Does the 80/20 rule mean anything to you? How about 50/30/20? These are both ratios of how experts recommend people budget their after-tax income. It was established by Elizabeth Warren and Amelia Tyagi in 2005 (thebalance.com). Before anyone can start seriously investing, it is essential to have your budget under control.
The 80/20 rule means that you should be spending 80% of your net income on expenses and 20% on savings, investment, or debt. The 50/30/20 rule further breaks that down. It recommends spending 50% on needs (Housing, auto, insurance), 30% on wants (Travel, clothing, Starbucks), and the remaining 20% on savings, investing, or debt.
There are several ways to figure out how you spend your money. The first is to manually track what you spend over a month in a spreadsheet. However, this is time-consuming and delays you from making corrections to your budget. I would recommend using a free app such as Mint. Mint will connect to your bank accounts and categorize all of your spending from the past several months.
After you know where you’re starting from, you can plan where you need to go. If you are spending almost all of your net income on expenses or wants, it’s time to start cutting. I recommend starting by seeing if there are any easy things you can cut back on. That could mean eating more from home, getting generic brand groceries instead of name brand, or changing from an unlimited data plan to a cheaper, more limited one.
The most significant areas where you can save are on your rent or auto payment in the longer term. I recommend that your monthly housing be less than 30% of your after-tax income. If you’re renting, this is something you can likely change in the next year if you find you’re overpaying for your apartment. I also recommended that you keep all of your auto payments (car note, insurance, gas, repairs) to under 15% of your budget. That is something to keep in mind if you think you’re about going out and purchasing a shiny new Tesla Model 3.
Once you have your expenses down to 80% or less of your net income, it’s time to find the best place to invest your remaining 20%. If you have a large debt, you should start paying off the debt with the highest interest first. After budgeting to ensure you can make the minimum payments, any surplus in the budget should go towards the debt with interest above 10%. You want to pay this debt off fast because the cost of carrying it is hurting you more than the return you could get from investing. Interest fees are guaranteed; an investment is not.
Three kinds of debt are okay to carry: a mortgage, federally held student loans, and low-interest auto loans. These debts are alright to have because of the low-interest rates and length/size of the loans. Your money would go farther if you invested it today than if you used it to pay these kinds of debt down early.
With your bud budget, debt, and savings in line, you can now start looking towards investments. There are many investment strategies, and which one would be best for you will likely come down to your appetite for risk, how soon you need the money, and how active of an investor you want to be. The one place you will want to ensure that you are investing as soon as possible is your employer-sponsored 401k. If your company offers a 401k match and you aren’t meeting it, you are leaving free money on the table!
Getting started is one of the hardest parts when budgeting. But if you start implementing some of these simple rules today, it will make all of the difference tomorrow. Budgeting is the foundation of personal finance and the first step to building personal wealth. If you make your money work for you, eventually you won’t have to work for money!
Paula Rant, “The 50/30/20 rule for budgeting.”
Courtney Jesperson, “Budget Calculator”