Someone who is just starting out in life, or a beginning budgeter, may wonder how they should be allocating their money. Here is a general rule of thumb to consider when budgeting.
Where should my money be going?
Begin by recording your net income and your expenses, and track your spending. Then divide your expenses and spending into three categories. Spend a bit of time determining which of your expenses fall into each category.
1. Fixed expenses
No more than 50% goes toward essential expenses. These are your fixed costs that don’t vary much from month-to-month. They include housing, transportation, utilities, groceries, loan payments and minimum payments on your credit cards.
You also include subscriptions and contracts here (such as cable/internet/phone plans and gym memberships) if you’re committed to paying them on a monthly basis for a certain period of time.
2. Financial priorities
At least 20% goes toward financial priorities which help you secure a strong financial foundation. This is the category that builds your wealth and increases your net worth. It includes retirement savings contributions, paying down credit card debt, and building an emergency fund. Your financial goals can also include larger savings priorities like a down payment on a new home.
These payments should be made after essential spending, but before any other.
3. Flexible spending
No more than 30% goes toward your lifestyle choices. These are your personal and fun choices that can vary from month-to-month. They can include charitable giving, entertainment, hobbies, personal care, restaurants and bars, shopping, weekend trips, short term savings, and other miscellaneous expenses.
They enhance your lifestyle. But, if you are spending more than 30% on “wants” you need to start prioritizing.
Pros and Cons to this budgeting approach
This budget plan is a good starting point. It makes sure you are covering your expenses, saving for the future, and still allowing some enjoyment into your life today.
Budgeting is not just about knowing what your expenses are and whether they fit into your paycheque. This budget directs you to look at your spending and see where it fits, especially if you’ve never looked at the big picture. It can show what you are paying for necessities, which can suggest where you need to make some changes.
It helps you to start building your wealth. Putting an extra $100 on your credit card payment, or saving $500 doesn’t seem like it will help you much today, especially if you are starting out with a negative net worth. Often, people just don’t see the advantage in the near term. The benefit always seems to be 10 or 20, or more years away. That could be a big reason why many people don’t save more money.
Another problem is that we don’t know the difference between necessities and lifestyle choices. For example, you need a place to live, but many of us could significantly reduce our monthly expenses by moving to a smaller place; or the suburbs instead of downtown or by the beach. The same is true for the vehicles we drive and the clothes we wear. We look at these as necessities, but actually spend more than we need to and have turned these essentials into expensive lifestyle choices.
Relying on the experiences of others can help, but only so much, because your income and expenses are unique to you.
Keeping fixed costs under 50% and saving 20% may be unreachable for some people depending on circumstances. Your situation may not fit the mold.
The 50/20/30 budget provides a framework. It can be a helpful benchmark when you’re assessing where your money is going.
It’s an especially good budgeting system for young adults who are just starting out in life. When you know how to achieve a balanced budget, you can take the next steps to further customize this rule around your own unique expenses and specific goals and help you make the most of your money.