Creating a budget can be a challenge. How exactly do we go about categorizing our spending? Here we show you how to create the perfect spending plan using just 5 high level budget categories.
When I started my first real budget as an adult, the concept was not difficult. I knew I had to track my spending.
Tracking my spending would keep me from spending too much. And that would help me control and fix my financial situation. I was trying to reverse the trend of increasing my debt every month. So I came up with a simple spending plan that suited my needs.
Experimenting with My Budget
At the time, I used a free version of MoneyDance, a budgeting software. I also experimented with GnuCash. I categorized my expenses into at least twenty categories. But I quickly found that complicated budgets don’t work that well. Instead, what worked best for me was a simple plan that broke spending down into a few core components.
I started working towards J.D. Roth’s Balanced Money Formula. He suggests approaching your very basic budgeting categories this way:
- 50% of after-tax income goes towards needs
- 30% of after-tax income goes towards wants
- 20% of after-tax income goes to saving
These ratios were my goal. But, for one thing, I wasn’t quite there yet. And for another, this isn’t a complete solution. It laid the groundwork. But I needed to examine my spending with a little more detail. So I started asking myself a few questions.
Asking the Right Questions
The questions I asked, and answered for myself, included:
- What’s a need, and what’s a want? For an entrepreneur whose business relies on internet access, good internet access is a need. But what about those who only use the internet for personal entertainment and browsing?
- Does a cell phone count as a want or a need? What about a Smartphone versus a basic phone?
- Where does charitable giving fit in?
- How about food? Eating is, of course, necessary for survival. But what about dining out?
This is just how I started dividing out my spending among J.D.’s broad categories of spending and saving. These questions are complicated and can be difficult to answer. Plus, in order to answer some of them, you need to know what you’re already spending in these categories. We’ll get to that later.
Maslow’s Hierarchy of Needs
So instead of just using those broad categories, I referred to Maslow’s Hierarchy of Needs.
This image is one you often see in a Psychology 101 class in college. The basic theory is that in order to fulfill higher-level needs, you must first fulfill lower-level needs. In other words, it’s really hard to feel safe and secure if you don’t have adequate food. And it’s hard to create relationships when you’re struggling to meet your basic physiological needs.
It’s pretty easy to use this hierarchy to prioritize your finances. In fact, using the Hierarchy of Needs is a great way to decide how to spend your money when there’s not enough to meet all of your expenses. Think about it this way:
- First, consider basic physiological needs. This includes adequate food, running water, heating in the winter, housing, and basic clothing. Given how much we rely on electricity, you can probably put paying the electric bill here, too. The most important spending is on these items.
- Next, spend on things that are essential for your safety and security. This includes health insurance, especially if you’re one medical emergency away from bankruptcy. Affordable term life insurance can give you peace of mind for your family’s future, too.
- After this, spending, you’ll start moving from wants into needs. Some items, like the internet access we talked about above, are a gray area. You may have certain “wants-like” expenditures that enable you to continue earning money so that you can pay for your needs. For instance, this could include daycare for your children or transportation costs.
You might put your spending in slightly different categories, but here’s a basic breakdown of what this might look like:
Level 1: Physiological Needs
- Housing: rent or mortgage payments
- Basic sustenance: groceries, cooking, and water
- Clothing: non-designer brand essential wear
Level 2: Safety Needs
- Power (electricity, gas)
- Basic telephone service
- Insurance: health, home, and life
- Vehicle or other transportation
- House repairs and maintenance
- Expenses related to operating your business
Level 3: Love and Belonging
- Charitable contributions
- Spending time with friends and family
Level 4: Esteem
- Work-appropriate clothing
- Education and professional development
- Dining out
- Fitness beyond basic health needs
Level 5: Self Actualization
- Internet, if not needed for generating income
- Vacations, non-essential travel
Creating Your Budget Based on the Hierarchy
So what do you actually do with this information? Here are some steps to take when creating a needs-based budget, especially if you can’t pay all your expenses every month:
- First, budget for your most basic physical needs. If you can pay for nothing else, pay for these.
- Next, budget for the safety and security related needs.
- After this, you can start budgeting for the next two levels lumped together. For instance, some months, you might need to budget for a wardrobe upgrade or a new suit. To do that, you might need to cut back on dining out with your family. That’s technically mixing up the hierarchy, but it still makes sense.
- When you have extra money, use it on the self-actualization categories.
As you get better at budgeting, you may not need to be so strict with your categories anymore. But when you’re starting out, it helps to divide things down to their basic components. This is a great way to get going!
For a great budgeting tool, check out Personal Capital Financial Dashboard. It’s totally free, and you can track all your spending, credit cards, bank accounts, and even investments.
Published or updated August 15, 2017.