Zero-Based Budgeting: How to Make Every Dollar Count
Do you want to know where every dollar you earn goes? Give zero-based budgeting a try
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What Is Zero-Based Budgeting?
In 2021, Americans lost an average of $1,389 because they lacked sound financial knowledge. There are several components to financial literacy. Budgeting is one of them.
When you create a budget, there are several approaches you can take. Zero-based budgeting is only one of them, where you assign each dollar a job. After subtracting your expenditures from your income, you will end up with zero.
However, not every dime is spent. Yes, it includes expenses and debt repayments, but zero-based budgeting also accounts for the money you set aside for savings.
It's an excellent way to track where your money goes for each budgeting period.
Understanding the Zero-Based Approach
Being financially healthy means learning to manage a budget, but that's easier said than done. Zero-based budgeting is only one of several approaches, but it's worth considering if your goal is to see where your money goes each budget period.
It's also known as zero-sum budgeting, given that once you subtract your expenditures from your earnings, you'll end up with $0. Another reason why it's called zero-based is that you start your budget from scratch each month.
After several months, you can spot patterns in your cash flow. It'll be easier to see where you might need to manage your spending.
That said, it's not the most convenient budgeting strategy. For example, the 50/30/20 method is more straightforward but may not work for those with debt.
Zero-based budgeting makes it easier to consider debt repayment strategies like the debt snowball approach or the debt avalanche method. It's an excellent tool for tracking your expenses and increasing your savings.
How to Use Zero-Based Budgeting
Zero-based budgeting doesn't have to be complicated. It does require much patience and can be better suited for naturally detail-oriented people. However, even if that’s not you, zero-based budgeting can be a helpful method or a stepping stone in finding the right fit.
MoneyGeek detailed the steps you must take to apply zero-based budgeting. We covered the essential elements, such as considering your income, coming up with categories and allocating your expenses and other financial commitments to those categories accordingly.
In the end, there are only five steps to zero-based budgeting.
Consolidate and Establish Total Income
First, take stock of all your sources of income. If you're earning from multiple jobs, you'll have to include them. How much comes in each month will be the amount you'll allocate later, ensuring you don't spend more than you earn.
Track Expenses for a Couple of Months or Use Previous Month’s Record
Next, you need a clear picture of your monthly expenses. Ensure you track your expenditures for several months. This way, you'll know which ones are constant and whether or not you have variable costs. This step sets the stage for steps three and four.
Identify Necessities, Wants and Savings
From your list of expenses, categorize them as follows:
- Necessities (rent, food, utilities, tuition fees, debt payments, etc.)
- Wants (travel fund, things on your wishlist, etc.)
- Savings (401k contribution, savings account, emergency fund, etc.)
If you can, break these three broad categories down even further. It’s better to itemize expenditures under each category. Remember, the more detailed you are, the easier it will be to manage.
Allot for Each Category
When allotting your income, prioritize your necessities and financial goals. For example, you can allocate a considerable amount to your savings if you have a big purchase on the horizon.
Remember, whatever amount you allot is how much you can spend in each area for the coming month.
Spend Accordingly Until Your Budget Equals Zero
Doing steps one through four ensures you have your limits ready by the time the next month begins. It's best to keep your expenditures within your allocations. However, should there be any unexpected costs, don't forget to add a category and update your budget. At the end of the month, you can do a quick review to ensure that you are effectively budgeting toward zero.
Using Zero-based budgeting to manage your monthly expenses allows you to spot patterns. Over time, you can see from which category you spend the most. From there, you can adjust your allocations for the following months.
There are also short-term advantages. For example, if you have a medical emergency, you can quickly adjust your budget to accommodate it. Of course, it means taking funds from other areas (usually your wants) to end with zero. You may have to shift your allocations around, but it'll help you avoid spending more than you earn.
Zero-Based Budgeting in Practice
There's no better way to understand zero-based budgeting than seeing how it applies in real life.
Let's look at Rich, a 35-year-old project manager planning to propose to his long-time girlfriend. Here's how he uses zero-based budgeting to achieve his financial goal while meeting all other financial obligations.
Step 1
Figure out your total income
Rich works full-time as a project manager for a petroleum company. He brings home $5,000 a month. On weekends, a side hustle adds another $1,500 to his income. Although he's been able to live off his earnings, he wants to ensure he can save enough money to buy an engagement ring for his girlfriend.
Step 2
Review your expenses for the past months and categorize them accordingly
Looking at his expenses for the last three months, Rich determines that his current budget is the following:
Necessities
- Rent: $1,500
- Food: $500
- Utilities: $800
- Auto loan debt: $900
- Credit card debt: $750
Wants
- Eating out: $700
- Weekend expenses with friends: $1,150
Savings
- Retirement plan: $200
Step 3
Be clear about your financial goal
He has his eye on an engagement ring that costs $4,000. Rich decides that zero-based budgeting is the best method for saving enough money without neglecting his other financial obligations.
