The 50/20/30 Budget Rule
The following is a guest post from Lloyd who runs the blog The Extra Income Project. He shares his journey of getting out of debt and paving the way to financial freedom through smart money management and passive income building.
I’m a big proponent of creating and maintaining a personal finance budget. I didn’t for many, many years. I thought I was good with money. I owned a home and a business, life was happy and my family and I had no complaints.
I was about to learn not only that I could have been better with money but that setting up and keeping to a budget would have made all the difference when the following happened.
It started when we immigrated to the other side of the world and rented our family home in the UK. We had difficult problems with tenants paying rent that are unremarkably difficult to deal with from the other side of the world. No sooner than starting these difficulties, the financial crisis joined the fray. The crisis hit my property. I was caught up in the Northern Rock saga, bleeding cash for a mortgage on a variable rate interest with no way to service it because our tenant wasn’t paying the rent. I then started to experience clients struggling to pay their bills leaving me with no income. Then a side-line business I was running suffered the sharp end of some unscrupulous behaviour with suppliers. Stock I had ordered using credit cards went “missing”. To add insult to injury the credit card companies found loopholes in the insurance part of their contracts which should have protected me from the loss, refusing to pay out. They started heavy handed debt collection despite me lodging disputes. On principle I became embroiled in a three year legal battle with three major UK banks.
It didn’t end there. In 2009 amidst these battles, I experienced an accident that left me with serious health issues that spanned over two years. I was prevented from working for months on end. I had no income protection. As a freelancer, I was paid for my time, if I didn’t work I didn’t earn. Life became excruciatingly hard and stressful. The impacts on my financial situation were deep. I had expended far more time and energy on these battles than I realised and I came out to face a mountain of debt that had grown beyond all imagination as a result.
And the universe remained unapologetic, continuing to throw more at me as if to test how much I could take. These events compounded into a breaking point. Ironically, I’m incredibly grateful for my moment of weakness. For me, it was like taking a cold shower. My eyes opened and I quickly decided to take stock of my life and make some radical changes.
Taking stock of your debt
Debt is a compounding problem. If you don’t face it quickly it becomes an overwhelming problem.
Many don’t see it coming. Looking back, I should have. I thought I was wiser than that.
Often by the time you realise you’re into a level of debt you can’t handle there’s a tendency to bury your head in the sand and try to ignore it. Somehow, we think, it’ll fix itself. It won’t! I had hit overwhelm. If you’re reading this knowing you’ve gone past that mark; know that you can get out. I’m the proof you need! There was one thing that I did that turned my situation around quite radically.
The one simple thing?
I made a plan. In fact, that’s not the most important part of it. The most important part was that I created a budget. It sounds so God damn simple, doesn’t it? That’s because it is. But so many people don’t know where to start. Others don’t understand the incredible power of creating and sticking to a budget. A budget helps you understand where your finances are going. It’s like a time machine into the future for every financial decision you are making today. A budget is the very foundation of things that took away so much of my stress, put me back in control of my life and helped me find money where I didn’t realise I had it.
A budget needs to drive you toward a goal.
As I started to talk to my friends and relatives I would find a consistent theme of people struggling to live in some way, shape or form. People who were earning large amounts of money were still living hand to mouth, pay cheque to pay cheque. I was shocked. I quickly found that many of these people didn’t keep a budget. Of those that did they weren’t managing the budget effectively or more importantly weren’t approaching their budget effectively based on what they were bringing in.
In contrast, by creating and sticking to a budget I was able to pay off $5,000 of credit card debt in just 6 weeks!
I had one overarching goal. To pay off my debt, fast. I look back and realise that was no mean feat. I pushed myself to the extremes in terms of living frugally. But my budget helped me find money where I didn’t think I had it. I found out where my money was going and redirected it all toward the debt that mattered. And since then, by sticking to a budget I’ve made massive strides to pay off debt that reached hundreds of thousands of dollars. It feels good to have paid off large quantities of this debt, but the most gratifying experience has been gaining a sense of control and direction.
Start a budget today
A budget is easy to set up. If you want a head start I give away the budget spreadsheet on my website if you sign up to my mailing list.
But even then, I found that many don’t know how to approach managing their income when they set up a budget. The power of a budget hinges on setting financial goals. Whether that’s building up savings, investments, retirement funds or paying off debt.
