Today I want to cover an interesting topic that can help anyone to kick their wealth building journey off. Specifically I want to answer the question – what is the 50/30/20 rule and why should you consider using it on your path to wealth.
There are many different techniques of how to budget. Some of these are complex and confusing. Others in my view are really simple and powerful.
As a result I will explain below the key principles of this budgeting method and give you examples of how it works. No budget is perfect and fits everyones needs. I will do my best to empower you to be able to adjust it to your personal needs and circumstance.
why should you budget?
I will however start with the very basics first. What is a budget and why should you do it?
Budgeting is a tool that allows people to get on top of their personal finances. This can be seen as a framework or a plan of how much money is coming in and out. This should also be used as a blueprint for how the money is spent.
A great budget in my personal view should start with how much money is actually coming in. For those of us employed – this is easy. You simply take your payslip and look at the bottom right corner … at least I believe the figure is normally there.
For those working for themselves or those who have side hustles – you need to add all your income. This can also vary month to month which makes it a somewhat more difficult of a task. You can take an average of 3-6 month as a guide. If your monthly income can be significantly different then averages might not work the best for you.
Once you are clear on your income – start by understand your expenses. Have a good understanding of the main categories, habits and patterns.
If the above is done correctly and simply enough – this will become the best tool for you to understand your money, plan for the future and save. These points will then become your best friend to keep you debt free and help you achieve your financial goals.
what is the 50/30/20 rule?
50/30/20 budget rule is a popular strategy. In my view it is also the one that actually works and can help people achieve their financial goals.
The strategy divides your after tax or disposable income into 3 different buckets. The buckets are – needs, wants and investing. This is a great strategy for those looking to build their wealth and achieve financial freedom.
Below I will give you my take on these 3 buckets. For the illustration purposes I will use a £2,000 monthly disposable income. If this is far from your income – apply the same percentages and get your numbers.
50% for necessities
I will start with the biggest part of the budget – the 50% bucket. In case of £2,000 being our disposable income we would be looking at a total of £1,000 here.
This bucket is the needs that you have. Think of it as simple as all the expenses that you have that are unavoidable for you to survive.
The largest proportion of this will go towards your rent or mortgage. Next you need to add the rest of your needs – food, utilities, transportation and the likes.
Think of it as the type of expenses that no matter what happens will always be there.
By doing the above exercise and understand the actual amount of expenses in this category you will at the same time learn your freedom number. This is the bare minimum of passive income/side hustle income you need to make in order to be able to say goodbye to your 9-5.
By no means I say that you should quit your job the moment you arrive to this.
30% for your wants
Next are the wants. And this category gets 30% of our imaginary disposable income. In the example above – this is £600.
All of the expenses in this category can be summed up simply as anything that is not a must. Think of it as anything that brings you joy. This can be going out, travelling, hobbies you might have, etc.
Shopping in my head should also go here. While many will say that shopping is a must as they can’t go around naked. I will challenge you here – a basic T-shirt is what you need. An expensive branded one sounds more like a want to me.
20% for investments or paying off debt
The last piece of the puzzle is the remaining 20% of your disposable income. This is the good stuff, the future fund, the pot of money that will make all the difference…
In the example above we are talking about £400 per month. This is the amount you should be saving or investing each month. In case you currently have expensive debt to your name – use the money to clear that debt first.
When investing this money – make sure this is done through a tax efficient investment account (ISA). Choose a simple yet effective investing strategy to help you grow your wealth over a long run.
what if I can’t afford to invest 20%?
A comment I often hear – I can’t afford to invest 20%!
This can be the case for many people indeed. I would however suggest you go through the process of budgeting first to understand roughly the reasons why 20% is unachievable.
your needs are more than 50%
This can be the first case. Your income isn’t high enough compared to your basic needs. This can be especially the case for people living in expensive big cities like London.
The options you have in this case are the following:
- understand what proportion of your income is allocated towards your needs
- adjust both investing and wants down accordingly
- alternatively reduce your investment however accept the fact that you will not achieve your long term financial goals for longer
An example of this can be – your needs are 60% of your total disposable income. Since it is only 40% left for your wants and investment you can reduce both by 5% from the formula above.
This will leave your wants at 25% while investments will go down to 15%.
The above is just an example and you will be the one who will need to find the right balance that works for you personally.
your wants are more than 30%
This is the other scenario that often is seen in younger people. While your needs are roughly 50% the reason you can’t invest 20% is the fact that your wants take away more than 30% of your disposable income.
In this situation it is critical to realise that it is your lifestyle that prevents you from investing more. This will impact your financial freedom later in life.
I want to highlight – there is nothing wrong with spending more than 30% on your entertainment. It is however worth realising this and doing so while understanding the impact this will have on your future self.
how to apply the 50/30/20 rule?
This is probably the most important next step after you know what your numbers actually look like. You need to find tools that help you execute the strategy in real life.
One way you could do this – having different bank accounts or credit cards that you use for different purposes. Some mobile banking apps actually offer you the feature to have your money to sit in different pots. This way it is easier for you to make sure that you don’t overspend the budget you have.
Next, track your expenses and adjust as you go. The 50/30/20 is more about having a strategy in place rather than sticking to the exact numbers.
If you are earning less and can’t afford to invest that much – reduce to the level that feels comfortable. If however you are more fortunate and don’t need to spend as much money on your needs and wants – increasing the allocation for investments can also be a great thing to do.
One further hack that can benefit people – use automated transactions. As soon as your salary comes in divide it into pots automatically through direct debits so you don’t even have to touch the money yourself.
benefits of the 50/30/20 budgeting rule
Now, lets get to the good stuff. Why do I believe that all of the above is a great strategy?
Firstly, the concept of budgeting is great as you will be fully in charge of your money. You will have a clear picture of your income and all the expenses you have. This will allow you to spend money while being fully aware of how this impacts you and your future financial goals.
There is a lot of science behind people tracking their progress towards their goals and how much more likely they become to achieve these.
There is a further benefit to the above. The one that not many people actually consider and highlight. And that is your discipline.
Let’s stick with the above example of £2,000 disposable income. If you are looking for ways to replace your active income from your job with a passive income – you need way less that you actually think.
There is a rule – once your investments are large enough that you can use only 4% of those, you become financially free. The 4% rule states that the asset appreciation will offset the expenses you might have.
Let’s use the number above – £2,000 per month is £24,000 per year. You would need to have £600,000 invested in order to get £24,000 annually at 4% withdrawal rate.
The good news is – all the time you were actually living off only 80% of that as the rest was invested. The 80% was actually covering both your wants and needs.
This now means that you will actually be able to sustain the same lifestyle with your portfolio being worth only £480,000.
I would encourage you to have more to make sure your portfolio keeps growing each year to make allowance for the future inflation.
summary
For those looking to get on top of their personal finance and start building their investments to achieve financial freedom later in life – budgeting can be an incredibly powerful tool.
The 50/30/20 rule is a great simple formula for you to apply to your disposable income to help you achieve financial freedom at an earlier date.
Understand your income and track your expenses to stay within the given parameters. Keep in mind – 50/30/20 is only a guide and the actual numbers can be adjusted to your specific needs and wants.