Is budgeting a word that you would rather avoid? Budgeting may not sound like a lot of fun, and many people may try to avoid it entirely. Some people think it is too hard to make a budget. Others say that budgets are just too restrictive and not right for their lifestyle. The deeper reason, however, may be that people are just too afraid to confront the reality of their spending habits.
Yet, budgeting is a key component of pursuing your life goals. Almost all goals have some kind of financial component to them. Whether it is checking items off your bucket list, taking a special vacation, sending your kids to college, starting your own business, or mastering a new hobby – all these goals in some way involve money. Rather than thinking about budgeting as being restrictive, start thinking about how a budget actually puts your money to work in a way that allows you to address your life goals.
The 50/30/20 Rule of Thumb
Plus, budgeting doesn’t have to be hard. Senator Elizabeth Warren and her daughter Amelia Warren Tyagi popularized the 50/30/20 Rule of Thumb for Budgeting in their 2005 book entitled All Your Worth: The Ultimate Lifetime Money Plan. Their plan simplifies budgeting into just three areas. First, you find your after-tax income. This is your income after deducting only federal and state tax, local tax, and Medicare and Social Security payments. This is the amount you divide into needs, wants, and savings.
50% to Needs
Needs are the basic things that you need to survive. Every month you must pay your health insurance, housing expenses, utilities, groceries, and automobile or transportation expenses. You should devote no more than 50% of your after-tax budget to needs. It’s important to be honest with yourself when it comes to distinguishing between needs and wants. You need to eat, but you don’t need to eat all of those meals at a restaurant. You need to have clothes, but you don’t need a closet full of designer labels.
Debt payments can also be considered a need. Car loan payments, mortgage payments, student loan payments, and even credit card payments are a need if you are carrying an outstanding balance. When you add your monthly debt payments into your needs budget, however, only include the minimum payment that is due each month. Hopefully, you are paying more than that every month. Yet, you only need to pay the minimum. So, that is all you put into this part of your budget.
30% to Wants
Next, you get to devote 30% of your budget to your wants. When you realize how little you really need, however, you’ll probably find you are spending more on wants than you thought. For example, only the minimum phone service charge can go into the needs column. You need some kind of phone service. Unlimited data and the newest $1000 cell phone are not needs. Those are wants. Restaurants, coffee shops, salon visit, Netflix, and a new outfit for a friend’s party are all part of your wants. When you think about how little you have available in this budget category, you can’t help but stop to think about what it is that you really want. In the end, you’ll probably find that this rule not only helps give you financial freedom but also helps you to identify the most important and meaningful uses for your money.
20% to Savings and Debt Repayments
The final 20% of your budget goes to all of your savings and debt repayment. Remember that the minimum payment due on your credit cards and loans went into the needs part of your budget. If you have credit card debt and have any hope of paying it off, you should be paying more than the minimum each month. Anything that you pay above the minimum, however, is part of this final 20%. Savings for your emergency fund or future purchases is also part of this category. Also, remember when you first calculated your after-tax income, which did not include savings going into your retirement account? Retirement savings and investments are the last part of your 20% savings category.
The 50/30/20 Rule of Thumb is a simple rule to follow when setting up a budget. Remember that these are maximum percentages as well. You can put less than 50% towards needs and devote the rest into savings and debt repayments. The rule also adjusts along with your income, so you can use the same budgeting theory throughout your entire life. Finally, thinking about your expenses as needs, wants, and savings can help you to focus on what you don’t need and what is actually important to you.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.
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