What is the 50/30/20 Rule of Budgeting?

“It’s just the second week of the month and I have totally run out of cash! “, a frustrated Kabir groaned, staring at the abysmal state of his bank balance. This has now become a monthly ritual. With hunger pangs adding to his money woes, he staggered to his food cupboard rummaging for that last packet of ramen noodles that would have to suffice as his lunch for the day.

After all, with no money in the bank, and quickly dwindling food rations, he has only two options left; go hungry or resort to an already maxed-out credit card. While Kabir whipped out his credit card to make yet another purchase, conveniently ignoring the “ outstanding amount”, he wondered where he went wrong with money… after all, it’s been 6 months since he has been in Bangalore now, has a decent in-hand salary, doesn’t pay exorbitant rent either … then where did all the money go? Turns out Kabir is not alone. 

In the time of inflated lifestyles and instant gratifications enabled by the indiscriminate use of credit cards and “ pay later “ apps, this hardly comes as a surprise.  Young and ambitious professionals trying their best to live the city life, often grapple with poor money management issues. If you are someone facing the same predicament, there is a famous rule of budgeting that can help you get your derailed finances back on track; the 50/30/20 rule of budgeting.

If you cannot track back where have you spent and on what, this rule is for you. initially popularized by Senator Elizabeth Warren in her famous book named ‘All your Worth: Ultimate Lifetime Money Plan’, the basic idea behind this rule is to work on your after-tax income and divide it in such a way that all your needs, wants and savings are justified. Let’s see what this rule is and how can you implement it in your daily life. Read On!

Decoding the Rule

The rule is very simple in practice. It asks you to break your in-hand income into three parts. 50% of the income goes to needs, 30% for wants and 20% to savings and investing. In this way, you will have set buckets for everything and operate within the permissible amount for each bucket. This will instill a sense of discipline at the same time ensuring you neither compromise on the quality of living nor planning for your long term goals. Now that the rule is clear, let’s see how to categorize your spending buckets into needs, wants and savings.  

Breaking the 50-30-20 Proportion

Needs: 50%

Needs are the things which you absolutely require for your survival or must necessarily do to live. Needs are activities like paying bills, fetching groceries and food, paying rent, paying the mortgage, insurance premiums, minimum debt repayments and more such obligations that you must fulfill to live peacefully.

 According to this rule, half of your after-tax income can be used to take care of such things which are always on the urgent list with money. If you fail to make these payments, you will either be in trouble or will end up gathering more such obligation for the next month which will most likely include interest charged on the late payment.

The Needs section does not include luxuries like TV Cable, Netflix subscription, gym membership, kitty payment, etc. According to the rule of 50-30-20, if you end up spending more than 50% of your after-tax income in the needs part, then you will have to chuck few things out from your ‘Wants’ list. If that is not possible then you are only left with the option of lowering down your lifestyle and start living frugally with only what is absolutely necessary and required. A minimalist lifestyle may be the answer to all your problems relating to lifestyle inflation and overspending habits. 

Wants: 30% 

As the name suggests, “ Wants” are the niceties that money can buy. In simpler terms, these are not what you need for basic survival, but something that you aspire for. This is also the trickiest section to navigate because wants are endless unless you are a modern-day Buddha, content with the bare necessities. Wants include things that bring you pleasure, some examples include occasional dining, movie outings, leisure travel, seasonal shopping, grooming splurges, hobby classes, etc. As you can see, the list of “ wants” is never-ending and if unregulated, it can encroach over the savings bucket as well.

To regulate your wants section, you can do several things. The first thing you can do is not go on retail therapy and waste money on useless things. While it is good to pamper yourself, be a judicious shopper, make sure the thing or experience you buy is worth the money and that you are making this purchase because you absolutely want to and not under peer pressure. 

The second thing is to not give in to instant gratification and space out your purchases. For instance, if you want to buy that new iPhone 11.  Start building a small “shopping fund” where you deposit money to meet your short term goals, instead of falling into the EMI trap.

Even if it’s the enticing “ no-cost EMI “ route, there are hidden charges that users are not aware of. My dear customer, when it comes to finances, ignorance is not bliss. Please know that in the zero percent schemes the interest part is often dressed up and passed on to customers as “ processing fee”; remember there is no such thing as a free lunch. 

