Zero-based budgeting sounds fancy and complicated, but it’s actually an incredibly simple – but powerful – tool to help you spend smarter. If you are trying to balance your budget and increase the likelihood that you will meet financial goals like saving money or paying down debt, zero-based budgeting can help you do that.
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What is zero-based budgeting?
Zero-based budgeting means that every dollar of income you have coming in must be accounted for in your budget. Every dollar is given a purpose by being allocated to specific expenses, savings, or debt repayment. The idea is that every month your budget is balanced to zero.
Before you get excited, no, that doesn’t mean that you get to spend all your money. It’s not continuing the current cycle you may be in of living paycheque to paycheque. It means that you decide at the beginning of each month exactly where you are going to allocate your hard-earned cash, and then you stick to it.
Why use zero-based budgeting?
Humans are notoriously bad at planning for the future. It’s in our genetic make up to live in the here and now – which makes impulse spending a common challenge for most of us.
A zero-based budget is an effective budgeting method for those who struggle to save or pay off debt because they lack focus. When you use zero-based budgeting, you force yourself to spend within your means, save money and pay off debt. By ensuring that you don’t skip any priorities, you are much more likely to meet all your financial goals.
How do you make a zero-based budget?
A zero-based budget follows this one simple formula or rule:
INCOME minus SPENDING minus DEBT REPAYMENT minus SAVINGS equals ZERO.
In other words, it’s a zero-sum budget.
A zero-based budget is no harder to create than any other form of traditional budgeting.
Start by analyzing your incoming and all outgoing cash flow demands
Your income is relatively simple to list. It should include your net paycheque, social assistance, child or spousal support, pension income, business income, rental incomes, and any other cash you bring in. If you earn commissions, estimate on the low side. If you earn more or get a bonus, our recommendation is to exclude this initially. This provides some buffer in your planning and ensures that you don’t go negative right off the bat.
Your outgoings may be harder to nail down at first. If you don’t know where you are spending your money today, start with a 30-day spending journal. Look through all your past credit card and bank statements and utility bills for on-going expense items. In addition to the big three – rent or mortgage, food, and transportation – be sure to include all memberships, an amount for personal care, prescription medications, anything you spend money on. Don’t forget to include periodic or seasonal expenses like insurance premiums, property taxes or gifts.
Zero-based budgeting accounts for all cash outlays so you also need to list all the money you spend each month either paying off debts and any amounts you wish to set aside for savings. And of course, I highly recommend allocating a small amount each month towards building up an emergency fund.
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Subtract your outgoing spending from your income until you balance to zero.
Once you have a clear picture of exactly what money you have coming in and out each month, it’s time to balance them to equal zero. Your initial budget might reveal that you are spending way more than you have coming in.
To get your budget to balance you can:
- increase your income
- find cost savings to decrease discretionary expenses
- increase or decrease debt repayment. Remember however that you must keep up with all minimum payments.
- increase or decrease your savings
Ultimately, it’s your zero-based budget. Your rules.
The key advantage of zero-based budgeting is that it mimics what you must do in real life to achieve your financial goals. If you want to allocate more money to savings goals or debt repayment, you need to cut back on expenses somewhere. All that matters is that you clearly assign your money somewhere – otherwise, you may spend it on a whim on who knows what.
How do you know how much you should save or spend?
Keep in mind your initial goals. Do you want to eliminate debt? Do you want to increase savings? When choosing where to spend your money, make sure you meet your very specific financial objectives.
You can use rules of thumb to distribute your money like the 50-30-20 rule, which means that:
- 50% should be spent on things you absolutely need (rent, groceries etc.)
- 30% should be the maximum you spend on things you want (gym memberships, vacations, clothes, fancy food etc.)
- 20% should be immediately saved (goals or retirement) or put towards paying down debt.
However, these rules of thumb are not realistic for everyone. If you have a lot of credit card debt, then you may want to allocate more than 20% to pay off high interest debt sooner. If your income is high you may not have an extra 30% for discretionary spending. Your rent or mortgage might take up more of your income, limiting how much disposable income you have to allocate.
The zero-based budgeting approach makes sure you allocate money first to the most important items like necessary expenses and debt repayment or savings. For your budget to work, it must be realistic. If your living costs are high or you have a lot of debt, meeting your goals may mean making some hard choices to reduce discretionary spending for a while.
Track your results
All that’s left to do now is to track your progress. You can do this with an app, on a spreadsheet or simply automate your bill payments and savings, so they align with your zero-based plans.
A zero-based budget works very well alongside the envelope method or reserved bank account method. Once you balance your budget to zero, you move money into these envelopes or separate bank accounts in accordance with your overall plan. I often recommend against leaving your entire paycheque in your checking account. It’s too much of a temptation to spend. If you’ve earmarked monthly income to cover certain future expenses, move the money out into a separate account you use only for that purpose.
Don’t worry if you have a few slip-ups. Looks at your line items again to see what you can reduce to make up for where you overspent – your budget should still total zero at the end of the month.
Does zero-based budgeting mean zero flexibility?
No, absolutely not. At any time, you can tweak how and where you allocate money throughout the month. Priorities and situations change, and your budget can and should adjust accordingly.
The best thing about zero-based budgeting is that you get to spend your money guilt-free. If you have allocated $100 to your restaurant fund for the month, then by actually spending that money you are simply sticking to your budget. Rather than feeling guilty, you can spend your money stress-free, safe in the knowledge that you’re only ever spending within your means.
Creating a zero-based budget is a powerful way to put you in control of your finances. You consciously decide exactly where and how you are going to spend every cent you make, which in the long run will help you to achieve your financial goals.
Zero-based budgeting is absolutely not about taking away your financial freedom. It’s about putting you in charge of your budget so that you can enjoy more of the things you love, without worrying about a nasty surprise at the end of the month.