How Do Budgets Work?

How does an exercise like budgeting miraculously transform your monthly finances from a source of anxiety and stress into a solid platform for achieving your goals as an individual or as a family?

The short answer is that it doesn’t. Budgeting, and it’s bigger sibling, Financial Planning, are merely tools. Properly applied, these tools allow you to take control of your finances by organizing how you will earn and spend money. They allow you to identify opportunities for recurring savings and give you a way to plan your way out of a financial deficit, or into a position of financial strength.

Let’s take a closer look at the process and how it can help transform your financial situation.

What is a Budget?

How Do Budgets Work? A Roadmap For Financial Independence.

At it’s simplest, a budget is a single number. An amount of money you expect to spend over a given time period. Typically a month, a quarter or a year.

A useful budget is more than one number. It’s a series of numbers that reflect not only how much you’re going to spend, but what you’re going to spend it on. Picking those categories appropriately is important, but the basics are simple. How much do you spend on rent, on utilities, on food, and so on.

I tend to focus on monthly and yearly budgets. The monthly budget allows you to control your spending over a repeated period of time, setting short term targets for you to meet. The yearly budget gives you visibility of where you will be if your stick to those monthly targets.

Once you’ve established a budget – in written form – you use it to control your spending by making efforts to remain within its limits. If you budgeted to spend 300 pounds or dollars or euros on food in a given month, then you would think about that number every time you go grocery shopping. You ask yourself, every time you purchase something, whether this purchase is appropriate given the targets and constraints you’ve set yourself.

The budget, however, is merely a set of numbers on a piece of paper (or a spreadsheet, if you’re like me). It has no mystical power of its own.

Making a Budget Useful

There are a number of ways in which a budget becomes a useful tool. A number of articles on this site go into this in depth, but here they are in list form:

  • Taking the time to create a budget makes you think up-front about how much you spend on various things, and how reasonable that is (or isn’t). This brings into focus things like the relative weight of your rent or your car in your overall finances
  • Splitting your spending into categories allows you to look at each separately and decide what’s driving that spending and how best to reduce it. Your rent for example can only be reduced by renegotiating or moving home, but your cell phone bill or your grocery budget are things you can reduce quite quickly if you have to
  • Budgets force you to set targets, which are the first step in setting yourself limits on how much you spend. Once you’ve told yourself how much you want to spend on something, it becomes something you think about every time you decide to spend money on that kind of product
  • Calculating how much you can spend in each category forces you to measure the value you get out of that spending. You might reconsider how much pleasure you really get out of shop-bought sandwiches and whether it’s better to make some nicer sandwiches at lower cost at home and take them to work. Or perhaps a salad?
  • It’s an iterative process. What that means is that each time you set yourself a budget and then try to stick to it, you’ll learn a little about what parts of your spending you could probably save more on, and where it’s actually really challenging to stick to the amount you’ve set and it’s perhaps a good idea to be less strict

The core and essential value of a budget is the visibility it imposes on your spending habits. You no longer spend money in the abstract, but rather spend money from allocated buckets of cash which you are supposed to stick to. This process drags a lot of unconscious decisions into the light, giving you the chance to decide not to spend that money.