While budgeting and forecasting are financial tools primarily used in businesses, you can also leverage them to take charge of your personal finances. Through budgeting, you can set financial goals you want to achieve in a given timeframe. Through forecasting, you can take note of your progress and make changes as needed. The goal is to build long-term wealth by developing a financial plan and executing on it.
We will go over what budgeting and forecasting entail and how to incorporate them into your daily life to set yourself up for financial success.
Key Takeaways
- While the budgeting and forecasting processes are commonly used in business contexts, you can apply these financial tools to your personal finances as well.
- Budgeting allows you to plan the direction of your financial journey, while forecasting helps you reflect and iterate on your expected performance. In simple terms, budgets provide targets for you to hit, while forecasts help you hit these targets.
- Without accurate budgeting and forecasting, it becomes harder for you to determine whether you are on track to reach your financial goals.
Budgets
Believe it or not, we all have a budget.
But, some people’s budget is their paychecks, whereas others track every dollar they spend. In simple terms, a budget outlines how you will spend your income over a specified time, such as a month or year.
Common characteristics of a budget may include:
- Estimates of expected income and expenses
- Expected savings rates
- Bucketing expenses into categories
- Detailed data on cash flows, financial standing, goals, etc.
- Remedial steps to stay in line with the budget
By creating a budget, you set expectations early on and summarize what all your goals are. Depending on how in-depth your budget is, you may use different tools to track it, such as Mint, Personal Capital, You Need a Budget (YNAB), or spreadsheets.
Currently, I use Mint to aggregate all my monthly expenses and then export the data into a custom spreadsheet to track the big picture of my financials, including expense categories, taxes, monthly income, investments, etc. While this may be a bit excessive for most people, doing this allows me to see exactly how much I am spending and prioritize my needs and wants better.
Having a monthly or annual budget helps you see how feasible your long-term financial goals are, whether that involves tackling student debt, saving for a home down payment, planning a wedding, etc. Budgeting creates a baseline to compare your expectations to your results, thus helping you gain more visibility into your performance over time.
As you start seeing how you are doing financially, you can iterate and make adjustments as needed. When I first started tracking my budget, seeing just how much I was spending on shopping every month helped me reprioritize where my money was going. Rather than constantly buying new clothes or shoes that just end up sitting in my closet, I now choose to spend more on experiences instead because I derive more joy from them.
While budgets are often static, you can put yourself back on track if you are not meeting expectations by comparing how far away you are from where you want to be. In my case, categorizing all my spending every month and comparing them month over month helped me recognize I was overspending in categories that were not making me happy. So, I adjusted my budget allocations to reflect my needs and wants better.
Types of Budgets
There are different budgeting guidelines you can follow, each with varying benefits and costs. Depending on your financial objectives and personal circumstances, you can mix and max to find the best solution for you.
1. 50/30/20 Rule
If you are a beginner, using the 50/30/20 rule is a great way to get started. This system divides your after-tax income into 3 simple categories:
- 50% of your income goes to needs
- 30% goes to wants
- 20% goes to savings and debt
Your needs are things that you cannot live without, such as rent or mortgage payments, groceries, healthcare, insurance, utilities, etc. Your wants are things that you can reasonably live without, such as concert tickets, vacations, video games, subscription services, etc. Savings includes your emergency fund, retirement accounts, or investment accounts, while debt is any high-interest debt, such as credit card debt.
Using this budget system, you should spend roughly half your income on needs, a third on wants, and a fifth on savings and debt. If you find yourself overspending and not having enough to save, it may be time to downsize your lifestyle or find areas to cut down expenses.
2. 80/20 Rule
The 80/20 budget is a straightforward system that takes a “pay yourself first” approach. When you get paid, you immediately put 20% of your income into your savings and investments accounts before spending the rest, or 80%. What is great about this system is that it is simple to follow and relatively easy to maintain. If your expenses end up being lower than expected, you can gradually increase your savings rate while steadily growing your net worth.
3. Envelope System
The envelope system is an old-school, hands-on cash approach to budgeting. The goal is to put spending limits on all your expense categories, such as rent, groceries, utilities, etc. To do so, you would put cash into different envelopes and mark them with a specific expense category, but you can use digital envelopes as well. By putting all your cash into envelopes, you instill discipline into your money habits and hold yourself accountable for sticking with your budget. Once you spend all the money in each envelope, you need to either move money around or wait until the next month to spend more.
4. Zero-Based Budgeting
Zero-based budgeting, or zero-sum budgeting, is a strategic but time-consuming process. Under this plan, you start from a “zero base” and then give purpose to every dollar of your income. With this budgeting system, you track where every penny of your money is going.
