Hey guys, today I want to share a rule of simple finance, so without wasting any time lets begin.
Like most of my posts lets start with a story, Pocso Mike Tyson a great boxer won the WBC heavy weight championship at the age 20. He made over 400 million dollars in his long 18 year career, but in 2003 with a lot of loans declared himself as bankrupt.
If he had followed some simple finance rules, he had never fallen in such a condition.
Today I want to share a very popular, simple finance rule, so that you don't fall in such a condition.
It is called the 50-30-20 rule of self budgeting.
Its very simple, no rocket science so lets get into it.
Step One: Calculate Your After-Tax Income
Your after-tax income is what remains of your paycheck after taxes are taken out, such as state tax, local tax, income tax, Medicare, and Social Security. If you're an employee with a steady paycheck, your after-tax income should be easy to figure out if you just look at your paystubs. If health care, retirement contributions, or any other deductions are taken out of your paycheck, add them back in.
If you're self-employed, your after-tax income equals your gross income minus your business expenses, such as the cost of your laptop or airfare to conferences, as well as the amount you set aside for taxes. You're responsible for remitting your own quarterly estimated tax payments to the government because you don't have an employer to take care of it for you.
Step Two: Limit Your Needs to 50% of Your After-Tax Income
Now go back to your budget, and figure out how much you spend on "needs" each month—things like groceries, housing, utilities, health insurance, car payments, and car insurance. According to Warren and Tyagi and their 50/30/20 rule, the amount that you spend on these things should total no more than 50% of your after-tax pay.
Of course, now you must differentiate between which expenses are "needs" and which are "wants." Basically, any payment that you can forgo with only minor inconveniences. This can include your cable bill or back-to-school clothing. Any payment that would severely impact your quality of life, such as electricity and prescription medicines, is a need.
If you can't forgo a payment such as a minimum payment on a credit card, it can be considered a "need," because your credit score will be negatively impacted if you don't pay the minimum. By the same token, if the minimum payment required is $25 and you regularly pay $100 a month to keep a manageable balance, that additional $75 isn't a need.
Step Three: Limit Your "Wants" to 30%
This sounds great on the surface. If you can put 30% of your money toward your wants, you may be thinking about beautiful shoes, a trip to Bali, salon haircuts, and Italian restaurants.
Not so fast—your "wants" don't include extravagances. They include the basic niceties of life that you enjoy, like that unlimited text messaging plan, your home's cable bill, and cosmetic (not mechanical) repairs to your car.
You might spend more on "wants" than you think. A threadbare minimum of warm clothing is a need. Anything beyond that, such as shopping for clothes at the mall rather than at a discount outlet, qualifies as a want. The rules are tricky, but if you think about it, they make sense.
Savings: 20% of your income
The next step is to dedicate 20% of your take-home pay toward savings. This includes savings plans, retirement accounts, debt payments and rainy-day funds—things you should add to, but which wouldn’t endanger your life or leave you homeless if you didn’t. That’s a bit of an oversimplification, but hopefully you get the gist. This category of expenses should only be paid after your essentials are already taken care of and before you even think about anything in the last category of personal spending.
Think of this as your “get ahead” category. Whereas 50%(or less) of your income is the goal for essentials, 20 percent—or more—should be your goal as far as obligations are concerned. You’ll pay off debt quicker and make more significant strides toward a frustration-free future by devoting as much of your income as you can to this category.
The term “retirement” might not carry a sense of urgency when you’re only 24 years old, but it certainly will become more pressing in decades to come. Just keep in mind the advantage of starting early is you will earn compounding interest the longer you let this fund grow.
An Example of the 50/30/20 Plan
Let's say your total take-home pay each month is $3,500. Using the 50-30-20 rule, you can spend no more than $1,750 on your needs per month. You probably can't afford a $1,500-a-month rent or mortgage payment, at least not unless your utilities, car payment, minimum credit card payments, insurance premiums, and other necessities of life don't exceed $250 a month.
If you already own your home or you're locked into a lease, you're pretty much stuck with that $1,500 payment. Consider relocating when your lease expires to make your budget more manageable or take a look at your other "needs" to see if there's a way that you can reduce any of them. Maybe shop for more affordable insurance or transfer the balance on that credit card to one with a lower interest rate so your minimum payment drops a bit.
Your goal is to be able to fit all these expenses into 50% of your take-home after-tax income.
You can spend $1,050 a month on your "wants" based on that $3,500 you're bringing home each month. You might consider doing without a few things and shifting some of this money to your "needs" column if you're coming up short there—not necessarily indefinitely but until you can get your needs down to a more manageable level. Remember, you still need 20% leftover so you can save and pay down your debts according to the 50/30/20 plan.
Now you have $700 left, that last 20%. You know what to do with it. Pay down on debt, save for an emergency, and plan for your future.