The 50/30/20 Rule of Thumb for Budgeting
We have all been in a bad place financially, where we had to live paycheck to paycheck. It is either when you’re young and you have not had the time or experience to learn how to setup your finances so that they work for you. And it happens when you’re in a bad financial situation, because of unexpected health issues, family emergencies, or a financial crisis.
However, it comes a time in all our lives for when we see ourselves with a little bit more money than we need. It is the time to decide if you want to be smart with your money.
And you know there is only one decision a smart person would take.
In fact, while there is some correlation between how much money you have or earn and the need to budget, there is no bad time to become smart with your money. It is never to early and it is never too late for good decisions.
Read this article to the end in order to learn one way to budget smart.
STEP #0 TRACK
The first rule before you can become smarter about your money spending is to learn how bad you have been spending so far.
You need to know what you have spent for the past one here at least.
Make sure you reveal the money that has gone into or out of your accounts for the past 12 months at least. Consider all of your bank accounts. You want to track every cent that has entered or left your accounts. Every cash payment. Every currency exchange while you were travelling. You want to know all about your bank taxes, ATM fees, how much you tip in restaurants, and how much money your grandmother gave you for your birthday in your birthday card.
Now you need to categorize your spendings:
- By purpose. How much do you spend for entertainment? How much do you spend for rent? How much do you spend for education? How much is the payment on your credit cards monthly? How do you spend for cat food? How about the vet? How about travelling? How about Christmas gifts?
- Repetitiveness. Some payments are due once a year – your taxes, your yearly checkup at the doctor, anything subscription based. Some, you do monthly – the rent, you gym subscription, etc. Weekly payments – grocery shopping, gas, etc. Some spendings are one-time only.
- Importance. You probably cannot live without paying your rent and it is not smart to miss doing your credit card payment. You probably don’t want to save on cats food, for the sake of the little monster. But as much as you want to see that movie, tickets for the cinema are probably not an essential expense.
That is the basis of becoming a smart spender. You want to be able to predict what payments you will have to do this month. And you want to be able to prioritize your payments so that you know what part of your budget is essential for your living and what part is just for your lifestyle.
It may sound complicated in the beginning. It may sound like a task you will never compete, but now there is an app for that. Depending on how scattered your finances are, you might meet up to four hours to enter, categorize and analyze your every expense. Your apps will show you information in a way it’s easy to comprehend – in charts and graphs you will find it is very simple to think about your finances when you have the visuals of your statistics.
STEP #1 ‘INCOME’ ANALYSIS
It is not necessary that the amounts that enter your bank account represent the accurate amount of your income.
To calculate your real income amounts you need to take out all taxes. Income taxes are obviously unnecessary payments to do, but we will not add them to the ‘needs’ category. The way will think of taxes, those are not actually your money to spend, those are the government’s.
Have in mind that this rule only applies to income taxes. The tax on your car or property Will be added to your budget because you do have a say in them – if you buy a more expensive vehicle or more expensive house, your taxes will be higher. That is why, you need to have those expenses in mind and they will be included in your budget.
The next thing that you need to do, is to check if any health insurance payments or retirement contributions are taken out of your paycheck by default. If they are, put them back in – add them to your income-after-taxes. The reason is we consider contributing to your health insurance or your retirement to be in the ‘savings’ category.
If your government or your employer is already sensible enough in order to make those payments mandatory for you, that still means that you have the situation taken care of so you are allowed to boost up your total income with these amounts.
Yes, we’ll later include them in ‘savings’, but since of this budgeting is reliant on percentages, adding those payments back into your income will increase your spending abilities for ‘needs’ and ‘wants’.
If you’re self-employed, your income should be equal to your gross income, from which you take out your business expenses:
- Conference fees
- Travel and hotel
STEP #2 ‘NEEDS’ ANALYSIS
Open your budget app or spreadsheet and revise your categories per purpose. Your mandatory payments should be your ‘needs’.
The budget you are allocating for your needs must not exceed 50% of your income. Those include:
- Rent or mortgage
- Health insurance
- Car payment
- Car insurance
- Expenses for your children
- Expenses for your pets
Why those categories and not others? How do you know if you should add more or remove some?
As far as the car payments are concerned: if you are buying a car, a down payment for the vehicle should not be considered a need. You are supposedly always capable of choosing a more affordable car before you have signed a contract. However, once you’re already engaged legally, your car payments become your debt and your debt is a ‘saving’. Unless you pay for your debt, you might hurt your credit score. What is a ‘need’ is gas and mechanical repairs.
