How can the numbers 50, 20, and 30 help you manage your finances? Today, we’re going to talk about the 50-20-30 rule of budgeting. A company called LearnVest popularized this rule of budgeting recently, but it’s been around long before them. I’ve seen many financial experts write about it, as well.
The bottom line is that the 50-20-30 budget has some advantages as a starting point, but, like most financial rules of thumb, it can also lead you astray. So today, we’re going to walk through this form of budgeting and talk about its pros and cons.
What is the 50-20-30 budget?
The 50-20-30 budget divides your money for spending and savings into three buckets. (It’s all based on after-tax dollars.)
The first 50% of your budget goes towards necessities, including shelter, food, utilities, transportation, clothing – the things you need to get by day to day. This rule of thumb says that those expenses should comprise no more than 50% of your take-home pay. So that’s the first financial “bucket.
Also, if you have a car loan, for instance, paying the minimum payment would probably be considered a necessity because you need a car to get from point A to point B. But if you make extra payments on that car loan debt, that goes into the 20% bucket.
Basically, the 20% bucket is for your financial priorities – your long-term savings and some debt repayment. This bucket does not include short-term savings, like a vacation. That’s for the third bucket.
The 30% bucket is for your lifestyle choices. This includes things like vacations, entertainment, gym fees, hobbies, pets, eating out, cell-phone plans and cable packages. These are things you do not have to have to get by, but are lifestyle choices. So the remaining 30% of your take-home pay goes into this bucket.
To sum it up, with this budgeting rule, you put 50% of your money to necessities, 20% to long-term savings and debt payments, and 30% to lifestyle choices and non-necessities.
A personal shift in thinking
I do want to give you my thoughts, specifically, on the 50-20-30 plan for budgeting. But first, I want to talk about a shift in my own thinking on money that’s occurred in the past five or six years.
Before I started blogging about personal finance in 2007, I thought about money like most people do. I went to college, got a job, and started spending. We saved some, but our savings was typically in the 5-15% range. We’d contribute to our 401(k) and a little bit beyond that, but nothing more.
My attitude was that my job was going to finance our living expenses until we retired at age 65. It was all about the job. I’d go to work for 40 to 50 hours a week, earn income, save a little, and spend the rest.
With that mindset, I did what a lot of people do. I bought a new car, the expansive cable TV package, and the big TV. We bought a big house, and then a bigger one. We took expensive family vacations. We did things that most middle-class Americans do. In that sense, we were very normal.
But that all started to change when I started this blog and began to write extensively about personal finance. The change wasn’t immediate, of course. But as I wrote and blogged about personal finance, I started to save a little more money, pay off more debt, and watch my retirement nest egg grow. Then, I suddenly had this “aha” moment.
I looked at the money we were saving. It was starting to add up and become more significant. It takes some time because you need to benefit from the power of compounding. But after a while, I started thinking about how much my money was working for me. It was almost like sending out employees who were working for me. That money was starting to grow into something significant.
And then I started to see how that money could fund a fair amount of our expenses, particularly if we became more frugal with our lifestyle. And then I began to realize that the most important thing to me was not a bigger house, expensive vacations, 200 cable channels, or a new car. The most important thing was my freedom.
Don’t get me wrong. I didn’t want to quit and not work at all. But I wanted the freedom to work when I wanted to work, where I wanted to work, doing what I wanted to do. I didn’t want to be chained to a desk five days a week.
I realized that I could get there by giving up things that had once seemed important to me. I could trade in the bigger house, new cars, cable packages, and expensive vacations for freedom. I could trade those things for a lifestyle where I spend less money and save more, which would let me have this lifestyle where I have the ability to work where and how I want.
When you’re just starting out, this seems like an impossibility. When I graduated from college, we had no money and a lot of debt. I had about $55,000 in student loans, so we had a negative net worth. So if I saved $500 or $1,000 or whatever, it might help me when I turned 65. But how was that going to help me now?
The truth is, that at that moment, it wasn’t going to help me much. And I think that’s a big reason why many people don’t save more money or cut back on expenses. They don’t see the advantage in the near term. The benefit is always 20, 30, 40 or more years away.
And eventually, that just shifted for me because I’d been saving for a while. As I learned more about personal finance, I started to look at money in a different light. Now, I don’t see money as a way to buy “stuff.” I look at it, instead, as a way to achieve freedom for myself and my family.
An example of financial freedom
Have you ever noticed that people you think have a lot of money seem cheap? I’ve had plenty of discussions with people about that idea. You know that the person is probably wealthy, but they watch every dime.
In some ways, my stepmother, who passed away a couple of years ago, was that way. She watched every dime. And you know why? She lived off her wealth. By retirement, she had done pretty well for herself. She had a part-time job, but mostly lived off her nest egg of about $1 million.
How much income can that generate in a year? Well, if you use the 4% rule of thumb, $1 million generates $40,000 in income. That’s not a lot of money, so my stepmother had to watch what she spent. But by making her nest egg last, she was able to enjoy freedom.
For instance, she was able to take a part-time job she loved. She was a pilot for years, and her part-time job was with a company that built things for pilots. It didn’t generate a lot of income, but she could do it because she loved it and had money saved to live on. And then she could do things in her community on the side, as well.
