How to apply the 50/20/30 rule

Prioritising your budget can allow you to save effectively, pay off debt and reach a goal

The process of building a budget can get very daunting, especially if a person has just started to invest. You may realise with time that budgeting is simply categorising your expenses and setting them in line with your priorities. Most people go through their day or month and spend money where they feel is necessary. While, on one hand, it seems logical, on the other, the spending may not correlate with your personal priorities.

If you don’t have a structured plan in place, you realistically don’t know where the money is going. Prioritising your budget can allow you to save effectively, pay off debt and also reach a goal — whether it is a new car, a house, emergency savings or retirement savings. But if you are struggling to save money and pay off your debt, the 50/20/30 rule can help you align your budget with your financial goals.

This rule first came to be known after author Elizabeth Warren mentioned about it in her book All Your Worth: The Ultimate Lifetime Money Plan. It rule essentially focusses on classifying the after-tax income, by spending:

  • 50 per cent: on rent/loans, food, bills, minimum debt payments and other essentials
  • 20 per cent: on financial goals such as savings, investment, etc
  • 30 per cent: on dining, entertainment, etc

To adapt this rule, you need to start by categorising your expenses.

The needs: Needs are those bills that you absolutely must pay and the things necessary for survival. The ‘needs’ category does not include items that are extras.

Savings: Allocate 20 per cent of your income to savings and investments. This includes adding money to an emergency fund, contributing towards mutual funds and other investment instruments.

Wants: Wants are all the things you spend money on that are not absolutely essential. This category also includes those upgraded decisions you make, which are purely for the purpose of splurging on a luxury. Basically, wants are all those little extras you spend money on, to make life more enjoyable and entertaining.

How does it work?

1. Find your disposable income at hand

Your after-tax income is your net income; it’s what remains from your paycheck after taxes are deducted. These deductions come in form of a local tax, income tax, State tax and other expenses.

2. Allocate 20 per cent to savings/investments

This category suggests you allocate 20 per cent of your net income towards investing and savings. This includes building an emergency fund, investment in mutual funds, or building a retirement corpus. Buying something from spontaneous urges is one of the things that kills people’s budget. As I mentioned earlier, the rule isn’t the one ultimatum to follow, but if you are able to follow it through, it can help you create tailor-made budgets for every situation in your life.

3. Segregate your necessities and wants

First things first — figure out your necessities. The 50/20/30 rule defines these as ‘needs’. The most difficult thing for people to grasp is differentiating their ‘needs’ from their ‘wants’. A payment that can be eradicated with minor inconveniences, or does not impact your life monumentally, is a ‘want’. A payment that would overwhelmingly affect your quality of life, such as your electricity or paying off a debt, is a ‘need’. With this rule, the total amount of these necessities should not exceed 50 per cent of your net income.

The writer is Head, Personal Wealth Advisory, Edelweiss

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