards. Of course, if your credit card spending has gotten that far out of hand, it's time to break out the scissors and begin cutting.
Draw Personal and Professional Lines Between Debt -- If you are self-employed, you may need to borrow for business purposes. Be sure your records are accurate enough to track personal and business borrowing separately. Better yet, use dedicated sources for your business borrowing. For example, use one credit card for your business spending and a different one for personal use.
Keep up with Uncle Sam -- If you are self-employed or have substantial investment income, you are probably required to pay all or part of your taxes in quarterly installments. Interest and penalties on unpaid installments can currently reach 12%, compounded daily. Unlike a salaried taxpayer who has tax withheld at the source, it is very easy for a tax installer to slip deeply into debt to the government. It is a good policy to keep your tax money segregated - and fight the temptation to dip into it.
Loan or Lease? -- When you are trying to decide whether to buy or lease your next car, keep in mind that a lease is another form of financing. Find out the effective financing rate implicit in any lease proposal, and compare it to prevailing new car loan rates.
Stay Squeaky Clean -- Protecting your capacity to borrow is a worthwhile financial-planning objective. Buying a house or a car, going into business for yourself or jumping on that unique investment opportunity are occasions that often require external financing. Also, normal cash reserves may be insufficient to deal with a financial emergency. Keep your credit rating clean. Do not take on debt you cannot handle. Do not miss payments. If you do find yourself in a default situation, do not try to hide from your creditors. Take the initiative to propose revised repayment schemes and keep them fully informed at all times.
Keep it fun. Open a bottle of wine, make a date with your loved one, and flip a John Mayer CD into your stereo. Saving money will put a smile on your face and make you feel good about yourself. It's time well spent.

The Next Step
When you have filled in the sections of a budget table relevant to you, simply make totals of expenditure (including savings and investments) and income, and subtract expenditure from income. If your total is above zero, you are cash flow positive. If the total is below zero, you are cash flow negative. If the total is zero, you are cash flow neutral.

If you end up with a positive cash flow, you can then consider investing the surplus, preferably in real estate, stocks or mutual funds. Or, you can spend it. If you have a negative cash flow, you should examine what non-essential items you can eliminate.

The most common problem people have with budgets is sticking to them. Individuals who aren't very organized by nature need to have a more flexible budget, with broader categories such as "rent, entertainment, groceries and bills" under expenses, rather than more detailed entries.

The last word on your budget. When you first start your budget, you should review it every pay period to see if you're on track. After that, review it when you do it - every month.

A Monthly Budget Checklist