This money rule is a very simple tool that will help anyone to make a budget. The 50-30-20 rule can be applied to anyone regardless of their status or their earnings. Elisabeth and Amelia Warren popularized this easy budget formula in the book Ultimate Lifetime Money Plan. Nowadays this approach is wide spread due to its simplicity and effectiveness.
“You must gain control over your money or the lack of it will forever control you”. Dave Ramsay
So how does it work? This formula divides your AFTER TAX income in three groups.
The first group consists of your NEEDS, and it will take 50% of your income. In this category we will include expenses such as housing, utilities, food and transportation.
The second group consists of your WANTS and it will take 30% of your income. In this category we will include all the things that we purchase for instant gratification and aren’t necessities: TV, phone payments, vacations, etc.
The third group is the one destined to achieving FINANCIAL GOALS and it will take 20% of our income. In this category we will find investments, savings, emergency fund, side businesses and small debts.
Lets try to put this into practice with an example. Mike is an average American that has a gross income of $38.000 per year and takes home $30.000 after tax. Following the 50-30-20 rule Mike’s numbers look like this:
50% of 30k = 15k a year = 1.250 per month
30% of 30k = 9k a year = 750 per month
20% of 30k = 6k a year = 500 per month
Following this example, Mike needs to make sure that his rent, food and transportation don’t cost him more than $1.250 per month. He also needs to make sure that he doesn’t enjoy himself too much and his leisure expenses stay below $750 per month. That way he will have $500 to invest or save.
In an ideal situation we should be looking for a 40-20-40 ratio where we are able to invest 40% of our income. Does this mean that we are only enjoying life a 20%?
Well, it does, and it doesn’t.
By investing 20% of our income at the beginning, we will create a series of passive income streams that will increase our original gross earnings. Ideally some years down the line our investments will be making us an amount of money where just 20% of our income will be greater than the initial 40% we had originally invested.
What this means is that by putting some money aside for investing and delaying gratification, we will be earning our financial freedom. It means a cut in lifestyle at the beginning but it also means a better life later on.
The 50-30-20 rule is a very easy way to take control over your finances but there are 3 things we need to take into consideration before applying it.
Number 1: We need to sit down and really think what is and what isn’t a necessity. Failing to do so will cost us money down the line, as we will not have a clear strategy to follow.
Number 2: Don’t take these numbers literally and try to adapt it to your life and circumstances. The most important part of this is to sit down and come up with a budgeting plan. It doesn’t need to perfectly match this rule.
Number 3: If you have a big debt, I highly recommend that you allocate more money to pay this debt first. The 20% that goes to savings, investing, and paying small debts is not good enough to cover these kind of financial obligations. (Click here to read how to get rid of debt)
I first started using the 50-30-20 rule a few years ago. It was quite handy, but after some time it didn’t meet my needs anymore so it has been evolving. Today it looks (more or less) like this:
Needs: 40% of my after tax income goes to housing, food, transportation, etc.
Wants: 20% goes to my leisure activities and hobbies.
Invest: 20% goes solely to increase my monthly income via long-term investments.
Savings: 10% goes to an emergency fund and retirement.
Business: 10% is invested in making my business grow (and 100% of my business’ income goes again to my monthly income).
To make this rule easier and less tedious, once you have decided which % of your income goes to each category create different bank accounts and program payments to each of them. That way every time there is some money coming into your main account it gets split into the others without having to do it manually.
You might be interested in:
Ultimate Lifetime Money Plan by Elisabeth and Amelia Warren
Thanks for your time and remember, keep growing.