Putting your money on work is one of the best ways to maximize your financial potential. Whether you're making six-figure annuals or a minimum wage, every dollar you bring in is an opportunity to make more.
However, strategically allocating your finances is not just about getting money into your investment accounts. It's also the best way to plan and save the things that matter most to you, like a Bali vacation or a down payment for a new home.
Zero-based budgeting is one of the most popular ways to do this. Read on to find out if this strategy is right for you.
What is Zero-Based Budgeting?
Zero-based budgeting, also known as zero-sum budgeting, is based on the principle that every dollar in your budget should be categorized. At the end of the month, a zero-based budgeting system tells you where 100% of your income has gone.
The difference between a regular budget and a zero-based budget is that a traditional budget leaves leftover money in your checking account. A zero-based budget would require you to use these additional funds for savings, debt settlement, or some other goal. If productivity, efficiency and structure are important to you, this system may be exactly what you are looking for.
Mapped Out Money's money trainer Nick True and his wife Hanna have been using a zero-based budget for seven years. Using that budget has forced them to spend their money better reflecting their goals.
"A zero-based budget has helped us be efficient with our money and consciously spend it in a way that reflects our values," he said.
How to create a zero-based budget
First, make a list of all the categories in which you spend money each month. These can be:
Debt including student loans, credit cards and personal loans
Utilities and Internet
Health insurance and medical expenses
Subscriptions and memberships
Gifts and charity
Then decide how much you want to allocate for each particular category. Use your monthly credit card and bank statements to estimate a realistic number.
One of the characteristics of zero-based budgeting is that you use your last month's income to determine how much you can spend. This way, you are only using money that is already in your bank account and not relying on a future paycheck. For this reason, zero-based budgeting is especially helpful for variable income consumers.
When you've written everything out, subtract the expenses from the income. On condition that your expenses exceed your income, you will need to revise the budget to bring costs down.
If you have any money left, you need to put it into a category. If you don't, you're more likely to spend it on something minor than on a long-term goal. This is the essence of zero-based budgeting.
How to Implement a Zero Based Budget
Now that you've created a budget, it's time to start tracking and categorizing your expenses. It's best to do this every day or at least once a week as it can get overwhelming if you wait longer. Find a routine and schedule that you can easily stick to.
If you continue to spend too much in a particular category, stop and see if you need to increase the amount in that category – or find ways to remove the temptation.
You should also remember that a zero-based budget is not static and that you should change the budget if necessary. For example, when Christmas is approaching, you may want to allocate more money in the gifts category.
How does it compare to other budgeting methods?
A zero-based budgeting system may require more maintenance and care than other types of budgets. Since you have to give every dollar a job, you also have to keep track of every dollar that you spend. This can be time consuming and frustrating.
If you have unexpected expenses in a zero-based budget, it is time to revise your budget or use your savings.
"For example, I recently had to take my cat to the vet and the bill was more than I currently had in my Pets category," said True. "So I moved money from clothing and food to the pets category to cover it for the month."
Since you need to classify every transaction, with zero-based budgeting you have to grapple with how much you are actually spending. If you continue to spend too much on take-out or random purchases on Amazon, your budget will let you know. You can't hide your spending habits from a zero-based budgeting system.
Other budgeting systems
If a zero-based budget is too confusing or difficult to set up, here are some simpler alternatives:
The 50/30/20 budgeting method developed by Senator Elizabeth Warren is a simple budgeting system that works well for beginners.
This method divides your monthly income into three categories: 50% for needs, 30% for needs, and 20% for saving / debt settlement. When you conduct a transaction, you classify the item as a need, want, or saving / debt settlement.
The 50/30/20 system is easy to use as there are so few categories that leave room for personalization and improvisation. It is a good choice for someone who wants to budget regularly but finds zero-based budgeting too burdensome or too restrictive.
The cash handling system involves the use of physical cash to pay for all eligible expenses. You decide how much you want to spend and withdraw the funds from your bank account, then divide it into envelopes marked with the category name.
For example, if you set aside $ 500 for groceries, you would withdraw $ 500 in cash and put it in an envelope labeled "Grocery." That $ 500 should last you for the rest of the month. If you are going to spend it before the month is up and still need groceries, you will need to take money from other categories, dive into your savings, or find a way to make more money.
This system is great for those who prefer a more analog approach or anyone who needs extra help avoiding over-spending on certain categories.
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Zina Kumok (114 posts)
Zina Kumok is a freelance writer who specializes in personal finance. As a former reporter, she has covered murder trials, the Final Four, and everything in between. It has been featured in Lifehacker, DailyWorth, and Time. Read how she repaid $ 28,000 in student loans at Conscious Coins in three years.