If we considered the expenses for your pets, those could be ‘wants’ or ‘needs’ as well. If you’re thinking of buying a cat, that would be a ‘want’, it is not a bad idea to include all expenses for a three months period. Once you have gotten the little creature, you have to feed it and take care of it. Expenses for it become a must. You are responsible for its well-being. If it becomes too much for your income, however, you have to consider giving it away to someone who can care for it better.
How do you know it’s too much? According to the 50/30/20 rule, your ‘needs’ should not exceed 50% of your income.
Have a look at your budget app or your budget spreadsheet. What percentage do you needs take up currently? If you go over 50%, check your categories for importance. From your ‘needs’ you could probably cut some expenses in the following ways:
- Spend less on groceries. Be more cautious about the pricetag in the supermarket. Look for a coupons and deals.
- You can downgrade to a smaller apartment with more affordable rent.
- You could downgrade to an older car with a more affordable payment plan.
STEP #3 ‘WANTS’ ANALYSIS
According to the 50/30/20 rule, your wants should not take more than 30% of your total income.
Now, an important clarification is due. Do not mistake ‘wants’ for ‘lavishness’.
How to make the difference between ‘needs’ and ‘wants’?
Any payment that you can skip on without any significant consequences for your financial situation further on, is not necessarily classified as a need. For example, you cannot really skip on your rent or you will live on the street. Rent payments are not a ‘want’ they are a ‘need’.
At the same time, there will probably be some consequences if you skip on your cable monthly fee. But also, you can probably go with out watching cable news if you have the Internet. Then you can watch the news on your computer can’t you? Again, that will only be needed if you happen to need to cut your expenses in order to meet the 50% or 30% quotient.
How to make the difference between ‘wants’ and ‘lavishness’?
Okay so this is the more difficult one. Let’s say that ‘wants’ are expenses that you can skip and still live your normal life, but you have a very heavy decision factor in those purchases.
For example, winter is coming, and you need to buy some warm clothes. You can probably use last winter clothes, but you sort of feel you need a wardrobe change. Perhaps, you can go about buying two sets of clothes and two sets of shoes. But you can goal without buying more even if you want to, even if your friends want you to shop with them, even if you feel the colors of the clothes you currently own are ‘so last season’.
You need to be very smart about your vacations. Those could sometimes qualify as a ‘want’. But most times, when it comes to vacation people feel they deserve it and they do tend to spend more than they have to. Just because it’s a big expense than you are used to spending on entertainment every month, does not mean that you have to make it bigger than it has to be.
STEP #4 ‘SAVINGS AND DEBT’ ANALYSIS
Credit card payments are neither ‘wants’ nor ‘needs’.
At least 20% of your income should go into saving money and repaying debt. Now, those are not necessarily mutually exclusive. Let’s say you have a student debt for which you need to pay €200 every month. However, the 20% of your net income actually amounts to €500. Do you need to use the €200 to repay your debts, and save €300? Or should you put in the entire amount of €500 so that you repay your debts faster and save on interest on your credit?
It is a complex question. You need to consider the following factors:
Is there a penalty interest or tax for repaying your debt earlier? Talk to your account manager at your bank and ask what it will cost you if you’re close the credit account earlier? Together you might be able to think of a plan to reconstruct your debt in the most beneficial way for you. You might want to close it just before you are charged to your yearly interest fee or your yearly bank tax. That will save you some money, but you will also not be spending your entire savings budget if it’s not necessary.
Bottom line, it is quite possible that you get the same benefits from closing one month earlier or six months earlier so you don’t need to push yourself.
Our advice is to make sure that you have access to some cash at all times. Perhaps, in the scenario above, you should aim for, using no more than €400 to repay your student loan. And save €100 in a separate account for emergencies.
If you’re lucky enough, those emergencies will never occur, and you will actually be able to contribute this emergency budget to your retirement savings. Moreover, once you repay your student debt, you will be able to contribute a larger amount to your retirement funds.
STEP #5 OVERVIEW AND PERSEVERANCE
50% of your income must be spent on your needs. 30% of your income must be spent on your wants. 20% of your income must be spent on debt repayments and savings.
Once you have planned your budget for the month, go on and act according to it.
Here is some helpful advice:
- For the first three months at least, be constantly conscious of all your expenses. Make sure you use an app to track all of your payments and categorize them accordingly.
- Make an analysis at the end of the month. Did you reach your goals? Are you sure you are completely honest for the categorizing wants and needs? Is it possible that you substituted one for the other in order to make more room for what you wanted to spend more on? If you have such concerns, recategorize your budget. It’s more important to be honest than to see the right percentages at the end of the month.