As I get older, that’s what I’m trying to achieve, too. And looking at money this way puts saving into a whole new category.
Changes in thinking lead to changes in doing
Now I’m stunned when I see someone I know is struggling financially pull in with a brand new, 100% financed car. I guess they can afford the payment, but what are they thinking? To me now, people just seem so casual about the money they spend. And I’m not perfect here, either. But I’m trying. For example, I’m reducing the cost of our cell phone plan by moving to prepaid plans with Republic Wireless. I’m also reducing our cable package. And eventually I want to downsize our home. I look at how much this big house costs us to heat and cool and maintain, and we just don’t need the extra space. So we’re working on those things.
The point to my ramblings is so you understand how I look at something like the 50-20-30 budget.
My thoughts on 50-20-30
So what are my thoughts on this approach to budgeting?
I actually think that 20% is a pretty decent savings rate. Sure, some folks could save more. For instance, Mr. Money Mustache, who saved upwards of 70% of his income and retired at age 30. This is kind of extreme, but it’s fun to read his blog and dream a little.
But here’s the thing: saving 20% of your income is hard for a lot of people, given their current spending habits. When you think of the 50-20-30 budget, the first thing to consider is just how much people spend on shelter and cars.
Like a lot of folks, if you’ve bought a home, you may have a large mortgage. And you may also have that $20,000 or $30,000 or $40,000 bank-financed car sitting in the driveway. Depending on your income, those two things alone could easily eat up 50% of your budget.
So if that’s you, then the 50-20-30 budget can actually be a good thing for you. It may help shine some light on these issues and suggest where you may need to make some changes. Fifty percent for necessities may seem like a lot, but a lot of families are spending far more than that. And if that’s you, you may need to look at ways to reduce your essential expenses as much as possible.
Rules of thumb are a starting point
The second thing to consider about this budget is that rules of thumb are fine – as a starting point. It’s okay to compare your current spending to the 50-20-30 budget, but it’s just a starting point. It isn’t one-size-fits-all.
Part of the efficacy of this rule of thumb depends on your income. Are you making $50,000 a year or $500,000 a year, or something in between? Let’s say you make $100,000 and you’re thinking, “I don’t know if I can get by with only 50% of my income going to necessities.” Well, how do you think folks making $60,000 do it? You can get by.
The first thing to recognize is that it’s all about the choices you make. I know that circumstances vary, but by and large, spending is a bigger problem than income for people. We all want to make more. I get that. And some of you may be in difficult circumstances – maybe unemployed or seriously underemployed.
But for most folks in the United States as a whole, our biggest problem isn’t that we don’t make enough money. It’s that we spend too much money. If you’re making anything above average in income, you should try to do better than spending 50% on necessities and only saving 20%.
Necessities vs. lifestyle choices
Saving 20% is a good start, but you should aim for more. This goes against the traditional rule of thumb to save 10-15% of your income. But saving 20% is possible, and it’s a good goal. It all depends on your priorities.
After my “aha” moment in my own personal finances, I wouldn’t be happy any more with a 20% savings rate. I want to save more. Sure, the 50-20-30 budget is a good rule of thumb. But many of us can do better – often without sacrificing all that much.
Part of the problem is that we don’t know the differences between necessities and lifestyle choices. For most of our spending, it’s really a lifestyle choice. For instance, you need a place to live. But the house you choose to live in is a lifestyle choice. Many of us could significantly reduce our monthly expenses by moving into a smaller place. The same is true with the cars we choose to drive and the clothes we choose to wear.
When we look at all of these necessities, we tend to spend more than we truly need. And I speak from experience here. So when you think about necessities in this 50-20-30 budget, be honest. You may find a few things that fit into the necessity bucket, but you’ve gone overboard and turned those things into an expensive lifestyle choice.
Consider using YNAB
I’m a big fan of YNAB – You Need a budget. It’s the budgeting software I use, and it’s incredibly helpful.
YNAB doesn’t really deal with this 50-20-30 formula. It’s more of a nuts-and-bolts approach to how much you spend on the categories you create. You could use it to create a 50-20-30 budget with three categories: necessities, financial priorities, and lifestyle choices. You could even make those your high level categories, and then add some sub-level categories. That’s fine, too.
But what I really like about YNAB is that it forces you to think beyond the “rules of thumb” and to look at the details of how you’re actually spending your money. It’s been a real eye-opener for my wife and I. I looked at what we spent at restaurants and Starbucks last month, and what we spent on clothes. It’s very revealing.
To truly manage your money, you need to go beyond these rules of thumb, including the 50-20-30 budget. It’s fine as a starting point, but you need to look at the specifics of how you spend your money and how you can make better choices. It’s been a process for my wife and I, for sure.
The bottom line here is that once you start down the path of living like everyone else does and pursuing the American Dream (as it’s commonly defined), it’s hard to reverse course. It takes time. It doesn’t happen immediately. If you’re just starting out, keep this in mind so you don’t go down this road at all. But if you’ve already started spending more than you should, figure out where you can cut back on your expenses – sometimes with almost no sacrifice – and think about how different choices now can buy you financial freedom later.