The 50/30/20 Budgeting Formula
A great strategy for learning to budget is the 50/30/20 formula. Harvard bankruptcy expert Elizabeth Warren and her daughter Amelia Warren Tyagi coined the 50/30/20 rule in the book they co-authored titled “All Your Worth: The Ultimate Lifetime Money Plan.”
To get started working with this formula, first create a spreadsheet that lists all the things that you spend money on. Be honest! Don’t forget the Hulu subscription and any other items that come automatically out of your account. The more complete your spending list is, the better your results will be.
Now that you’ve done that, get started with these steps:
Step one: Calculate Your After-Tax Income
Your after-tax income is the amount you deposit after taxes are taken out of your paycheck, your take-home pay. If you don’t have a regular paycheck, average the last 3 months of income to determine your after-tax income.
If health care, retirement contributions, life insurance, disability insurance or any other deductions are taken out of your paycheck, add them back in to your total monthly income.
Step Two: Limit Your “Needs” to 50 Percent
What’s considered a need and what’s a want? That’s the million-dollar question. Any bill that you can eliminate and only experience a minor inconvenience, like your cable bill, is a want.
Any bill that would severely impact the quality of your life, like electricity, is a need. If you can’t miss a payment, like a minimum charge on your credit card, it is also considered a “need” because your credit score would be negatively impacted.
Review your budget and note how much you spend on “needs” (groceries, housing, utilities, health and auto insurance). The amount that you pay should be no more than 50-percent of your total after-tax income.
Step Three: Limit Your “Wants” to 30 Percent
Before you go crazy thinking “This is great, 30 percent of my income can go towards things I want!” remember how strict we were with the definition of a “need.” Your “wants” should include things like your unlimited text messaging plan and your cable bill. After that, anything like shopping for new clothes or dining out at a nice restaurant qualifies as a want.
Step Four: Spend at Least 20 Percent on Savings and Debt Reduction
Put at least 20 percent of your after-tax income towards reducing debts and saving money. If you carry a credit card balance, the minimum monthly payment is a “need.” Anything above that is an additional debt reduction and qualifies towards the 20 percent savings target. If you have a mortgage or a car loan, the minimum monthly payment is a “need” and any extra payment counts toward your “savings and debt reduction.”
Now that you understand the 50/30/20 formula, you can give yourself permission to have fun, knowing that you have a balanced approach to budgeting.