This has got to be the most basic common sense financial goal to master. With the easy credit schemes on the market many people find themselves in a tough spot by simply spending more than they make. Its easy to get lulled into the habit of using your credit cards to pay for everything. It’s so simple, you don’t need to run to the bank to get cash, instead you pull out your plastic and complete the transaction without even thinking.
50/30/20 Model
The 50/30/20 model is a framework for budgeting spending. Essentially the model states:
- 50% of your income should be allocated to your Needs. This is to say your essential expenditures. What falls into this category? Usually it’s your rent, utilities, food, auto payment, etc. It doesn’t include any discretionary spending.
- 30% of your income should be allocated to your Wants. This category is all of your discretionary spending, yes all of it. It is a good idea to get comfortable having to prioritize your discretionary spending because that skill will help you keep more of your money in your pocket just by asking yourself how important a purchase is compared to all the other purchases you might make. It’s okay to defer an expense by a month or more. It might even go on sale or you might decide you don’t really need that thing since you let time cool off your emotions. A lot of discretionary spending is emotional based.
- 20% of your income should go into Savings. Savings represent future purchasing power. It is your retirement savings (long term), it is your child’s college funds (mid term) and it might represent your next vacation (short term). It’s important to view savings in buckets because you can afford a different level of risk relative to the time horizon. The longer you have before you need to use the money the more risk you can tolerate to grow that money. Remember higher risk = higher returns.
Watch your spending for several months and think really hard about how to categorize that purchase. You paid your gym membership and wonder if that is a Need or a Want? You need to decide but most people would say it’s a Want. As each expense occurs, categorize the expense and add it to the total for the group. Do this for each month and start over for the next month. After about 3 – 6 months you should have a good idea of your normal spending habits. How well did your budget cover your needs? If you can’t pay for everything using your budget you should reconsider the expense. It’s also okay to have a slightly different allocation such as 55/25/20. You need to find a split that works for you. The key is to understand your spending and spend less than you make.