Budgeting is probably the biggest factor that will determine your financial security. There is an old saying that I love: It’s not how much you make, but how much you keep. What’s so great about having a million dollars if it’s all gone in an instant, with nothing to show for it? This is where the 50/20/30 rule comes into play.
No matter how much money you take in, it’s important to put aside a portion in savings. Whether you’re saving for a rainy day, or a home, or retirement, it’s critical to your financial health that you get good at saving.
The 50/20/30 rule of budgeting helps to make sure that you allocate at least of the recommended 20% of income to savings, while still having enough for your necessary (and unnecessary) expenses.
The 50/20/30 Rule
According to this popular rule, you should put aside 50% of your after-tax income for essential expenses, such as rent, utilities and food. 20% of your income should be allocated to savings. The final 30% of your income should go to discretionary expenses, or “fun” money. This is for that new pair of shoes, or a night out at the movies.
The 50/20/30 rule is just a general guideline, though. Ideally, you would want the first and the third categories to get as low as possible, and have the second category as high as possible. This would ensure that you are saving as much money as you can, and cutting expenses. This is a good way to learn the basics of budgeting and living within your means.
Let’s take a minute and go through the three categories for this rule.
50% of income – Necessary expenses
To start, set aside 50% of your income to pay for your necessary expenses. This includes rent, utilities, transportation, and anything you can’t live without. 50% is generally a good place to start, as many people can get by living off of 50% or less of their income.
The point of this is to get yourself into good spending habits, and to really understand what’s a necessary expense as opposed to a discretionary expense. Start at 50% and work your way down, as you cut expenses. You’ll be interested at how many expenses turn out to be less necessary than you thought.
I personally try to live off of less than 50% of my income. I have my necessary expenses right around 42%. More on this later.
Everyone’s definition of what a necessary expense is. It’s completely up to you to determine what falls into this category for your personal situation. Regardless of what makes the cut and what doesn’t, make sure you don’t exceed the 50% limit.
20% of income – Savings
Next, set aside 20% of your income to savings. This includes any money going to rainy-day funds and savings plans. This is probably the most important part of the 50/20/30 rule, as it promotes good savings habits.
For this category, the goal is to start at 20% of savings and work your way up. Ideally, you would like to save 20% or more, if possible. If you’re a saver like I am, you don’t have to limit yourself to 20%. Last I checked, I’ve been saving approximately 26% of my after-tax income.
Debt payments can also fall in this category. Technically, if you’re paying off debt, you’re reducing how much you’re paying in interest, so you’re saving money. I’ve seen debt payments fall in either the 50% or the 20% category. My debt payments currently make up ~18% of my budget, which would put my savings at 44%.
30% of income – “Fun” money
After you’ve determined what your necessary expenses are, and saved 20% of your income, you can finally set aside 30% of your income for discretionary expenses. These are things that you don’t really need, and aren’t really necessary, but are nice. This includes clothes, entertainment, trips, electronics, etc. Luxuries, if you will.
I personally think that 30% is too high to spend on discretionary expenses. I’m not a particularly big spender (not anymore, at least). Since learning to budget and paying off my debts and student loans, I’ve naturally become more frugal.
Looking at my expense report above, I spend approximately 12% on discretionary expenses. This number fluctuates from month to month, as I occasionally take trips or make large purchases.
Flexibility is the name of the game
Since 20% is the recommended amount for saving, it’s a pretty good idea to put this much (or more) away from each check. However, the other two categories can be a little more flexible. Let’s say you don’t pay rent, or you don’t have to pay car insurance.
In that case, it might not be necessary to use 50% of your income for living expenses. Maybe you can get by on 40%.
Theoretically, you can put that extra 10% toward your savings, and make it the 40/30/30 rule. Or maybe you want to spend 40% on discretionary expenses and only save 10% (I don’t advise this method). The point is that it’s ok to play around with the numbers to see what works for you. The 50/20/30 rule is a guideline that will help you find a good place to start.