How to Calculate the Right Amount of Savings for Your Budget
The main reason to create a budget is to establish a balance between income and expenses. But another reason that's equally important is enabling you to save money. That's what allows you to build a cushion into your finances and makes your budget less constricting. It also paves the way to begin investing in a better future.
So how do you calculate the right amount of savings for your budget? Let's look at some steps to make that happen.
Step 1: Create a Budget
Begin by listing your stable monthly income, as well as all expenses. That’s everything from your monthly house payment, down to how much you spend buying coffee on the fly. It's usually best if you go back a few months. At a minimum, you should include the past three months. But going back six months, or even a full year, may provide a lot more insight.
The basic idea of this step is to do a realistic assessment of your income and expenses as they actually are. Don't worry if the numbers are ugly or uncomfortable. The only purpose of this step is to create a baseline. It’s just a starting point to build your budget on.
It can be messy and involved, but there are budgeting apps that can help you do this in a matter of minutes. By linking your spending and income accounts to an app, the analysis can be done for you.
Step 2: Analyze Your Spending
Whether you do it manually or using an app, you should summarize your spending patterns. Create expense categories, such as mortgage, car payments, utilities, groceries, and entertainment.
Organizing your spending into categories will accomplish two important goals:
- It will let you see exactly where your money goes (which can be surprising!)
- It can enable you to make adjustments.
The second point is the most important because it's the basic foundation of a budget. You don't want to merely track your spending, but develop plans and strategies to control it.
Once you know what your monthly spending is in each expense category, group your expenses into three categories:
- Necessary fixed expenses. These include basic living expenses, like rent, health insurance, and debt payments.
- Necessary variable expenses. These are items you need, but that vary in amount. It includes groceries, gasoline, and some utilities.
- Optional expenses. This broad category includes everything else, and are desirable, but not necessary. Entertainment and eating out are two prime examples.
There's not much you can do about necessary fixed expenses. But you can work to gradually lower necessary variable expenses. For example, you can set a goal to cut your grocery bill by 20 percent, and your utilities by 10 percent.
The biggest savings will be optional expenses. Since these are totally discretionary, you can literally cut them to zero, without hurting your basic standard of living.
Now you don't need to cut your spending in this category by 100 percent. But 50 percent would free-up a solid amount of money for savings.
The entire purpose of categorizing and analyzing your expenses is to identify areas you can reduce in favor of saving.
Step 3: Set a Savings Goal
Set a target amount for savings. For example, you may want to have three month’s living expenses in an emergency fund. If you need $3,000 per month to cover your expenses, you’ll need $9,000 to fill the fund. That’s your savings goal––you can set others later.
You'll then need to create a reasonable plan to reach that goal. For example, you can decide you're going to save a flat dollar amount each month. If you save $450 per month in your budget, you'll reach your savings target in 20 months.
An alternative method is to use a percentage of your income. If your net income is $3,000 per month, and you save 10 percent ($300), you’ll reach your target in 30 months.
Step 4: Know When You’re Pushing Too Hard
You might set high goals at the very beginning, with the idea of making up for lost time. This is probably not a good idea. If you haven't been a saver up to this point, it’ll take time before it comes naturally.
Your best bet is to start with a savings goal that's doable. For example, if saving 10 percent of your income is fairly easy, go with that number. You can increase it over time, as your earnings increase, and you get better at cutting spending.
Under ideal circumstances, your budget becomes a lifelong commitment. An imperfect one that works is better than a perfect one that forces you to give up early.
Step 5: Knowing When You’re Not Pushing Hard Enough
One of the inherent problems in setting any savings goal is the need to see results. In Step 4 I suggested starting by saving 10 percent of your income, or some other number that’s an easy fit. That's fine when you're just starting out, but it should increase as you go along. If not, your savings plan could derail.
For example, if you set a goal of $9,000 in your emergency fund, using 10 percent of your income, and one year later you have $3,600, you may decide the budgeting/saving strategy isn’t working.
So much of budgeting and saving is psychological. Budgeting is like being on a diet, and it will be easier to continue if you're showing steady progress. If you're not satisfied with the progress you've made thus far, you may have to increase your efforts. It’s part of keeping your head in the game.
When all is said and done, budgeting and saving are as much about adjusting yourself psychologically as it is about controlling your money. Finding the right balance between results and a comfort level is central to the whole process.
Start small, increase your savings gradually, and you'll find that balance. Once you do, budgeting and saving will start to come naturally, and you'll begin to reap the rewards of an improved financial condition.