Zero-Based Budgeting

This original article was written by Amy Freeman for Budgeting.

Budgeting is hard. 50% of Americans have less than one month’s income saved for emergencies. Experts recommend at least six months. The problem, however, may lie with flawed budgeting advice.

Traditional budgeting methods ask you to examine how much money you expect to earn in a month and how much you expect to spend. It’s a formula ripe for failure as it’s full of guesses. Even progressive strategies such as envelope budgeting and the anti-budget system don’t always work.

The ultimate goal of budgeting is to have your expenses be less than your income, but traditional budgets don’t always tell you what to do when you have extra money in the budget. Even if you don’t go over budget, you can end up wasting excess cash and missing your financial goals. The zero-based budgeting system solves that problem.

What Is Zero-Based Budgeting?

Zero-based budgeting is different from a traditional budget in two significant ways. First, you assign every dollar of income a role. If you add up your income for the month and subtract your expenses and you somehow manage to have $250 left over, you need to find something for that $250 to do. It can’t just sit in your checking account for the proverbial rainy day. The goal is to have your income minus expenses equal zero at the end of each period.

You can use the “extra” money to pay off debt, add to your emergency fund, or grow your IRA or other retirement accounts. You can also use the money to purchase something discretionary. The important thing is that you give the funds something to do.

The other big difference between zero-based budgeting and traditional budgeting is the source of the money. You live off money you earned in a previous month or pay period rather than money you expect to earn that month. That means that in February, you are using money you made in January to pay your bills. Any money you make in February will be used in March.

What Are the Problems With Traditional Budgeting?

I’ve tried dozens of budgeting programs, but none ever worked until I switched to zero-based budgeting. Whether I was tracking my expenses and income by hand or using an online program like Mint, I always ended up going over budget in certain categories.

Although it might work for some people, there are a lot of issues with traditional budgeting that can leave many of us wanting or needing more.

1. Lack of Flexibility

Many budgeting programs have one space for income and expect you to earn the same amount each month. They only work if you always get a steady paycheck. If you don’t, major problems arise.

Another issue is that they assume the money you receive is yours to keep – that taxes have been taken out. As a freelancer, I’m responsible for my taxes, so I set aside a percentage of each payment to put towards my estimated quarterly taxes.

Although you can always create a category for taxes or other deductions, the systems are often inelegant. I could never get things to add up correctly using traditional programs and a category for taxes.

Additionally, many programs assume you have the same expenses each month and don’t give you the option for quarterly or annual costs. Plus, if you go over in one category, there’s no wiggle room or ability to allocate funds from a different category to make up that overage.

2. Your Human Brain

When it comes to traditional budgeting, your brain is often working against your financial goals. You get paid on the second Friday of the month, and for a brief moment, you’re flush with cash!

Budgets tend to fail because it’s difficult to see the financial forest for the trees. When your payroll deposit hits your account, it’s easy to think “I’m rich!” It’s even easier to spend it on a new outfit, a fancy dinner, or a vacation. You haven’t assigned your money a role or accounted for upcoming bills, so it’s too easy to spend it all at once.

Meanwhile, your electric bill, car payment, and student loan payment are all due in a few days. But since they’re not immediate needs, you’re not thinking about them until you’ve spent the money and it’s too late.

Alternatively, your brain can make you rebel against your budget. You get paid on Friday, you know your bills are due, and you feel cranky because you worked hard for the money but don’t get to spend it on fun things. So you revolt against the budget and go on a spending spree.

3. There’s No “Why”

Why follow a budget? Whether you use a traditional or zero-based budgeting program, having a reason to create and stick to a budget makes you much more likely to follow it. If you don’t know why you’re not spending money, it’s much harder to say no to excess costs.

Since you give every cent you earn a role when you create a zero-based budget, it’s easier to understand the purpose of the budget.

What Are the Benefits of Zero-Based Budgeting?

Since I started using a zero-based budgeting system, my financial picture has improved considerably. I’ve paid down a chunk of my remaining student loans while saving for retirement. There are several advantages to switching to this type of budget.

1. Breaks the Cycle of Living Paycheck to Paycheck

When you live paycheck to paycheck, you depend on future paychecks to cover bills and expenses. If your income changes, you’ll find yourself in a tight spot, possibly tapping into an emergency fund.

Before I switched to zero-based budgeting, I often found myself stressing out if clients paid late or if a check didn’t arrive on time. I didn’t have credit card debt, but I would use the cards to hold me over until my income arrived. Then I’d worry about paying those cards off and would often pull from savings accounts to cover any overages or late payments.

Since you use last month’s income to cover this month’s expenses, you no longer have to worry about late or nonexistent paychecks. Zero-based budgeting doesn’t eliminate the need to make money, but it does cut out some of the related stress. If you lose your job, your immediate expenses are covered, giving you a small cushion.

Making the switch from living paycheck to paycheck to using last month’s income for this month’s bills doesn’t happen overnight. It’s the biggest hurdle you come up against when changing from a traditional budget method to a zero-based budget.

