Having a set budget is the best way to get out of debt.
Posted on 04/26/2018
Most Americans have trouble managing their personal finances. The average household carries $16,000 worth of credit card debt, and one in three people has a bad credit rating. Are you one of those people who budgets by the seat of your pants? Are you stressed out worrying whether you have enough money in your checking account to cover your order at the coffee shop? It doesn’t have to be that way.
No matter how much you make, you can cover your key expenses, pay off your debts, and invest for the future. If you do it right, you can even have money on hand to spend on the little things you want, like that coffee. One of the easiest systems you can use to budget your money is the 50/30/20 rule. Let’s a look at how you can use this rule to start putting your finances in order.
The 50/30/20 rule defined
The 50/30/20 rule is a minimalist budgeting plan designed for people who want a simple way to manage their finances. Under the 50/30/20 rule, people allocate their monthly take-home pay into three categories.
- 50% of income applied towards essential expenses such as rent or mortgage payments, utilities, food, healthcare, etc. All the items in this category are things you need.
- 30% of income applied towards discretionary spending, or your wants. Items in the discretionary category include entertainment expenses, restaurant dining, and cable bills.
- 20% of income applied towards savings, investments, and debt repayment. Examples of items in the debt repayment category include emergency fund savings, retirement savings, and credit card payments above the mandatory minimum payments you have to make each month.
Setting up a 50/30/20 budget
You can establish a 50/30/20 rule budget by following some simple steps.
Determine your after-tax income
Your after-tax income is the pay you take home after federal, state, and local taxes. However, to get an accurate starting point, look at your paystub; if you have automatic deductions for things such as health insurance and retirement savings, add those items back in to your after-tax income. We’ll address them in a moment.
Consider an example of the 50/30/20-rule:
An individual has an after-tax income of $4,200, and had an additional $600 deducted each month for health insurance and $200 deducted for a 401(k). After adding the health insurance and retirement savings back in, that person’s starting point for the 50/30/20 rule would be $5,000.
Set your essential spending at 50% of after-tax income
Once you determine your after-tax income, look at all your current essential spending bills, or needs. Under the 50/30/20, the total amount you should be spending on these items is 50% of your take-home pay. The individual in our example should allocate $2,500 each month toward essential expenses, including the $600 deducted each month for health insurance.
Besides items such as healthcare, rent, and transportation, you should account for the mandatory minimum payments you have to make on credit cards or other debt here as well, since you “need” to pay those each month. If your calculated essential spending is above 50% of your take-home income, see if there are any changes you can make to get in compliance with the 50/30/20 rule. For example, can you find a cheaper apartment rental, or a less expensive car lease to decrease your essential spending?
Establish a 30% floor on your “wants”
Now, calculate how much you can allocate towards discretionary spending, meaning your “wants.” The person in our example can spend $1,500 on things such as dining, shopping, entertainment, etc. As you look carefully at your spending on items that enhance your lifestyle, ensure that you only spend 30% of your after-tax income in this category. If your discretionary spending is greater than 30%, prioritize the items that you cannot live without and start making cuts.
Allocate 20% of after-tax income to savings and debt repayment
The final 20% of your income should go toward saving and investing money, and repaying debts. The person in our example should allocate $1,000 each month toward this budget category. That figure includes the $200 that the person is investing in the 401(k) retirement savings account. Any additional savings or investments would be accounted for here, as well as any debt repayments that go beyond the mandatory minimum payments.
Implementing the 50/30/20 rule
After you set up your 50/30/20 budget framework, you need to monitor your spending and savings closely. Review all your financial activity in a given month, and use the data and trends you see to make course corrections to get yourself in compliance with the 50/30/20 rule.
Closely monitoring your finances like this can be tedious, but there are ample rewards for learning to live within the 50/30/20 budget. You’ll always be able to cover your critical bills, and you’ll be saving money each month to deal with the unexpected. You’ll also have money on hand to enjoy yourself.
If you want to get your finances under control, you need a budget. The 50/30/20 rule is easy to implement and simple to monitor. Having this type of budget can get you on the road to financial peace of mind, so think about setting one up today.