How can I use zero-based budgeting to better manage my finances?
Budgeting — and saving money — is hard. One-third of Americans would have trouble covering a surprise $400 expense with cash, according to the Federal Reserve. Part of the problem may lie with flawed traditional budgeting advice.
Traditional budgeting methods ask you to examine how much money you expect to earn in a month and how much you expect to spend. It’s a formula ripe for failure as it’s full of guesses. Even progressive strategies such as envelope budgeting and the anti-budget system don’t always work.
The goal of budgeting is to ensure your expenses are less than your income, but traditional budgets don’t offer guidance on how to handle that leftover income. The zero–based budgeting approach ensures every dollar of income has a designated purpose, preventing you from accidentally spending that excess on unnecessary expenses.
What Is Zero-Based Budgeting?
Zero-based budgeting is different from traditional budgeting techniques in two significant ways.
First, you assign every dollar of income a role. If you add up your income for the month and subtract your expenses and you somehow manage to have $250 left over, you need to find something for that $250 to do. It can’t just sit in your checking account for the proverbial rainy day. The goal is to have your income minus expenses equal zero at the end of each period.
You can use the “extra” money to pay off debt, add to your emergency fund, or grow your IRA or other retirement accounts. You can also use the money to purchase something discretionary. The important thing is that you give the funds something to do.
The other big difference between zero-based budgeting and traditional budgeting is the source of the money. You live off money you earned in a previous month or pay period rather than money you expect to earn that month.
That means in February, you are using money you made in January to pay your bills. Any money you make in February will be used in March. You’re no longer forecasting your income. You know exactly what you have to spend and save.
What Are the Problems With Traditional Budgeting?
I’ve tried dozens of budgeting programs, but none ever worked until I switched to a zero-based budgeting process. Whether I was tracking my expenses and income by hand or using an online program like Mint, I always ended up going over budget in certain categories. As a freelancer with variable income, it was also tough to guess how much I’d have to work with month-to-month.
Although it might work for some people, there are a lot of issues with traditional budgeting that can leave many of us wanting or needing more.
1. Lack of Flexibility
Many budgeting programs have one space for income and expect you to earn the same amount each month. They only work if you always get a steady paycheck. If you don’t, major problems arise.
Another issue is that they assume the money you receive is yours to keep – that taxes have been taken out. As a self-employed person, I’m responsible for my taxes, so I set aside a percentage of each payment to put towards my estimated quarterly taxes.
Although you can always create a category for taxes or other deductions, the systems are often inelegant and time-consuming. I could never get things to add up correctly using traditional programs and a line item for taxes.
Additionally, many programs assume you have the same expenses each month and don’t give you the option for quarterly or annual costs. Plus, if you go over in one category, there’s no wiggle room or ability to allocate funds from a different category to make up that overage.
2. Your Human Brain
When it comes to traditional budgeting, your brain is often working against your financial goals. You get paid on the second Friday of the month, and for a brief moment, you’re flush with cash!
Budgets tend to fail because it’s difficult to see the financial forest for the trees. When your payroll deposit hits your account, it’s easy to think “I’m rich!” It’s even easier to spend it on a new outfit, a fancy dinner, or a vacation. You haven’t assigned your money a role or accounted for upcoming bills, so it’s too easy to spend it all at once.
Meanwhile, your electric bill, car payment, and student loan payment are all due in a few days. But since they’re not immediate needs, you’re not thinking about them until you’ve spent the money and it’s too late.
Alternatively, your brain can make you rebel against your budget. You get paid on Friday, you know your bills are due, and you feel cranky because you worked hard for the money but don’t get to spend it on fun things. So you revolt against the budget and go on a spending spree.
3. There’s No “Why”
Why follow a budget? Whether you use a traditional or zero-based budgeting program, having a reason to create and stick to a budget makes you much more likely to follow it. If you don’t know why you’re not spending money, it’s much harder to say no to excess costs.
Since you give every cent you earn a role when you create a zero-based budget, it’s easier to understand the purpose of the budget. You can see yourself making progress toward your goals and can rest assured that your money is working for you.
What Are the Benefits of Zero-Based Budgeting?
Since I started using a zero-based method of budgeting, my financial picture has improved considerably. I paid off my student loans, started saving for retirement, and ultimately saved enough for a down payment on my home. There are several advantages to switching to this type of budget.
1. Breaks the Cycle of Living Paycheck to Paycheck
When you live paycheck to paycheck, you depend on future paychecks to cover bills and expenses. If your income changes, you’ll find yourself in a tight spot, possibly tapping into an emergency fund or relying on credit cards to cover your bills.
Before I switched to zero-based budgeting, I often found myself stressing out if clients paid late or if a check didn’t arrive on time. I didn’t have credit card debt, but I would use the cards to hold me over until my income arrived. Then I’d worry about paying those cards off and would often pull from savings accounts to cover any overages or late payments.
Since you use last month’s income to cover this month’s expenses, you no longer have to worry about late or nonexistent paychecks. Zero-based budgeting doesn’t eliminate the need to make money, but it does cut out some of the related stress by improving your cash flow. If you lose your job, your immediate expenses are covered, giving you a small cushion. It’s like giving yourself an automatic one-month emergency fund.
Making the switch from living paycheck to paycheck to using last month’s income for this month’s bills doesn’t happen overnight. It’s the biggest hurdle you come up against when changing from a traditional budget method to a zero-based budget.
There are two ways to stop relying on future income to pay current bills:
- Stash Extra Money Aside Each Month. Create a timeline and set aside a certain amount of money each month until you have a month’s worth of expenses saved. For example, let’s say your expenses are $3,000 per month and you want to switch to a zero-based budget in six months. You’ll need to save $500 each month before you have a whole month’s worth of expenses.