There are two ways to stop relying on future income to pay current bills:

2. Allows You to See What You’re Spending

In the lead up to switching to a zero-based budget, track all of your expenses for a few months. This part of the process can be eye-opening. For example, I found out that I was spending hundreds more on groceries per month than I had budgeted, mostly over the course of trips to the supermarket to “pick up one thing.”

Once you see where your money is going, you can cut back in certain categories or spend more in other categories to help you pay down debt or save more.

3. Changes Your Relationship to Money

The biggest benefit of zero-based budgeting is that it completely changes your connection to money. I used to stress out about my finances even though I have savings and my only debt is a federal student loan. Since I’ve changed my way of budgeting, I now see the bigger picture financially.

Changing my budget has allowed me to take a more detailed approach to financial goals. I’m actively working on growing my savings accounts and paying off my loans.

Seeing what I was spending each month helped me cut back. I now eat out less and buy fewer non-essential items. If a surprise expense arises – such as a broken washing machine in need of repair – I can rest easy knowing that the money is available in an emergency account and that I won’t have to scramble to rearrange my budget to make up for an unexpected expense.

How Can You Make the Switch to Zero-Based Budgeting?

Switching to zero-based budgeting takes some planning. It gets easier once you start using last month’s pay to cover this month’s expenses, but don’t let a lack of savings keep you from trying it out.

1. Keep Track of Your Expenses and Spending

Before you start, have a clear idea of how you’re spending your money. Keep an accurate record of your purchases, savings, debt payments, and other costs over a period of a few months. The longer you track your spending, the easier it will be to see where your money is going.

You can use a traditional budget tracking program for this step, but I think it’s simpler and more effective to track by hand or use a spreadsheet. When you manually record your purchases and spending, you can see where the money goes.

Don’t forget to track expenses that don’t happen every month, such as car insurance, birthday gifts, and holiday purchases. If you have to track your taxes, gauge how much you’re setting aside.

2. Pay Attention to Your Income

For some people, the income part of zero-based budgeting is a snap. If you earn the same amount each month, just record how much you make.

If your income fluctuates – maybe you’re a freelancer or get paid on commission – you’ll want to give as much attention to your income as you do to expenses. One option is to use the average amount you earn per month as a baseline. If you earn more than usual in one month, create an “income overage” category and stash the extra amount for when your income is less than expected. That way you aren’t scrambling to cut your budget in months when your income is lower.

3. Create Expense Categories Based on Your Needs

Once you know where your money is going and how your spending relates to your income, start trimming and shaping your budget to meet your needs. Remember, the goal is to end up with zero left over at the end of each month, meaning your income minus expenses needs to equal zero.

Let’s say your average income is $2,500. Your housing payment is $500, your loan payment is $300, you spend $100 on gasoline, and $350 on groceries. Utilities come to $150 total. You have a $200 car insurance payment due every quarter, which works out to $50 per month. So far, $1,450 of your $2,500 income has gone to necessities, leaving you with $1,050.

Many people would spend the extra $1,050 per month on meals out, new clothing, and other luxuries. Now that you know how much you have to work with, you can focus on giving that extra money a chore. Perhaps you send $350 to an IRA each month, give yourself $100 for restaurant meals, and put the remaining $600 toward your loan.

Let’s say that you bring in an extra $500 during one month. It’s up to you to find a home for that money. You might put it in your emergency fund or make an extra contribution to your IRA. You can create a vacation fund or use the money to treat yourself.

Now, let’s say in a different month, your income is $500 less than usual. You’re going to have to make cuts. Luckily, since your necessary expenses are lower than your average earnings, reducing costs is less of a challenge. You can cut out restaurants that month and make a smaller payment towards your loans.

4. Make Your Budget Work for You

It’s incredibly important that you create a zero-based budget that works for you. Since the budgeting method is so flexible, you can tweak it to meet your needs.

For example, although there are tools available such as You Need a Budget, I’ve found that using a spreadsheet to track my finances is easiest. Each month, I total up what I earned the month before, then subtract taxes and savings to get my net income. In a separate section, I list my necessary expenses.

Below that, I have a section for flexible expenses, which change based on season, month, or income. I always hated having specific categories for spending, so things like restaurants, clothing, and personal care are all lumped into “miscellaneous.” If I have extra income for the month, I put it toward my student loan or add it to long-term savings or a vacation fund.

Figuring out a tracking system that worked was half of the battle, but now that it’s in place, sticking to a zero-based budget is a breeze. Since the money is already in my checking account before bills are due, I don’t have to worry that I’ll overdraft or miss a payment.


Final Word

Bad financial habits are easy. Changing your budget is hard. Give yourself time to switch over and to get used to living on last month’s income today.

People often assume that budgets are all about restrictions. The truth is that your budget should help you and be something you want to follow. Since it’s flexible, a zero-based budget can be the method that finally works for you.

Have you tried a zero-based budget? What budgeting methods have worked for you?