The 50/30/20 rule provides a plan to budget your after-tax income into different spending buckets. How do you plan your expenditure? You all have access to limited financial resources and multiple avenues to spend them. So how do you allocate your scarce financial resources among your multiple competing needs? You need to fall back on the 50/30/20 rule of financial budgeting and plan to achieve a measure of financial discipline in your lives.
Senator Elizabeth Warren in the US wrote a groundbreaking book titled “All your worth, an ultimate lifetime plan”. She has given a rule of thumb method for budgeting your financial needs and advises you to divide your post-tax income into three buckets in this book.
According to her plan: your consumption basket is divided into three buckets as follows:
These include all your basic needs and necessities—your must-have list of things. Your basic requirements of food, shelter, and clothing fall into this bucket. Your needs dominate your expenditure basket, and you cannot live without them. You need to pay your rent, water, electricity charges, etc. These are indispensable to you, and your demand for them is inelastic. They also take up a larger proportion of your budget allocation.
Your wants are the second component of your consumption basket. Wants are those articles you can do without but would love to have. It may be the latest iPhone, gadget, a foreign trip to a place you have always wanted to visit, or the latest car; the list is endless. Most of the wants are expensive and require a lot of funds. You can fulfil some of your wants but not all. You have to allocate your scarce resources to satisfy your wants frugally.
Wants are normally big-ticket items. You are tempted to buy expensive items on your to-do list and satisfy your wants. Some of you may purchase these items on no-cost EMIs or under schemes that promise zero processing charges. Honestly, there are no free lunches in the world. Schemes, zero cost processing charges, and no-cost EMIs have some high hidden costs which are not apparent to us.
Every month, you should save some money by creating a sinking fund or a shopping fund for expenses. This fund can then be used to purchase different products.
Last but the most important component of your budget is your savings component which facilitates financial planning. This will be the mainstay of your retirement years and will enable you to live with dignity without looking for handouts from anyone. These financial savings will greatly help us to be self-sustaining. It helps you take care of your needs in your waning years and remain self-reliant. In your younger years, filled with the joy and exuberance of your youth, you do not like to think of old age and financial planning for that period.
An ultimate lifetime plan provides us with a ready-made solution.
Let us say you have a monthly income of Rs. 50,000 per month, which has to be allocated according to the 50:30:20 budget rule.
The 50/30/20 rule, the brainchild of Senator Elizabeth Warren, was devised to help Americans caught in the debt trap. American credit card debt reached an amount of US $ 998.4 billion in July 2021. The debt included mortgages, credit card payments, and auto and student loan payments.
By bifurcating your net after-tax income into the three buckets, Senator Warren said that you accumulate sufficient corpus in the savings basket, especially to pay off your debt obligations or save for your retirement. The saving component can be used to build your asset base, increase your net worth and pay off your debts.
This rule brings financial discipline and careful planning to your spending habits. You have to shop or save according to your financial limitations within your budget. You need to budget all your expenses whether for necessities, wants, or savings—all within the ambit of your after-tax income. Driven by the desire to have a larger-than-life kind of lifestyle, you run the risk of being caught in a debt trap. You then subject yourself to unnecessary harassment and headaches if the debt you have taken is not paid. Before buying anything, you need to ask yourself, “Do I need this product?”, “Can I still live a happy life without this?”. This will eliminate half of your wants. Alternatively, make a systematic plan of saving money every month so that you can secure the object of your desire.
Necessities are required to meet your needs. These are essential for your basic survival. You cannot reduce or minimise this portion of your expenditure. Savings provide the wherewithal for your living during your retired years and old age. Your life can be better if you can increase your contribution to this segment. The “wants” is the only area where you can cut, reduce, or otherwise minimise your expenditure is the “wants” area. When you consider buying any item classified as a want, think three times before committing to this purchase. Wants are purely aspirational goods that enable you to keep up with the Joneses. Sometimes you lose interest in these products after they are purchased after a new want captures your attention.
The 50/30/20 rule is right for everyone. Even if you are just starting your career, you should make it a point to save some portion of your after-tax income. Financial discipline and prudence with your income cannot start early enough. The earlier you start your savings, the better your life will be. Through the power of compounding, regular savings can help you build your net worth and asset base. This is the path to wealth maximisation in the long run. Avoid assuming unnecessary debt to buy expensive products that you particularly desire. This leads to the so-called zero cost EMIs or loans with zero processing fees, which are not costless. For the transient enjoyment of some wants, you are assuming the onerous responsibility of debt. Ideally, you can even allocate your post-tax income based on the following ratio: 50, 20, and 30. This means you increase your savings component by reducing the wants component. Such an allocation helps make your retirement years financially secure and your life independent.
The 50/30/20 rules may be taken with a grain of salt. There are some potential grey areas in this rule. It can be difficult for low-income people to bucket their income into the different spending/savings baskets and remember to track the household budget for variations.
Other budgeting methods include:
You can adapt your rule as per your convenience. It is crucial to remember that, whichever method you adopt, building your savings and your net worth is necessary for your long term wealth maximisation.
The 50/30/20 rule is not laid down in stone. It provides only a guideline. At the beginning of your career, when you are earning a small income, a 50/30/20 rule may seem appropriate. But as you grow in your career and your salary increases, you will not spend all your incremental salary on expenses. Expenses are necessarily curtailed and do not grow exponentially, even if you have a larger family. You need not spend all your incremental income on your wants. It makes more sense if you increase the allocation to your savings component. For instance, if you receive a large lump sum, it makes more sense to allocate this amount to your savings component. This is the only component that will grow exponentially. It ensures a financially-secure stress-free life for you in your retirement years without looking for handouts from anyone. A 50/30/20 can even become a 40/20/40 allocation with careful planning.
The 50/30/20 rule teaches the need to inculcate financial discipline and prudence in your expenditure patterns and savings habits. This rule, combined with a no-debt policy, is the best way to secure financial freedom. Plan your budget carefully. Estimate your after-tax income and apply your spending thresholds. If you cannot satisfy a particular want, push that expense forward into the future. Making budgets without guidelines or thumb rules seems like a complicated process. Applying the 50/30/20 rule seems an easy enough option. There are some areas where you cannot neatly sort all your expenditures into these three buckets. With experience, you would be able to analyse and sort the expenses. After applying the 50/30/20 rule, you must carefully examine whether you are adhering to your spending thresholds. Though it may seem like an additional chore, doing this in a disciplined manner will ensure that you do not veer off the path and lose financial discipline.
Normally, debts, including credit card debt, get paid out of the savings portion.
Normally, you should ensure that after saving 20% of your after-tax income, you spend the rest of your income on necessities and wants. If you are carrying debt, a portion of your savings portion goes to defray your debt. If your debt overhang is large, you may need to curtail your expenses to pay off your debt obligations.
Yes, you must monitor your expenses rigorously.
50/30/20 is only a guideline or a rule of thumb to help you better plan your financial future and achieve your wealth maximisation goals.