What is the advantage of zero based budgeting?
When it comes to budgeting, most of us have a pretty general idea as to what that means. In fact you might have a simple traditional budget where you set spending targets on certain categories, like groceries. When you’re over budget, well, you might remedy that by spending less next week (if you can get away with it). But where did that “over budget” money come from? Without a zero-based budget you’ll never know! Importantly, if you ignore those over budget expenditures, you’ll almost certainly end up with unexpected pinches in other categories, or even taking on unwanted credit card debt.
What is zero based budgeting?
Simply put, the process of zero based budgeting starts with your income. The idea is you have some number of dollars that come in via your income. You then prioritize how to spend those dollars until every last dollar has a role in the budget. In other words, every dollar is accounted for, until you have none left to budget, thus “zero-based”!
When setting up zero-based budgets from scratch you’ll want to think about all of your various monthly expenses like rent or mortgage, utilities, cell phone, internet, groceries and on and on. Once you have your list of expenses, it is a good idea to think about them in terms of priority. For example, the expenses that cover your basic needs like shelter and food are probably more important than your entertainment or “fun money” categories.
Once your prioritized list is complete you’ll start allocating money from income to those expenses, working your way down from highest priority to lowest. Try not to get too caught up with making the perfect list, prioritizing every expense is hard it’s a good idea to have only three priority levels: must haves, nice to haves and totally optional (or something along those lines).
You’ll most likely run into some situation during the budgeting process where you realize you can’t cover everything you want to. Welcome to a real budget! One of the nice things about this strategy is that if forces you to look at your spending and how you could be cutting costs. So don’t be surprised if you find yourself asking these types of questions: Do I really need to spend this much at the coffee shop every week? Are we eating out too much?
By the end of this exercise, you’ll know exactly what you need to cover your monthly expenses. You’ll probably groan about it at first, less dining out, waiting for Netflix instead of going to the theater. But don’t worry, every successful budgeter has been there. Almost all unwanted debt is the result of spending income indiscriminately without any knowledge of what you can actually afford, or the result of getting hit with a big unexpected expense. The zero-based budget we’ve discussed so far let’s you answer the question of, “can I afford this and still have enough for my other upcoming bills?” But what about the unexpected medical bill, or mechanical failure with your car? How do you make sure those big unexpected expenses don’t send you into debt? Well, it’s all about having a rainy day fund.
The rainy day fund
The biggest budget killer is the unanticipated BIG expense. I took my car in for inspection expecting a $30 charge. (In some states you can’t drive legally without having a valid inspection sticker on the windshield, which means getting your car inspected by a qualified mechanic.) Little did I know, my tires needed to be replaced to pass the inspection. Thirty dollars suddenly became $850. Ouch! That will blow a whole in any budget. Unless, of course, you have prepared by also funding a rainy day fund, or what some call an emergency fund.
I know what you might be thinking, how can I put money into a rainy day fund if I’ve allocated all my income to cover my known expenses? You can’t! But do you see where this is going?
We really only have two choices, we have funds we can draw on for emergencies, or, we borrow in an emergency. Hopefully you have a rich uncle, if not, you’ll “borrow” from your credit card.
This is where the rainy day fund comes in: as you’re allocating your income to cover your expenses it is a really good idea to ear mark some of that income toward a rainy day fund. At first, just try to save up $1,000, this will help you absorb many unexpected irregular expenses. Once you reach that milestone, you can get more ambitious and try to save up three or even six months of your salary.
Allocating that extra money to the rainy day fund might force you tighten your belt a little more. But it’s like insurance, you don’t need it until you really, really need it. In this case, it can make the difference between slipping into unwanted debt versus just being able to roll with the punches.
Zero-based budgeting and the envelope system using Banktivity
We often see “zero-based budgeting” and “envelope budgeting” conflated as the same thing. However, technically they are two separate systems, but they go together like PB&J. With an envelope system setup with a zero-based method of budgeting strategy, you’ve prioritized how you will spend your money and you’re able to move money between envelopes if needed.
Here’s a sample of the flexibility you get with envelope budgeting . Say you’ve budgeted $600 for the month for groceries, and the last two months you’ve been killing that budget, spending only $500. So before your next paycheck comes along, you have $200 already in the grocery envelope. When you get paid you have the option to distribute the full budgeted amount ($600), or top off just what’s needed ($400) and put those extra dollars in different envelopes, like a rainy day fund.
Or here is another way the example can play out. You are still doing great with keeping under budget for groceries, but let’s imagine you find you overspent on your budget for on demand movies…too many good movies rented last weekend because not everything is on Netflix! With the envelope system, no worries, simply move the extra cash from your groceries envelope, and pay off that deficit from your movie binge. No need to even touch your rainy day fund!
Personal finance software makes all of this very easy to set up and manage. By categorizing all of your expenses and income, you’ll quickly see at a glance the envelopes you’ll need to fund in your budget. Banktivity’s envelope budgeting feature allows you to quickly see where you are at any time, and what might be underfunded by the month’s end.
No guesswork, no physical envelopes in your sock drawer that you need to shift dollars to and from. You’ll find yourself in total control of every dollar (and subsequently less stressed) at any time during your paycheck cycle when use a zero based budget in an app like Banktivity.
Are you ready to give it a try? If you’re needing more resources on the topic, check out our other Personal Finance 101 article on envelope budgeting, and attend our free webinar class Mastering Envelope Budgeting. Within a few months you’ll be seeing the impact.
Do you have a zero based budget? If so we’d love to hear how you’re doing.