A budget is simple in theory. Spend less than you make and you’re good. Spend more than you make and you’ll end up like Greece.

The devil is in details. I’m going to tell you step by step exactly how to put together a budgeting plan that’s tried and tested with about a dozen people I know, myself included. If you did the bonus challenge at posted at the end of the last article, congratulations, you’re already ahead of the game.

Step 1: Your past will define you

Gather up all your old credit card bills, pay stubs, hydro bills and bank statements for about three months. If you don’t already have online banking set up – do it!

Income
Add up your after-tax income from all your sources. If you do not work in a salaried job, then take an average of your last three months or just guesstimate.

Expenses
Add up all your expenses and divide them into fixed monthly expenses, variable monthly expenses and debt monthly expenses.

Fixed expenses are the things that you have to pay off every month. You know what the approximate amounts are (or can look from previous bills) and usually pay them off on the first of each month. Changing your fixed expenses can take some effort and usually take a month to switch (e.g., moving to a cheaper place, changing phone plans, switching insurance providers, etc)

Examples of fixed expenses include:

  • Rent/Mortgage
  • Utilities
  • Phone
  • Insurance
  • Healthcare
  • Transit pass

Debt Expenses are any payments related to debt that are not mortgages or car loan payments. These are interest bearing and require monthly minimum payments.

Example of debt expenses include:

  • Student loans
  • Credit card loans
  • Line of credit balances

Variable expenses are expenses where you have complete control over how much or how little you spend. Each time to make a variable expense purchase, you make a conscious decision to spend that money.

Examples of variable expenses include:

  • Home maintenance
  • Groceries/Eating out
  • Entertainment
  • Clothing
  • Car expenses (could be in essential fixed expenses depending on how good transit is where you live).

Step 2: Trimming the fat

Variable expenses are what blow budgets, but it doesn’t mean that fat can’t be trimmed in other areas. Fixed expenses are one area where the changes can range from extremely small (in terms of effort) to tremendous hassles. Some are doable, some are not, but it’s something to think about.

Examples:

  • Turning down the heat and turning off your lights to save on your utility bill
  • Calling your cellphone provider to switch to a cheaper plan
  • Giving up your car for transit
  • Switching to an insurance plan with a higher deductible
  • Moving to a cheaper place

There are two approaches you can take to debt. The first is to consolidate everything and pay off things with the highest interest rate first. Great in theory and financially sound, but it’s hard psychologically when your debt levels are high and it’ll take time to pay it off.

If that’s the case, then another approach is to create a debt snowball. Arrange your accounts from smallest to largest and try to pay off your smallest debts first. The psychological benefits from “closing the account off” will motivate you and provide a sense of accomplishment.

Step 3: Auto-Piloting

The first secret to making things easy is to pay yourself first. Set up automatic transfers with your bank account that funnel cash from your account each time you get paid. Set up the following transfers:

  • Fixed expenses – never worry about monthly expenses again
  • Debt expenses – make more than the minimum payments to your accounts that have the highest interest rates and make your way through your debt.
  • Savings – look at how much you have left over after paying for fixed and debt expenses. From that, pick a number. It could be $10, it could be $100, it doesn’t matter.

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Step 4: Cash Consequences

The money you have left over is what you have to spend on everything else. When it comes to spending money, our brains just aren’t very smart. Using cash makes us spend less than using credit cards.

So here’s what we’re going to do to force our brains to be smarter. First, withdraw that amount in cash. That’s all you have to spend on anything you want. Keep that in a safe place in your home.

Whenever you go out, only bring what you plan to spend with a small buffer for overallocations (<$20).

This forces you to look at the choices and consequences of your decisions in a holistic manner instead of separating purchases into little buckets that all come from the same place.

At the end of the month, if you have any cash left over, put it into your savings account and pat yourself on the back.

Resources

Thaler, R. Mental Accounting and Consumer Choice. Marketing Science, 1985. http://www.jstor.org/stable/183904

Sussman, A; Alter, A. The Exception is the Rule: Underestimating and Overspending on Exceptional Expenses. Journal of Consumer Research, 2012. http://www.jstor.org/stable/10.1086/665833

Raghubir, P; Srivastava, J. Monopoly money: the effect of payment coupling and form on spending behavior. American Psychological Association, 2008. http://www.ncbi.nlm.nih.gov/pubmed/18808275

Photo Credit: Phil Roeder