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Budgeting gets a bad rap. But when you start to think about it as a tool you can leverage to meet your financial goals, budgeting can be helpful, exciting — and maybe even fun.
The trick with budgeting is to find a strategy that works for you. Zero-based budgeting is one popular strategy that assigns a specific purpose to every dollar you earn, whether that’s paying a bill, bulking up your emergency fund, or shaving down debt.
Continue reading to learn more about zero-based budgeting, its pros and cons, and how it works.
What is zero-based budgeting?
Zero-based budgeting is a money management strategy in which your income minus expenses equals zero. That doesn’t mean you’re not saving, though. With this framework, savings, investments, debt payoff, and other financial goals are considered “expenses.”
With zero-based budgeting, you start by totaling your monthly income. Next, you add up all your expenses — regular and irregular — and categorize them how you want. For example, you might have categories for things like household supplies, transportation, and bills. You’ll also create categories for any discretionary spending and financial goals, such as investing for retirement or saving for vacation.
A zero-based budget then involves divvying up all of your monthly income among these different spending categories. To be a zero-based budget, your total outflow must equal your inflow.
A zero-based budget can change month to month, or as often as you need. But it does require you to track your spending — whether by hand or with an app — to make sure you don’t spend more than you have.
Zero-based budgeting example
To get a better idea of how a zero-based budget could look, check out the following example for someone who takes home $5,000 per month:
When setting up a zero-based budget, you may have to play around with your expenses to make sure your budget zeroes out. If, for example, you have $1,000 left after assigning a spending target to each category, you’ll have to distribute that $1,000 across your budget. Maybe you add $500 to your monthly investments, $300 to your vacation fund, and $200 to your dining-out category.
You can also redirect any extra money however you want each month. For example, say you spent $50 less at the grocery store than you planned. You may decide to add $50 to next month’s grocery budget — or put that money toward another goal, like your vacation fund.
Read more: Fixed vs. variable expenses: Key differences and how to budget for each
Zero-based budgeting vs. traditional budgeting
There are endless ways to budget, and zero-based budgeting is just one strategy. But it differs from traditional budgeting in a major way: It requires you to allocate every dollar you earn and address overspending as it happens.
With a traditional budget, you make projections of how you intend to spend your money. For example, the popular 50/30/20 method of budgeting suggests you spend 50% of your income on needs, 30% on wants, and 20% on savings goals. But it doesn’t put parameters around spending in specific categories. Nor does it account for months where you operate outside of that rule. For example, if you only spend 20% on wants one month, what happens to the other 10%? With a zero-based budget, you make sure any “extra” income has a purpose and plan.
Another major difference between zero-based budgeting and traditional budgeting is that zero-based budgeting accounts for everything. It requires you to analyze your spending and break everything down into a monthly expense. Rather than hoping your estimated transportation budget can cover you for the month, you have to break down these costs and build your budget accordingly. And if you ever fall short in any category, you have to allocate money from another to cover the difference.
Pros and cons of zero-based budgeting
Before creating a zero-based budget, consider the following pros and cons of this strategy:
Pros
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It eliminates mindless spending. A zero-based budget forces you to be honest about your goals and priorities and cut out what you don’t want or need.
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It reduces surprise expenses. Breaking down irregular expenses into monthly goals means categories such as gifts, insurance premiums, and oil changes don’t catch you off guard.
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It’s adaptable. If you overspend in one category, your budget isn’t broken. You can cover that overspending with money from another. You can also change your budget categories and allotments as often as you need.
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It’s customizable. There aren’t any rules for how much you should spend on each category, so you can create a budget for your unique situation.
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It keeps you accountable. Budgeting your expenses so they equal your income means you won’t spend more than you have.
Cons
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It’s time-intensive. Creating and sticking to a zero-based budget may take more time and effort compared to other budgeting methods and requires consistent expense tracking.
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It can feel restrictive. When you put so many parameters around your spending and saving, your finances may feel tight — even if they’re not.
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It’s harder to use if you have irregular income. If you don’t earn a steady paycheck, a zero-based budget may involve even more work and month-to-month tweaking.
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It’s not easy to set up. If you want your budget to work, you have to build in irregular expenses. This involves a lot of up-front work and an audit of your annual spending.
How to create a zero-based budget
Creating a zero-based budget doesn’t have to be hard, but it does take time. A money management tool like Quicken’s Simplifi app can do a lot of the work for you.
Hot tip: Yahoo Finance readers can try Simplifi free for 90 days. Act now!
The following steps can help you create a zero-based budget that works:
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Add up your income. Include any W-2 income, freelance or business income, and anything else you earn each month. If you have irregular or inconsistent income, figure out how much you earned on average each month during the previous year.
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List your expenses. Look at previous bank statements to get an idea of how and how much you spend each month. In addition to regular monthly bills and expenses, include irregular expenses that pop up throughout the year. Remember, your “expense” category should include everything you want to spend money on — including savings and investments.
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Categorize your expenses. Categorize all your expenses in a way that makes sense to you. You can start with bigger buckets, like needs, wants, and savings. Your categories should be specific enough to help you plan and prioritize your spending, but not too specific that they overcomplicate your budget.
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Assign a portion of your income to each category. Based on your historical spending, figure out how much money you’ll spend in each category every month. Some of these categories — like bills — have fixed amounts with no wiggle room. Others, like savings goals, can be flexible and may depend on how much money you have to work with.
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Make sure your income minus expenses equals zero. Play around with your budget until all of your categories have an assigned amount, and your income minus expenses equals zero. It may take some trial and error, and you might have to prioritize certain categories — such as bills or debt payoff — over discretionary spending.
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Track your monthly expenses and reallocate any money as needed. Throughout the month, track your expenses within each category. (A zero-based budgeting app makes this much easier). If at any point you overspend within one category, make sure you cover the difference with money from another. For example, if you spend $40 extra on groceries, you can cover it by cutting $40 from your clothing budget.
Read more: How the 52-week savings challenge can help you save $1,300 in one year