How do you know how much money you can afford to put toward your financial goals? Should you pay extra toward debt or put that money in savings? What is a good way to budget how much you spend on________? These are all really common questions. It helps to have a good starting point or rule of thumb to go by when figuring out how to save and spend smartly.
I recommend the 50/20/30 rule. This is a simple way to divide up your net income to cover all of your expenses. Here is how it works:
Your essential expenses are all the items that you need to live. This is housing, food, insurance, energy (utilities), and transportation. You may fit other items into essentials, but these items are the essentials for everyone. Fifty percent of your net income should be allocated here.
Financial Goals- 20%
This is where you need to evaluate your priorities. You most likely have a number of financial goals and your money needs to be allocated in proportion to how you prioritize these goals. This would include payments on debt as well as savings and investment contributions. Twenty percent of your net income should go toward giving you a secure financial future.
This is where you are spending money to create the life that you want right now. Shopping, dining out, travel, kid’s activities, etc. Again, I recommend taking time to evaluate your priorities. Are you spending money on the experiences or items that really make you happy or are you spending out of bad habits? Thirty percent of your net income should go to paying for your lifestyle.
This is just a starting point
I fully understand that these ratios are not going to perfectly match everyone. Use these percentages as a barometer. If you live in a higher cost of living area like Southern California, New York, etc. your essentials may take up more than 50% of your net income. This is when you need to adjust the other areas of your spending.
Think of these ratios as a target as you go. Just like we rebalance investments periodically, you should rebalance your spending. As you earn more money, you should be conscious of these ratios so you can direct your increases toward the right area to balance out.
A few other thoughts:
I always recommend a combination of paying off debt and saving money. Don’t wait to start saving. The time value of money is a powerful tool that you need to take advantage of by saving as much as you can as soon as possible. Make sure to prioritize paying off debt but keep a portion of what you make going into savings.
Balance short-term and long-term savings goals. You need to be responsible about your future. Your retirement lifestyle is going to be largely up to your personal savings. However, short term goals like building up your cash for emergencies, purchasing a home, or saving for children also need to be considered. While building up your retirement plan is important, you don’t want to have to pillage your 401(k) or go into credit card debt if you need cash in an emergency. Use the 20% to cover short-term and long-term goals.
If you need help, make sure to ask. Having someone on your side who understands your strengths and weaknesses with your budget is really helpful. Having a good financial plan in place will help you prioritize your goals and identify how much you actually need to save to reach them.