Based on the post I made on financial independence, I will be doing elaborate posts on all the 8 steps in my financial independence post. This post is covering the second step to financial independence, which is creating a budget.
The second step to financial independence is creating your budget. The reason you create a budget is quite simple, to not overspend. To not overspend you have to know your income, expenses. Additionally, you want to calculate the savings rate you want.
Based on step 1 to financial Independence, which you can read here (first step to financial independence), we generated an overview of income, expenses and the savings rate. The second step is to figure out what the appropriate amount of expenses is for your budget.
If you are earning 10.000 EUR per month, there is no problem in using 5.000 EUR per month. However, if you earn 5.000 EUR per month, you should not use 10.000 EUR per month. You get where I going, right?
Step 2 to Financial Independence: Creating A Budget
A budget is a tool for you to control your expenses, and to make sure that you do not overspend. While budgeting might be boring, it is a necessity for your financial health. For sure your budget cannot always be on point. I use an average monthly budget. Hence, my planned monthly budget is average. E.g. most of my family has birthdays in the summer, therefore, my gift budget is higher in the summer months. Likewise, you might end up with an emergency, and therefore you need to have control of your savings to pay for emergencies.
For the example used in this post, I had to purchase a new laptop. Therefore, my budget is way overextended. This is why we have step 3: Emergency fund. Therefore, my budget this month is overextended, however, I have funds set aside for such things.
Figure out your expenses
Going through the expenses in step 1, the fixed expenses like housing and groceries which have to be paid should be a stable expense. These fixed expenses are going to be identified to categories which should be the same every month. Likewise, variable expenses should be identified. The variable expenses are something that you can not predict each month.
In the process of making your budget, you should also figure out which costs you want to downsize. If you found out that you have some budget categories which are higher than you want it to, you can start to plan some lifestyle changes.
The fixed expenses are expenses that do not vary from month-to-month. This could be rent, groceries, Netflix, gym memberships, etc. These expenses should be easy to identify and therefore does not require a lot of work. The fixed costs do not require a lot of work since they are fixed. What does require a bit of work is variable costs.
When the fixed expenses have been identified, you can start identifying the expenses which vary. Variable expenses such as personal shopping and replace/repairs. These expenses can typically not be predicted. However, if you go back and repeat what you learned from step 1, you have tracked the average expenses of the different categories a few months back.
From here you have the average costs of your variable expenses.
It is important to remember that they are variable for a reason. One month you might spend more than you have budgeted, however, another you might useless. You budget to find the average expenses. This means in months where you used less than budgeted, you must not use what is left. That should be saved in your budget account, for the coming periods where your expenses might go up.
Creating the budget
The budget which you create will be in the columns next to the tracked expenses from step 1. This way you have a direct overview of your budget to your actual expenses.
The actual expenses should hopefully be less than your budget.
If you recognize the sheet, good. That means you have completed or read the first step to being financially independent.
From the sheet I have presented above, you can see that I have used 173 EUR on entertainment, whereas I should have only used 27 EUR. However, this is because of my summer vacation. However, I do not have summer vacation all year long, and therefore this expense will match my budget better in the 11 other months.
From the summation of your budget and expenses (actual expenses), you can calculate your savings rate. As can be seen from my personal budget, I am aiming for a 50% saving rate. From my July budget, I have a -61% saving rate.
When the first step is done, you can start on the second step to financial independence.
Creating a budget is quite simple and only requires a little bit of work.
A budget is a tool you should use to not overspend. While I have described some months will be overspend, the budget should be made to an extent where that should not be a problem. Finding the average expenses should prevent overspending.
Having built an expense sheet from step 1, allows you to use the same sheet in step 2 to have an overview of your expenses compared to your budget.
Firstly, having a budget allows you to have an overview of your savings rate, which is important when wanting to be financially free. The higher your savings rate, the faster you can get to financial independence.