How Personal Budgets Work

While you can certainly create a successful personal budget with nothing but a pencil and paper, many people find it very helpful to use financial software. Whether you use software or go "old school," the first step for creating a personal budget is to calculate your average monthly income.

To keep things simple and honest, only include fixed earnings like paychecks from your job, alimony payments, legal settlements, royalties or dividends from investments that you don't plan to reinvest [source: Yahoo! Finance]. Don't bank on uncertain income like raises, bonuses or a particularly fruitful trip to Las Vegas.

Tracking your income is the easy part of creating a budget. It's much harder to pinpoint your spending. This is why personal finance software is so helpful. Programs like Quicken or Microsoft Money can access your online banking records and download all recent transactions for detailed analysis.

With a complete list of all of your bank deposits, outgoing checks and transfers in front of you, you can begin the important task of categorizing all of your income and expenses. With a few clicks of the mouse, you can label a $2,500 deposit as a paycheck, a $500 transfer as a credit card payment and a $1,500 check as a rental deposit.

In addition to specific categories like rent or groceries, personal finance experts recommend that you organize all of your expenses under two broad labels:

Fixed expenses are those expenses that stay the same every month. Not everyone has the same fixed expenses, but here are a few of the most common examples:

Discretionary spending is a broad category that includes every expense that changes each month. Not all discretionary spending is unnecessary. Take a look at the following examples:

In addition to using personal finance software, it might also be helpful to carry a small notebook with you to track your cash expenses. This can be especially helpful if you find yourself taking money out of the ATM more than once a week [source: CNN Money]. Every time you use cash to buy a newspaper, pay a toll or buy lunch, make a note of it.

Now that you've created a detailed worksheet of your income and expenses, you're ready to analyze the data and start drafting a better budget.

The first step toward drafting a successful personal budget is to compare your current monthly earnings and expenses. Simply add up your earnings and expenses separately and see which amount is bigger. If you earn more than you spend each month, then you're on the right track. But if you spend more than you earn, get ready to make some serious adjustments.

The goal of a good budget is to come up with a spending plan that allows you to save 10 percent of your earnings each month [source: CNN Money]. For most people, that means making some spending cuts. But where do you start?

Finance software like Quicken and Microsoft Money can do some of the analysis for you. They can look at your monthly spending habits and compare them to other people in your same demographic. If you're spending too much on rent or too much on restaurants, the software will let you know.

But even if you don't use finance software, a good rule of thumb is to cut back first on discretionary spending. This is one situation where you should definitely sweat the small stuff. Start with that notebook where you logged all of your cash purchases. Look for recurring cash purchases and figure out how many of them are really necessary.

Here are some common cash culprits:

This might be just the opportunity you're looking for to quit smoking, start taking public transportation and learn how to cook. That's not to say that you have to start living an entirely Spartan lifestyle, but look for ways to cut down on unnecessary cash spending.

­­­As you find ways to trim your cash spending, start deducting those amounts from your current spending totals. The idea is to draft realistic spending goals that will allow you to save more each month. Try to keep everything in its appropriate category (entertainment, transportation, et cetera), so it will be easier to keep things organized when you draft your new budget.

Next, move on to your other discretionary spending. Perhaps you're spending too much each month on new clothes, concert tickets and organic produce from the upscale grocery store. Make some reasonable estimates on how much less you could spend each month by only buying clothes during sales, only attending concerts from your favorite artists and shopping at the farmer's market. Use those estimates to draft your new budget.

Taxes are another place to make spending cuts. If you're self-employed, look for ways to increase your itemized deductions (without getting too creative, of course). If mortgage rates have dropped more than two percentage points in your area, consider refinancing your mortgage [source: CNN Money]. It could be worth the fee.

If you look at every entry on your current list of expenses, you can usually find a way to cut back, even if it's just a little. For instance, lower your heating bill by keeping your home a few degrees cooler during the winter. Switch from the unlimited cell phone plan to 500 minutes a month. Only play golf on the public course.

Take your new, lower spending estimates and write them down in each category. If you're using finance software, use those estimates as your monthly spending goals. Congratulations, you now have a personal budget!

Now that you've drafted a budget with new spending goals, it's time to put your plan into action. Read more on the next page.

T­esting your budget requires diligence. You need to keep detailed records of your earnings and expenses to see if the budget is working.

Once again, finance software can make this a lot easier. As you spend money throughout the day, make sure to keep your receipts. At the end of the day, sit down at the computer and enter all of your expenses into the appropriate categories. The finance software will automatically gauge whether or not you're on track for meeting your monthly spending goals.

The most important thing to know about personal budgets is that they're not written in stone. Budgets are designed to be flexible, especially during those first two or three months. Perhaps there are expenses or earnings that you forgot to include in your original assessment. You might not have accounted for seasonal or annual expenses like property taxes, car registration or tax preparation fees [source: Nolo.com].

Make adjustments as needed until you find a budget recipe that allows you put away a reasonable amount of money each month. The goal is at least 10 percent, but that doesn't have to happen immediately.

It's also important to recognize that budget priorities shift as you get older. Experts recommend that you review your budget every few months to make sure that spending goals still make sense [source: Yahoo! Finance].

Remember to consider inflation when you review your budget. Inflation grows at an average rate of 3 percent a year [source: CNN Money]. To stay ahead of inflation, you need to make sure that your income grows at a faster rate. Even if you get a 5 percent raise, don't think of it as an excuse to spend 5 percent more this year. At best, you can spend 2 percent more, but the truly smart thing to do would be to use that extra 2 percent to pay off debt and increase your savings.

Another tip: If you carry credit card debt or other high interest debts, pay off those debts first before increasing your savings. It doesn't make sense to invest in a low-interest savings account if your debt is growing exponentially.

If you want help with your personal budget, there are many non-profit and government budget counseling services and financial education centers. Beware of debt-consolidation or debt-reduction services that charge a fee.

For lots more helpful information on creating a successful personal budget, follow the links on the next page.