When I reached out to a few people on my blog I found that they didn’t know how to dissect their income to ensure they meet those financial goals. The consequence of that is living a life from pay cheque to pay cheque and not being able to pay down that debt or step toward financial goals a pace that you can feel good about. Questions came up like, how much should I be spending on my bills? How much should I save?
I’m about to introduce you to a powerful rule of thumb that will help you avoid this. It’s a rule I use now and it’s incredibly effective. It’s called the 50/20/30 budgeting rule.
The 50/20/30 budgeting rule
Naturally, it stems as an approach to dividing up your income. This is easier for those in permanent employment who have a fixed income. If you’re on a variable income then you can take two approaches to planning. You can average out and estimate your income from a number of weeks or you can opt to base your figures with a pessimistic view to your income.
Regardless of how much you earn and how regular your income the 50/20/30 budgeting rule helps you in three ways:
It will expose whether you are living beyond your means
It will help you focus on hitting the path to your financial goals
It will force you into cutting costs or raising your income to ensure you meet your goals
How does the 50/20/30 budgeting rule work?
It works by breaking your income into three portions.
50% of your income will be ascribed to fixed or essential expenses. These are the types of expenses that you can’t live without, for example rent, mortgage, loans, motor costs, insurance and travel expenses.
20% is put toward financial goals or savings. If you are in debt you are using this money to pay off that debt. This 20% should also be used for building up an emergency fund as a priority and then a savings account dependent upon whether you have debt or not.
If you are carrying high interest debt I’d suggest focussing on that over savings. If you are carrying some low interest baring debt it can sometimes be wise to put a little bit of cash to build up some extra savings. If there’s one thing I learnt from having no income for months as a result of my accident it’s that having a pot of savings can be a life saver. I didn’t have that luxury and I paid in the long term by having to survive using high interest credit.
Finally, 30% should be used for flexible or variable expenses. These types of expenses are generally your lifestyle expenses. They include things like phone usage, groceries, gas for your car and entertainment such as eating out, movies and hobbies.
All of these expenses can be modified by choice. You can choose to travel less, car pool or bike to work. You can choose not to eat out, or reduce the amount of times you do eat out. You can cut down on the types of things you spend in your groceries. Massive savings can be made by being careful what you spend your money on in your grocery budget.
Cutting costs through your budget
When I tell you that a budget can help you find money you didn’t know you had your flexible and variable expenses are generally the areas you’ll find that money the fastest.
For example, when I first started my budget I included several months of expenses to give me an immediate picture on where my income was going. I quickly realised I was spending $1800 a year just by grabbing a coffee from the local café on the way to work each morning. I was spending more than double that on buying lunch at the local bakery at work!
Cutting those expenses alone, and finding alternatives like taking leftovers with me to work, guaranteed I could pay off a $5,000 credit card within a year. By finding more and more of those expenses, reducing my groceries and eating and living frugally I was able to pay off such a debt in less than two months.
The real power in the 50/20/30 budgeting rule
The 50/20/30 budgeting rule becomes all the more powerful when you stick as rigidly as you can to the percentage guidelines.
By ascribing 50% to the top tier, your essential expenses, then 20% to your financial goals you may find, particularly if you are living beyond your means, you don’t have 30% left to live off.
This forces you to find cost savings to survive but relies on your determination to pay those top two tiers first.
Necessity is the mother of all invention
If you want to find out how creative you can be at finding or making cash it’ll be when you need it most. The easiest way is to find the savings in the money you pay out and how hard that has to be depends upon your short fall. I got super extreme for a short period of time and cut out all kinds of happy things like takeaways, having a beer with mates on a Friday and my daily coffee. I reduced my water and electric bills (and I’m still very mindful of that).
But there’s only so far you can go with reducing your expenses. Once you hit that point you have to hit look at raising your income. And there’s a plethora of ways you can earn extra cash – you can sell your old stuff at a car boot sale or on eBay. You can take up a second job, take on a boarder if you have a spare room, rent a room on Air BnB, try pet sitting, babysitting, take surveys online, start a blog and earn income online. The list could go on and on.
And if there’s one thing you’ll learn from Francesca’s blog, which you’re on right now, or my blog, it’ll be how to make extra cash online and save money elsewhere.
Does anyone else budget with the 50/20/30 rule or want to give it a try?