It uses this simple equation:
After-tax Income – Expenditures (Expenses + Savings & Investments) = 0
The goal is to gain visibility into all your expenses and learn how to prioritize your spending habits. That includes figuring out how much to budget for rent, groceries, student debt, entertainment, etc.
5. Value Proposition Budgeting
With value proposition budgeting, the focus is on spending purposefully. Whenever you want to make a purchase, challenge yourself to consider whether that expense provides enough value to justify the cost. The way I have incorporated this process into my budget is to spend money intentionally. It is not necessarily about being as cheap as possible, but about finding the right balance between enjoying what you have now and securing your financial future.
Forecasts
Financial forecasting works hand-in-hand with budgeting, but it draws from other sources of information to help determine whether your targets are achievable. In a business context, forecasting helps everyone see if the company will meet expectations for budgetary needs and give people the confidence to make strategic business decisions.
In the context of personal finance, your targets can vary depending on what you want to accomplish, whether that is saving for a home down payment, paying off student loans, or starting your own business. For example, one of my medium-term goals was to reach a $100k net worth by 24. So, at the end of every month, I aggregated all the data on my income, taxes, expenses, savings, investments, etc. to figure out how accurate my forecasted numbers are.
You can make both a short-term and long-term forecast as you can have multiple goals with varying timeframes. Some of my longer-term goals are purchasing real estate and saving for retirement. While I do not have any forecasts yet on when I want to retire or how much I will need to retire comfortably, I want to purchase my first property in the next couple of years. So, I have taken these types of future events into account in my forecasts for my projected net worth.
Factors you should consider when making financial forecasts include your expected income and expenses, financial situation, familial obligations, savings rate, personal and financial goals, etc. As the driver of your financial situation, you need to consider your circumstances to figure out the type of future you want and how you will get there.
Common characteristics of financial forecasting include:
- How your budget should get allocated in a given period
- Regularly updating your forecasts when there is a change in your life, such as starting a family or expanding a side hustle into a full-time business (capital expenditures)
- Short-term and long-term forecasts based on the timeframe of your goals
- Taking immediate action based on your forecasts
At a high level, forecasts are meant to give you a roadmap of how you want to reach your goals based on your previous and current circumstances. You do not necessarily need to go super granular into this process, but use it to provide a high-level overview of what you should expect your financial position to look like in the new few months or years as you plan for your future.
Key Differences Between Budgeting vs Forecasting
The key differences between a budget and a forecast are that a budget helps you plan what you want to accomplish, while a forecast gives you an insight into whether you are on track in your financial growth journey in a specific period. With a budget, sometimes you may set targets that are not possible, such as overestimating how much you can save or underestimating your expenses. A forecast allows you to consider all this information and make adjustments based on your targets.
Meaning
Budgets allow you to see where your money is going, which helps you gauge how realistic your goals are compared to your actual results in a particular period. For example, let’s say you want to use the 80/20 rule and save at least 20% of your income every month. But, you are spending every dollar you make. There is a disconnect here that should get addressed, whether that means cutting down on certain expenses or increasing your income.
Forecasting helps you model all these different scenarios and evaluate how feasible your plan is. If you decide to cut costs, then find areas of your spending where that is possible. For example, if you have a lot of subscription services, look into ones that you do not need. For example, last year, I cancelled my Amazon Prime subscription because I rarely use it and saved myself $100+.
Purpose
Think of a budget as the baseline for your expectations or an outline of the direction you want to take your finances. You should compare your actual results to your budget to determine how much money you are saving and spending versus how much you want to save and spend.
Once you have this baseline determined, you can use forecasting to plan for your future. Forecasts can serve as reports or strategic tools that indicate your growth over time.
Methodology
The purpose of a budget is to set a monthly or annual target for your finances. To figure out how these numbers should look, go through your bills to see what categories you are spending the most money in. Once you determine your monthly expenses, set a realistic target of how much you want to spend and save.
The purpose of a forecast is to understand whether you will meet the expectations you set in your budget. It analyzes changes in your circumstances and tries to account for unexpected events.
The Bottom Line
Though some may argue that forecasting is more useful from a strategic standpoint, forecasting and budgeting are not mutually exclusive. Both serve different purposes but work well together to give you a comprehensive picture of your finances. While the budgeting process provides granular targets set for you, the forecasting process helps you stay informed on your progress.
The goal is to boost your financial position and use these tools to aid you in your financial growth journey. Think of this process as training for a marathon. If you are a beginner, you need to research proper workouts to prepare you for the big race. Your training schedule acts as your budget, and your performance over time helps you better forecast your actual performance versus your expected future results. Without the insights on how your body is adapting to your training regiment, you cannot accurately predict your expected results for the marathon. Similarly, without a solid feedback loop, it becomes harder to track your financial journey.
