In How to defeat lifestyle creep, a Morningstar reader explained how he experimented with a budget to help him gain perspective. I was very inspired, which says a lot because I despise budgets.
My colleague in Australia, Emma Rapaport, agrees that setting up a budget is no one’s idea of fun. After all, we'd all like to spend what we make. But she also concedes that a good budget that quietly works in the background is an essential first step to saving and growing your wealth.
I have taken most of the text below from her article titled How to use the 50/30/20 rule for budgeting.
The 50/30/20 budget was devised by current Democrat presidential candidate Elizabeth Warren in a book she co-wrote in 2005 called All Your Worth: The Ultimate Lifetime Money Plan. Of course, when she wrote the book, she was not a presidential candidate, but the a Harvard academician and bankruptcy expert.
She advocates a few steps: Calculate after-tax income, limit needs to 50% of after-tax income, wants to 30% and the balance 20% dedicated to savings and debt repayment.
She believes that this 50/30/20 budget is a great way to put your spending and saving on autopilot. It's easy to follow, works quietly in the background, and is useful in shifting your focus to what you can spend money on. And best of all, you don't have to account for every single dollar you spend.
This basic budgeting rule gets you to split your after-tax income into three categories:
- 50% on 'needs' – rent, living expenses, school fees for the children, the essential bills like electricity and groceries
- 30% on 'wants' – things you want but don't necessarily need
- 20% on 'savings' – working towards your financial goals
So, how does it work?
# Step 1
Calculate the amount of income you've got coming in each month after your employer deducts TDS.
# Step 2
This is not as simple as it may appear; distinguishing a “need” from a “want”. Remember, this is purely subjective and has a great deal of emotion attached too. Your trip to the coffee shop may sound as a want to others, but it could fulfil an emotional need of bonding and being around people. There is a reason you see so many sitting at Starbucks on their laptop working or reading a book.
A good rule of thumb is to think about needs as the things you must spend money on each month, things like rent, EMI, electricity and gas bills, insurance premiums, transport to work, groceries, schools fees for the children, etc. It's a payment that would transform your life if you went without it.
On the other hand, wants are the basic necessities that make you enjoy life. New clothes, trying out new restaurants, a Netflix subscription would generally fall here. Remember, wants are not extravagances such overseas holidays, which is something you would save for.
Warren says your needs should be no more than 50% of your after-tax pay. If they're more, ask yourself if you can reduce your fixed costs.
#Step 3
Savings can include money your putting aside to save for something big – a home, a car, big holiday – to invest, to contribute to retirement, or to pay down debt.
# Step 4
This reminds me of The bucket approach to retirement.
Warren suggests three banks accounts that you label as “Needs”, “Wants”, and “Savings”.
# Step 5
The final step is to automate your Needs, Wants, and Savings system so you no longer need to visit your budget daily.
Your salary must be credited to your Needs account. From there, you can do automatic transfers to the other two accounts.
So 20% will automatically be directed to your account branded as Savings. From here, opt for systematic investment plans (SIPs) or other investments such as the Public Provident Fund.
The designated amount can go into your Wants account.
Verdict
It's important to note that these ratios are a guideline. Nothing is written in stone. These rules can be difficult to stick to when money is tight, or for those saddled with a lot of debt.
If you are living with your spouse or parents and don't have a lot of fixed expenses, do up your savings.
If you're struggling to save 20% of your income, don’t beat yourself up about it. Make it a goal you can work towards.
If you are nearing retirement and you really have not saved a lot, you will have to seriously give thought to changing the ratios to save more.
This budget works better for people with a singular source of income. It also helps you give consideration to the frivolous spending in your life and automating your savings. But most importantly, after most of the groundwork is done, you don’t have to monitor every single expense; you just have to stay within what is available in the relative account.