- You don’t solve money problems with money. If you’re not comfortable with the low amounts you’re spending, you will be tempted to think about extra income. Make sure you learn to live more modestly before your sign up for an extra job. In other words, learnt to live by the 50/30/20 rule for at least three months before you go on to trying to increase your income. Otherwise you are missing out on an important life lesson.
If you are still confused, watch this helpful video.
THE 15 WORST MISTAKES BEING ON A BUDGET
Here are several of the worst mistakes you can do if you’re trying to live by a budget:
- You are not your money. Do not succumb to peer pressure to spend more than you are comfortable with. You do not need to be cheap, or to share your financial situation around. But you also do not need to pretend to have more money than you do to impress anyone. Being smart about spending money is actually a trait of the richest people on Earth. So, in fact, if you spend less, you are acting richer. How does that logic work for you?
- Waste other resources. Preserve electricity. Preserve water. Preserve your food better. It could do wonders for your budget.
- Waste of free time. If you are broke, do something productive with your free time. Find a second job, a part-time gig, or freelance. In the worst case scenario, learn something that will help you improve your current financial situation or advance in your career.
- Take a loan. When you’re trying to limit your expenses it’s usually not the best idea to sign up for a loan or a credit card. As tempting as the bank employees can make those offers look, what you’re doing is your postponing your financial issues for later. There are services and products you might have no other chance for purchasing – a car, a house, education, etc. But you still need to be very mindful. Those are your own unearned money. Just because you’re not spending right now doesn’t mean that you shouldn’t be conscious of the price and the fees.
- Spend too much for one event. We all have events in our lives that we consider important, but that doesn’t mean that we should break the bank to pay for them – weddings, prom, christenings. It happens once-in-a-lifetime but you should still be cautious about the amount of money you are spending.
- Partying. It turns out, partying could be one of the greatest monsters that is eating up your budget. Especially if you party with alcohol, your purchasing decisions will not be very smart while you’re out. Not to mention, they will also be quite difficult to track.
- Overuse your car. Driving places when there is convenient public transport is a luxury. Can you afford that luxury?
- Overspending on gifts. If you’re not Rockefeller, it might not be the smartest idea to spend a lot of money for luxury gifts for your parents, your siblings or your loved one’s birthday, for a Christmas, or for vacations for your family.
- One-time purchases. Ladies are usually guilty of buying an expensive dress for an event that they will never wear again. It will just gather dust in the closet. This is a financial sin.
- Job security. Do not quit your job without having a backup option. It might sound like you have to forgo your freedom in a way, but you will also feel very not-free if you are jobless and broke. So, do what you have to do to keep your job unless you have a better gig around the corner. (A gig that gives you some financial security – quitting your job to pursue your dreams of creating your own band does not count.)
- Housing. Your lease is not the only expense that goes higher if you go to a more expensive apartment. Additionally, be smart about your rent as well, just because it looks like a fixed expense it doesn’t mean it is one. You can always talk to your landlord to maybe consider lowering your rate if you have been a good tenant.
- Gamble. Whether you have done it in the casino or you regularly play the lottery, this is not an investment, no matter what the TV commercial tells you. This is a waste of money. Don’t do it.
- Entertainment. Do you really have to pay for Cable TV, and Internet, and data on your phone? Are you sure you’re not able to just watch TV on your laptop?
- Coffee. An everyday expense that you can easily cut on. Find a way to enjoy the black coffee in your office rather than visiting an expensive coffeeshop.
- Be smart about food. There are many poor life choices you can make when it comes to food. First of all, you need to consider cooking more at home rather than eating out – at restaurants or getting takeaway. This step in particular can definitely scratch off several percent of your income from your ‘needs’ – you will save a lot. Something else you need to consider, is that you need to limit the amount of food that you’re throwing away. Buy smaller packages. Don’t go for deals if you’re not sure you can consume the food. A two-at-the-price-of-one is not a deal if you only eat the one and throw away the other.
The 50/30/20 rule is, of course, a simplification. And just like any simplification of complex situations, it will work for some and it will not work for others.
The rule is, however, priceless to follow for people who are just going into their first job and doing their first steps into trying to manage their own money.
It will work for anyone, who is struggling to figure out how much they should spend.
We hope this article will give you some helpful advice regardless of your current financial situation. Good luck.
When you have a start-up which consists of a team of several people, you need to have a clear and …
In order for businesses to remain profitable and continue growing in the face of stiff competition, …