Some rules can be restrictive while some, like the 50-30-20 rule may help you attain financial freedom. Popularized by bankruptcy law expert, Senator Elizabeth Warren in her 2005 book, All Your Worth: The Ultimate Lifetime Money Plan, co-authored with her daughter, Amelia Warren Tyagi, the budgeting rule offers an easy, intuitive plan on daily spending and saving towards emergencies.
In a nutshell, the 50-30-20 rule is to divide up income: 50% on needs, 30% on wants and 20% on savings. Simple enough but there are a few important considerations before you decide this is the budget plan for you:
This category is defined as essential for survival or ‘must-have’ living expenses. Warren’s rule explains earmarking half of your total income to cover basic needs such as rent or mortgage, utilities and groceries. It also includes transportation costs or a car loan, health insurance if you are privately employed or if a family member needs additional insurance, and school fees if you have children. If the above payments exceed 50% of your total income, it may be time to consider downsizing or relocating to a less expensive neighborhood or switching to a cheaper car or public transportation.
This is the ‘fun’ bucket. Think of all the things you spend on that are not essential but enhance daily living. This includes eating out, holidays, shopping on luxury items or gadgets. It is important to differentiate between needs and wants and rationalize how much you are willing to spend on the nicer things in life. Perhaps having a high-speed data plan is essential to your job if you work from home. A vacation or a staycation may be important to restore balance and mental well-being. However, if spending on wants exceeds 30% of your total income, you need to look at cheaper alternatives or cutting down on some altogether.
Savings and investments are the essential building blocks to long-term financial planning, and ultimately, financial freedom. Life can take unexpected turns and it is prudent to create that can cushion you from unexpected expenses without impacting your daily life. The rule of thumb is at least three months of living expense for an emergency and beyond that, a long-term retirement savings plan.
Where does debt fit in?
Savings also includes debt repayment. Making the minimum payment on your credit card or mortgage is classified as a ‘need‘ as missing the payment can affect your credit score and create deeper debt as interest charges and penalties pile up. However, getting out of debt takes more than paying the minimum so allocating any additional funds from the 20% savings bucket to reducing the principal and future interest owed can free you faster from debt and hence, also critical.
Why is the 50-30-20 rule important?
The 50-30-20 rule can help you plan ahead, for the medium and long-term. Having an emergency fund can prevent debt and enable your and your family to withstand unexpected job or income loss. In addition, saving and investing towards retirement at an early age can give you the flexibility to choose when you wish to retire from working for a living.
How do you know if the 50-30-20 rule is right for you?
While the 50-30-20 rule provides an easy to follow plan for people who don’t have the time or patience to track all expenses, you must remember it that only provides a general guideline.
For those that find it hard to differentiate between needs and wants, the former category refers to things you absolutely cannot live without. If you can do without it, it’s a need.
For high income earners, a 50% allocation on wants may be too high and that money may be better utilized towards needs, savings or charity. Critics of the rule also say that low income earners may have to spend their entire income towards needs, leaving nothing towards wants or savings, thus leaving them vulnerable to debt.
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