- Use Your Savings. If you have a full month’s worth of savings already, tap it to break the paycheck to paycheck cycle early. That’s what I did. Although it caused some stress at first due to my lower bank balance, I was able to quickly make up the amount I took out to get a month ahead.
2. Allows You to See What You’re Spending
In the lead up to switching to a zero-based budget, track all of your expenses for a few months or review your expenses from the last year. This part of the process can be eye-opening. For example, I found out that I was spending hundreds more on groceries per month than I had budgeted, mostly over the course of trips to the supermarket to “pick up one thing.”
Once you see where your money is going, you can cut back in certain categories or spend more in other categories to help you pay down debt or save more.
3. Changes Your Relationship to Money
The biggest benefit of zero-based budgeting is that it completely changes your connection to money. I used to stress out about my finances even though I have savings and my only debts were federal student loans. Since I’ve changed my way of budgeting, I now see the bigger picture financially.
Changing my budget allowed me to take a more detailed approach to financial goals. It’s also helped with decision-making because it allowed me to see how certain allocations of my income impacted my goals. I could spend $100 on fun things each month or I could stash that $100 into a savings account for surprise household expenses.
Seeing what I was spending each month helped me cut back. I now eat out less and buy fewer non-essential items. If a surprise expense arises — such as my cat needing emergency veterinary care — I can rest easy knowing that the money is available in an emergency account and that I won’t have to scramble to rearrange my budget to make up for an unexpected expense.
How Can You Make the Switch to Zero-Based Budgeting?
Switching to zero-based budgeting takes some planning. It gets easier once you start using last month’s pay to cover the current month’s expenses, but don’t let a lack of savings keep you from trying it out.
1. Keep Track of Your Expenses and Spending
Before you start, have a clear idea of how you’re spending your money. Keep an accurate record of your purchases, savings, debt payments, and other costs over a period of a few months.
The longer you track your spending, the easier it will be to see where your money is going. If you have a lot of irregular expenses or variable income, it can be useful to track your spending and earnings for the entire current year or to review those from the previous year.
You can use a traditional budget tracking program for this step, but I think it’s simpler and more effective to track by hand or use a spreadsheet. When you manually record your purchases and spending, you can see where the money goes. Another option is to look at your previous year’s budget, if you used one.
Don’t forget to track expenses that don’t happen every month, such as car insurance, birthday gifts, and holiday purchases. If you have to track your taxes, gauge how much you’re setting aside.
2. Pay Attention to Your Income
For some people, the income part of zero-based budgeting is a snap. If you earn the same amount each month, just record how much you make.
If your income fluctuates – maybe you’re a freelancer or get paid on commission – you’ll want to give as much attention to your income as you do to expenses. One option is to use the average amount you earn per month as a baseline. If you earn more than usual in one month, create an “income overage” category and stash the extra amount for when your income is less than expected. That way you aren’t scrambling to cut your budget in months when your income is lower.
3. Create Expense Categories Based on Your Needs
Once you know where your money is going and how your spending relates to your income, start trimming and shaping your budget to meet your needs. Remember, the goal is to end up with zero left over at the end of each month, meaning your income minus expenses needs to equal zero.
As a starting point, let’s say your average net income is $4,500 per month. Your housing payment is $1,000, your loan payment is $300, you spend $200 on gasoline, and $450 on groceries. Utilities come to $150 total. You have a $200 car insurance payment due every quarter, which works out to $50 per month. So far, $2,150 of your $4,500 income has gone to necessities, leaving you with $2,350.
What should you do with that cash?
Some people would spend the extra $2,350 per month on meals out, new clothing, and other luxuries. Now that you know how much you have to work with, you can focus on giving that extra money a chore. Perhaps you send $500 to an IRA each month, give yourself $200 for restaurant meals, set aside $500 in an emergency fund, and put the remaining $1,150 toward your loan.
You can switch up your allocation from month to month based on your needs. You might have a new expense one month, such as purchasing back-to-school clothes or holiday gifts.
You can also create a new budget or make adjustments to your zero-based budget if your income changes. Let’s say that you bring in an extra $500 during one month. It’s up to you to find a home for that money. You might put it in your emergency fund or make an extra contribution to your IRA. You can create a vacation fund or use the money to treat yourself.
Now, let’s say in a different month, your income is $500 less than usual. You’re going to have to make cuts. Luckily, since your necessary expenses are lower than your average earnings, reducing costs is less of a challenge. You can cut out restaurants that month and make a smaller payment towards your loans.
4. Make Your Budget Work for You
It’s incredibly important that you create a zero-based budget that works for you. Since the budgeting method is so flexible, you can tweak it to meet your needs.
I’ve found that using a spreadsheet to track my finances is easiest. At the start of the month, I total up what I earned the month before, then subtract taxes and savings to get my net income. In a separate section, I list my necessary expenses.
Below that, I have a section for flexible expenses, which change based on season, month, or income. I always hated having specific categories for spending, so things like restaurants, clothing, and personal care are all lumped into “miscellaneous.” If I have extra income for the month, I either invest it or stash it in my household repairs fund.
Figuring out a tracking system that worked was half of the battle, but now that it’s in place, sticking to a zero-based budget is a breeze. Since the money is already in my checking account before bills are due, I don’t have to worry that I’ll overdraft or miss a payment.
Bad financial habits are easy. Changing your budget is hard. Give yourself time to switch over and to get used to living on last month’s income today.
People often assume that budgets are all about restrictions. The truth is that your budget should help you and be something you want to follow. Since it’s flexible, a zero-based budget can be the method that finally works for you.