Money Monday: The 50/20/30 Rule is Your Budgeting Secret Weapon
To be financially literate, one must first know how to build a budget.
In my experience, “budget" is one of those words that fills people with dread. They associate it with being broke, being limited, when they should keep in mind that even billionaires have a budget. (Well, at least the responsible ones.)
As you read this article, I encourage you to think of a budget like a set of channel markers. Instead of holding you back, a budget can keep you afloat, keep you from running aground, so that you won't live in fear of insufficient funds and overdraft penalties anymore.
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While it’s great that computers can help you track your spending, I encourage you to prepare your budget via Excel spreadsheet at the beginning of each month.
This way, instead of automating a computer to break down your budget, for which you might turn off push alerts if you feel guilty about your spending, you’ve got to get in there, learn your spending habits, and crunch the hard numbers yourself.
One way to make the hard numbers easier is the 50/20/30 Rule.
What this breaks down to, essentially, is allotting percentages of your anticipated monthly income into one of three categories:
- Essential Expenses (50% of monthly income)
- Savings/Debt Payment (20% or more of monthly income)
- Incidental Expenses (30% or less of monthly income)
Essential expenses are expenses you can't live without. This includes line items like your rent or mortgage payment, groceries, necessary clothing purchases (think of new work shoes when you’ve worn through the soles of the last pair), and transportation costs like car insurance and gasoline or a MetroCard.
Savings and debt payment can include saving for retirement, investing in a stock portfolio, paying down student loan debt or credit card debt, and saving for a big goal like a mortgage down payment, a new car, emergency savings funds, or a big trip.
Incidental expenses are also known as “fun money,” and for good reason. They include such things as dining out, shopping sprees, gym membership, Netflix and Hulu subscriptions, travel for pleasure, books, movies, and other entertainment purchases.
Creating Your Monthly Budget.
To determine how your monthly expenses fit the 50/20/30 Rule, first write down your overall expected income for the month. If you are salaried or have regular hours each week, this should be relatively easy to calculate.
Next, make a list of every expense you anticipate having throughout the month. I like to allot up to $200 for unknown incidentals if possible. While you may know about your best friend’s birthday dinner weeks in advance, there’s always a last-minute invitation to come out on a Saturday night.
Finally, break these anticipated expenses into percentages of your overall expected income. You can do this by dividing the expense by your income. For example, $900 monthly rent divided by $2,000 monthly income = 0.45, or 45% of your monthly budget.
Tracking Your Budgeting Percentages in a Spreadsheet.
I like to track my budget in a plain old spreadsheet, the same one where I balance my checkbook. We’ll go into more complex budgeting for freelancers and solopreneurs next week, but right now, I've provided the following sample budget from my former 9-to-5 life for your reference.
In the cell labeled "Amount to Date," I totaled each month's estimated income. In this specific example, the total amount was a little over $2,300.
Then, I created a three-column table. Notice that cells that house essential expenses are blue, savings goals are green, and incidental expenses are red.
An equation in the "% Budget" column tells me how much money I have to spend in that category. I accomplished this by creating an Excel equation: “=CELL NUMBER OF TOTAL INCOME * EXPENSE PERCENTAGE.” In the previous rent example, that might look like “=H5*0.45," meaning 45% of the "Amount to Date" cell will pay for rent that month.
The third column ("Actual $ to Date") is where I tracked how much I’d actually spent in that category that month. I added expenses by hand as they came through, using the simple equation of "=EXPENSE + EXPENSE."
One of my favorite things about budgeting is how it can help an individual better meet her savings goals.
You’ll notice that my table has a mysterious, unlabeled fourth column to the side of it, which I've highlighted in yellow here.
I began budgeting with a goal in mind. Namely, to build an emergency fund so that I could leave my corporate job and work for myself full-time.
This highlighted fourth column helped me fund that goal by showing the difference between the amount I had available to spend and how much I actually spent.
Each highlighted cell calculated this by subtracting the "Actual $ to Date" cell from the "% Budget" cell for each row. I then determined whether I had an excess or a lack of funds that month by keying in the equation: “=SUM(M4:M11).”
If the sum was a negative number, then I knew I needed to transfer that much from savings to checking to keep a positive balance in my account. If the sum was a positive number, then I could sock that money away in savings at the end of the month.
(Alas, this sample spreadsheet shows a month in which I had to transfer a little over $700 from savings. It looks as though I overspent drastically on both miscellaneous essentials and miscellaneous incidentals. Do as I say, not as I do.)
The Shortcomings of the 50/20/30 Rule.
Now, remember. 50/20/30 may be called a rule, but it’s more like guidelines than actual rules.
As you get more comfortable with this school of budgeting thought, you can rearrange the percentages so that they work even more to your advantage. For instance, you might get a raise that allows you to shift from 50/20/30 to 40/35/25.
In this hypothetical raise scenario and others like it, I encourage people to avoid lifestyle inflation. As I said in my Fast Company article:
Lifestyle inflation is when a person comes into extra cash and changes her lifestyle to spend that money instead of saving it. It’s a no-brainer to avoid.
Instead of letting a raise go directly to extra dinners out or an expensive new car, use it predominantly for savings and the occasional smart purchase.
For further inspiration, check out the story of Detroit Lions' wide receiver Ryan Broyles, who lives on $60,000 annually and puts the rest in savings and investments.
But what happens if you don’t have the money to put 20% of your monthly income into savings? What if your essential expenses are 70% of your paycheck?
These are valid questions, and often an unfortunate reality for emerging writers who are paid by the project rather than by a salary.
Before you declare all to be lost, play around with your numbers. See if there's something you can do to help yourself. For instance, you could:
1. Build up your income by taking on some side projects or asking for a raise.
2. Cut down on incidental expenses.
A great deal of modern socializing happens in a third-party location like a restaurant, coffee shop, club, or bar. As a result, it may seem like your options are to be broke with a healthy social life or to be a frugal hermit.
I'm here to tell you there are ways around it. One way is to host more get-togethers at home. Friends may put up some resistance at first, but when they realize they can take home leftovers from your potluck or that drinks at home cost mere pennies compared to drinks out, they may be more eager to come around.
If you absolutely have to go out, see if you can find GroupOn deals. Be flexible: you might find a really good happy hour if you go out on a Tuesday instead of a Friday.
3. Once or twice a year, you might be able to bump up savings with windfall payments.
Even if you can't save regularly, if you get a check for your birthday or another holiday, you could use the majority of the check for savings and debt repayment. (Certainly buy yourself something nice, but try to use only 10% of the check for this. So, if you get a birthday check from Grandma for $100, buy yourself a nice lunch and put $90 in savings.)
If you still can’t play around with your budget enough to make the numbers fit, then I have a do and a don't for you.
Please DON'T be discouraged. The 50/20/30 Rule isn't for everyone. It simply may not work for your lifestyle and income.
Please DO take heart. In this article, I've discussed simple budgeting, for those with a known amount of income paid to them by a regular employer every week to two weeks. Next Monday, we’ll discuss budgeting for entrepreneurs, freelancers, and others who lack a “steady” source of income.
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I look forward to chatting with you soon!
Jessica Hatch is not a Registered Investment Advisor, Broker/Dealer, Financial Analyst, Financial Bank, Securities Broker or Financial Planner. The information in this blog post is provided for informational purposes only. It is not intended to be and does not constitute financial advice, is general in nature and not specific to you. Ms. Hatch is not responsible for any investment decisions made by you. You are responsible for your own investment research and investment decisions.