Step 4
Allocate your income to your expenditures
To put more money into savings for the ring, Rich adjusts the amounts allocated to each category. Keep in mind that his necessities remain the same. Now, his budget is as follows:
Expenditure | Original Amount | Adjusted Amount |
|---|---|---|
NECESSITIES |
|
|
Rent | $1,500 | $1,500 |
Food | $500 | $500 |
Utilities | $800 | $800 |
Auto Loan Debt | $900 | $900 |
Credit Card Debt | $750 | $750 |
WANTS |
|
|
Eating Out | $700 | $250 |
Weekend Expenses with Friends | $1,150 | $400 |
SAVINGS |
|
|
Retirement Plan | $200 | $400 |
Engagement Ring (new) |
| $1,000 |
Total Expense | $6,500 | $6,500 |
Total Income | $6,500 | $6,500 |
End-of-Month Budget | $0 | $0 |
Step 5
Stay within your limits and repeat the process each month
For the next four months, Rich ensured that he kept to the allocated limits of his zero-based budget. He was able to buy the engagement ring in the fifth month. Rich then revisits his budget and reallocates his income since he now has more available funds.
Benefits and Drawbacks
There is no perfect budgeting tool. Like all other methods, zero-based budgeting comes with advantages and disadvantages. Looking at it from both angles can help you determine whether or not it's something that'll fit your unique financial situation.
- It creates transparency. You'll have a better idea of your household's cash flow. Zero-based budgeting requires you to note every dollar that comes in and out. It'll give you a better picture of where your money is going and allow you to spot spending patterns over time.
- It’s flexible. Unlike other budgeting methods that use the previous month's figures as a basis, you start from scratch each month. It allows you to allocate varying amounts to different areas each time. Even if your income changes, you can adjust your budget.
- It prevents overspending. Your monthly earnings dictate the total amount you have to work with. You'll never spend beyond your income if you diligently stay within your budget.
- It allows you to make immediate adjustments. Expenses tend to fluctuate each month. Diligently tracking your spending may seem tedious, but it allows you to make real-time adjustments. It comes in handy if there are sudden expenses you didn't account for from the previous month.
- It considers your financial goals. You have the freedom to allocate how much you can spend for each category (necessities, wants and savings). That means you can assign a higher figure to items that will lead you closer to your financial goal.
- It takes up a lot of time. Creating a zero-based budget isn't as straightforward as other budgeting methods. It's not a matter of dividing your income into equal parts. The more detail, the more you get out of your budget in the long run.
- It doesn’t work well with variables. Although zero-based budgeting allows for flexibility, it works best if your income and expenses are constant. Since you're basing next month's budget on this month's expenses, this approach doesn't account for variables.
- It’s not ideal for first-time budgeters. Zero-based budgeting is typically better suited for advanced budgeters. Approaches like the 50/30/20 or the envelope budget may be better for beginners. You can transition to zero-based budgeting if you've gained more experience and are more comfortable creating and maintaining budgets.
- It requires discipline. To reap the benefits of zero-based budgeting, you must carefully track all movements of your funds. It includes calculating your take-home pay to listing all your costs. And you do this for the entire month, not just at the beginning or the end. A great deal of discipline is necessary to make it work.
Is Zero-Based Budgeting a Fit for You?
Only you can determine whether or not zero-based budgeting will work for you. Remember, although it offers many benefits, it's not for everyone.
If you're detail-oriented and won't mind the amount of tracking required, it's a solid option for a budgeting tool. However, if you're attempting to budget your money for the first time, you might find it too complex and labor-intensive.
Budgeting regularly and consistently brings the best results, so it's best if you can stick with your budgeting method of choice for the long run.
Zero-Based Budgeting FAQ
Zero-based budgeting can sound intimidating, but it might be an approach that fits your needs. Here are some commonly asked questions MoneyGeek gathered if you need more information.
Expert Insights on Zero-Based Budgeting
Consider an industry leader's perspective if you still have questions about zero-based budgeting. MoneyGeek gathered responses from subject-matter experts about how this budgeting method applies to everyday life.
- How does zero-based budgeting compare to a more traditional budgeting method?
- Does zero-based budgeting work better for specific consumers? Who and why?
- What challenges do consumers usually face when using zero-based budgeting?
- What advice can you offer to consumers so they can successfully use zero-based budgeting to manage their finances?
CEO of The Annuity Expert
Founder & CEO of Seniors Life Insurance Finder
Co-Founder & Technical Lead at Fig Loans
Strategist at Awning.com
Related Content
Budgeting is an essential aspect of maintaining good financial health. Fortunately, there’s no lack of online resources if you want to learn more about it. MoneyGeek recommends the following pages to deepen your understanding of financial literacy and how it affects various scenarios.
- Are You Financially Literate?: Financial literacy is a useful skill. MoneyGeek shares several ways to make better use of your funds.
- A Financial Literacy Handbook for All Life Stages: Your financial obligations change as you age. MoneyGeek’s guide shows you what to expect at different life stages and how to deal with them.
- 11 Ways to Start Saving Money: It’s never too early to start saving. Setting money aside means cutting your expenses. Here are several creative ways to lower your costs.
- Managing Personal Finances, Taxes and Savings as a Freelancer: The gig economy has made freelancing more popular than traditional nine to five jobs. However, because your income may not be as constant, you’ll need to manage your finances differently.
- How to Manage Your Money When You’re Unemployed: Being unemployed can be challenging for managing money, but there are ways to remain in good financial health. Review MoneyGeek's money-managing strategies while unemployed.
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sources
- Annuity.org. "47+ Fascinating Financial Literacy Statistics in 2022." Accessed October 10, 2022.