As an alternative, a shopping fund will help you achieve the required corpus easily without having to shell out a huge amount in one go. So instead of going the EMI route, you can start saving for that iPhone by setting aside some money in liquid funds. 

Taking 1 Lakh ( ballpark) as the amount you need to buy the latest iPhone, you can invest in a liquid fund for 6 months to reach the desired amount. As the name suggests, liquid funds offer you the flexibility of instant withdrawal like savings account with more interest rate, so your money earns for itself instead of lying idle in your savings account. 

According to the results generated by Groww ‘s SIP Calculator, you have to deposit Rs 17,000 per month to reach the amount in 6 months.

Here the net amount you invest is 17000* 6 = Rs 102000 and the amount you accrue at 6% interest rate is Rs 103,249 which essentially means, you gained Rs 1249. So by just spacing out your purchase by 6 months, you were not only able to save but also earn on your investment. This is also a good way to instill discipline in yourself and combat the urge to buy things instantly. The same can be applied to other big purchases like buying a vehicle, travelling, etc. 

Another tip is to compare the prices at various websites, during sale and off seasons so that you are able to buy the same thing at a lower price. You can also look for mint condition second-hand purchases to meet your requirements. So all it takes is planning your purchases rather than caving into your whims to balance the “ Wants “ bucket.  

Savings: 20%

While needs and wants cater to your well being in the present, the savings bucket is what will sail you through in the future. This bucket is perhaps the most important and yet the most ignored. 

As the 50-30-20 rule dictates, 20 percent of your post-tax income must be saved and then utilized through investments. Please note, unlike needs and wants, savings should be non-negotiable and need to be a top priority. If it means that you have to temporarily stall that Leh trip with the boys on the bullet, so be it. Everything can wait but your investments and savings shouldn’t suffer, period. 

The answer as to why this is the most important financial bucket lies in the times we live in. You won’t be young forever and neither will you be work till you are 60 like your parents did. The times are turbulent, we keep changing our jobs frequently and are increasingly taking up unconventional careers. Amidst all this uncertainty you must have a safety nest to bank upon, for your retirement and other unforeseen circumstances that can crop up. 

Thus the savings bucket will keep you financially fortified to battle out economic or personal ups and downs. The most important thing to remember is to put your savings to good use. Don’t put them in investment avenues that come with painfully long lock-in periods and interest rates that barely beat inflation. Invest in avenues that offer inflation-beating returns and give you easy access to your own money without the necessary paperwork and premature withdrawal charges. After all, what good is your hard-earned money if it doesn’t come to your aid when you need it. 

You can start by building up your emergency corpus and eventually move to other investment options once you have saved enough for a period of emergency. Ideally, an emergency fund must be equal to your three to six months worth your expenses depending on the size of your family plus the amount of the last emergency that took place. An emergency situation is not necessarily a medical situation but there can be unfortunate chances of losing a job and not finding a suitable one for some time. In such a case, your emergency fund must be able to fund your expensed especially needs during those times.  You can invest in liquid funds for this purpose as they offer high flexibility to withdraw money as well as offer a better appreciation of wealth. 

The next best thing to successfully employ your savings is to start investing for your long term goals. The biggest one is retirement planning. The key here is to start as early as possible to be able to achieve the desired corpus within the timeframe. Start early and invest in aggressive growth funds such as small-cap, multi-cap funds, etc. Start investing in a diversified equity portfolio via the SIP route. SIP will ensure disciplined investing so that you are not side-tracked from your goal. SIP also eliminates the fear of market timing as well as is easier on the pocket, needless to say, it is the best way to invest in equity mutual funds. SIP also employs the power of compounding that enables small investments over a long period to accumulate into a sizeable corpus. 

Conclusion

Once you successfully manage and stabilize your lifestyle, you can try to allocate more funds towards the Savings part. The rule can then be read as 50%- Needs, 20%- Wants and 30%- Savings and so on., you can always create your own iterations of this rule as per your suitability but you must ensure that at least 20% of your post-tax income goes towards the savings part.

Following the 50-30-20 rule will empower you to deploy due diligence in your money matters and ensure that all of their money is not just spent. Once you know the wealth inflows and outflows you will be able to exert greater control on how you want to spend your money and consequently become more mindful of your spending habits. Make sure you balance all the buckets according to this rule to take maximum benefit of the money you earn. 

Happy Investing!