How do I create an effective budget?

A budget is a powerful financial planning tool used to identify spending habits, limit extraneous spending and save more of your hard-earned dollars. Creating a budget includes tracking expenses for at least a month to identify where you're spending money, analyzing those expenses to see where you can make adjustments and then tracking those expenses to make sure you're staying within your limits. A budget is particularly important for those with limited income and those who want to save more.

Tracking Expenses

The first step to creating a budget is tracking monthly expenses. Expenses generally fall into one of two categories: fixed and variable. Fixed expenses include things like rent or mortgage, car payment, insurance premiums and more. Variable expenses include expenses that change from month to month: utilities, credit card payments, groceries and entertainment. You may want to sub-categorize these expenses into "needs" and "wants" to better identify your priorities.

To begin tracking expenses, CNN Money suggests gathering financial records from the last year to calculate totals for income and expenses and determine averages for each category. Also, keep track of every penny you spend for the next month to get recent data, since your spending habits may have changed in the last year.

The most important thing is to not leave out any expense. Include things like your monthly haircut, gas for your car and pet food. Include major expenses that only occur once or twice a year, such as your car insurance. The same goes for income; include any expected tax refunds or work bonuses, but budget a good portion below what you think you'll receive, just in case. Don't think that you have to cut out entertainment and "fun" expenses completely, either. Shelly Schwartz with Bankrate.com says all budgets should allow for entertainment and recreation, or else you're setting yourself up for failure.

Analyzing Expenses

Once you've tracked your monthly expenses and determined where you're spending your money, you can look at your budget and make adjustments as needed. If you spend more money than you bring in, you'll need to cut spending immediately. It's easier to cut back in areas like groceries, dining and entertainment, but you can make a difference in fixed expenses like car insurance or car payments. Shop around for lower premiums and see if refinancing your car loan is an option for you.

An idea from MSN Money is the 60 percent rule: keep your "needs" expenses at 60 percent of your gross income. These expenses include rent or mortgage payments, all bills, all taxes, food, clothing and insurance. The remaining 40 percent is divided equally among retirement savings, long-term savings (an emergency fund), short-term savings (vacations, Christmas shopping) and fun money. Another idea is the 50-30-20 rule: spend 50 percent of your income on needs, 30 percent on wants and 20 percent on savings.

How you choose to use your budget depends on your individual goals and situation. If you've got kids in college, you may be spending more on education right now and can't afford to allocate extra funds to your 401k. If you're single and want to retire early, putting more money into long-term and retirement savings may be your priority. A budget is fluid and can be adjusted each month as needed.

Following the Budget

A budget is only helpful if it's followed and revisited on a regular basis. In the first month after creating a budget, continue to track every penny you spend so that you can see where you've done well in following your budget and where you can improve. Nationally renowned financial adviser Dave Ramsey says to give the budget three to four months to really start working. Even after you've got your budget working like a well-oiled machine, you'll want to revisit it any time you have a change in spending priority or change in income.

Source:

CNN Money

Bankrate.com

MSN Money