What is a zero based budget and why is such a key idea when it comes to achieving your financial goals?
Let’s say that you estimate your income (after tax and other payroll deductions) for next month will be $5,000. When you create a zero-based budget for that month, you will decide in advance how you will allocate the whole $5,000. Your budgeting will account for every dollar.
At first glance, this might seem illogical. If you spend the whole $5,000, will that mean that you have nothing left to put into your savings?
No. The point is that part of your $5,000 ‘spending’ should go towards building your savings. You need to use savings as one of your budget categories.
There’s the big picture and the detail. It’s important to see the big picture first. The detail can come later.
The book ‘All Your Worth’ introduces another key concept: 50-30-20. The authors recommend that you divide your zero based budget into three major categories. (There’ll be further detail within each budget category).
If we use those percentages with the $5,000 example, that gives:
Bear in mind that 50-30-20 is a rule of thumb. The percentages don’t need to be spot on. But they give you a guideline, something you might want to aim for.
Most people think of budgeting as concerned with curbing their spending. But it’s more than that. There’s an equal focus on your income. Zero based budgeting is deciding in advance how to spend your earnings.
I’ll be covering 50-30-20 in more detail in another article. For now, though, bear in mind a couple of points about how 50-30-20 deals with debt repayments.
Necessities includes your minimum monthly debt payments.
Savings includes making extra debt repayments on top of your minimum monthly payments. In effect, ‘savings’ is shorthand for putting money towards your building your long-term wealth.
You don’t wait until the end of the month to see ‘what’s left’ and treat that as your savings. Instead, you decide ahead of time that you will save, say, 20%. And you can pay the 20% into your savings or investments at the start of the month.
If you think about 50-30-20, you can see that when you spend the 50% (necessities) and 30% (fun), your money is going into the bank accounts of other people. For example:
Necessities include:
Fun/Wants include:
On the other hand, the 20% savings is, in effect, paying yourself. This money stays in your bank account (or in your investments).
When you first start budgeting, setting up these budget categories - and tracking your spend - can seem daunting. Don't let this hold you back. If you want to take some initial small steps towards your financial goals, check out my guidance on the disadvantage of zero based budgeting.
Another key point with zero-based budgeting is that you stop buying on credit. The exception might be if you want to purchase a house. Many people who have learned out to get a grip on their finances no longer use credit for their regular monthly spending.
Why?
Because zero based budgeting means living within your means: your income. One of the big problems nowadays is the availability of easy credit. There are three issues with credit:
The one caveat is your credit rating. I’m not dealing with this in detail here but, if you want a good credit rating, you need to consider the pros and cons of holding some level of consumer debt.
Zero based budgeting may sound like a neat idea, but is it practical? I’ll be covering this in detail in another article. Just a few words here. There are some issues you’ll need to deal with:
For large payments like holidays, 30% of one month’s income (your Fun category) most likely won’t be enough. Let’s say you estimate you’ll spend $3,000 on annual holidays, and that your monthly income is $5,000.
Unexpected bills are a bit different. We’re pretty sure they will arise, but we don’t know the timing or amounts. The strategy for these to build an ‘emergency funds’ saving account.
There are two possible strategies to use here. (I’ll cover this in more detail in a further article).
One idea is to work out your average earnings per month, or take your lowest earnings in a recent month, and base your budget on that figure. An additional technique is to apply percentages to your income when it arrives.
Remember, you use zero based budgeting to decide in advance how you are going to spend (and save) next month’s income. The aim is not to buy on credit, but to ‘live within your means’. If you’re just starting out, this may sound tough – or it may sound exciting. Either way, it’s one of the budgeting strategies to help you achieve your goals and dreams.