The 20% Budget Rule: Part 1

So I have written about making your own, detailed spending plan (aka budget). I have also written about my own experience of budgeting without actually budgeting.

What if you’re starting from scratch and want something really simple? Something that doesn’t require a lot of number crunching, but also doesn’t require that you are a natural saver?

You can ascribe to the popular 50/30/20 rule. I’d like to just shorten this and call it the 20% rule.

WHAT IS THE 50/30/20 RULE?

This budget says that you should spend 50% of your take home pay on needs (housing, food, etc), 30% on wants (things that are not vital to your daily living), then 20% on savings.

How about we just focus on the 20% towards savings? Why? Because to me, it seems a little arbitrary that you’re wanting to put a percentage on your needs versus wants.  This money is getting spent, regardless. You could be spending 20% on needs and 60% on wants because you happen to have paid off your mortgage. Or on the flip side, you’re spending 60% on needs because you live in a high cost of living area and your housing costs are much higher than average.

YOUR SAVINGS IS A “NEED”

Using this rule of thumb turns your savings into a “need” that you take care of first, before your other expenses.

We’re already doing this with a “need” that many of us would rather not think about: taxes.  No one likes taxes (except maybe accountants), but it’s just part of the deal if you want to work and live in this country.  If you’re a W-2 employee, you have no choice; taxes are automatically taken out of your paycheck, whether you like it or not. This becomes crystal clear when you get your very first paycheck as a full fledged veterinarian.  If you get paid monthly and you do the math, your first paycheck is certainly NOT your salary divided by 12.

In the same manner, if we simply just take 20% off the top of your take home pay, then it’s your job to figure out how to survive on the remainder. This is what is referred to as “pay yourself first,” and if you want a super quick synopsis of the popular book, The Automatic Millionaire by David Bach, it boils down to this very simple phrase.

Too often, we go about this backwards.  We pay our bills first, then we spend on things that make us feel better or make our lives easier.  If we happen to have anything leftover at the end of the month, we might go ahead and put this in savings. Might.

RELIEVING MENTAL LOAD

Humans are very adaptable. That’s how we managed to survive this long as a species (although sometimes I really question how this has been possible when looking at some human behavior around me, including my own). Which means that if you automatically pay yourself first, after every paycheck, you will find ways to adapt to what you have left. It should be treated no differently than your monthly mortgage payment or your phone service. It goes out every single month, no questions asked. The earlier you start this habit, the easier it will be to acclimate to this version of normal.

Think of your monthly mortgage/rental payment.  Do you know how agonizing it would be if we treated our mortgage the same way we treated our savings? This would also put the country in a financial tailspin because people will find all sorts of reasons why they can’t pay their mortgage if a) they’re not forced to pay their mortgage and b) they don’t even know how much they’re supposed to be paying.  Placing this in auto mode allows you to use your precious time towards things that actually need your attention. Like binge watching your favorite show.

We used to have an automatic way of paying for retirement: pensions.  That’s a trend that’s disappearing quickly, and more than ever, we’re responsible for planning our own retirement. Most employer based plans typically require that you opt in, rather than automatically enrolling you as soon as you start working as an employee.

Paying yourself first frees you from the mental hassle of figuring out how much to save and whether you can save anything at all.  We all know that we should be doing it.  Automating your savings is about the easiest thing you can do to start saving ASAP.

NEW GRADS HAVE THE ADVANTAGE

This method of making a budget works best when you’re starting from scratch; typically when you make that transition from student to having your first real job.  You may feel burdened by debt, but you’re actually free to make choices based on just a couple of numbers.  Namely, your take home pay and how much debt you have.  From this, you should be calculating your monthly debt payments and 20% of your take home pay.  Once you plug these numbers in, you can actually build a budget on what you have left.

What’s the alternative? It usually goes something like this.  You graduate (woo hoo!). You land a great job (yes!).  You’re finally making some money and the temptation to spend is there (the temptation is real).

Before you know it, you buy a car, because your current car is dying and you deserve one that’s not so beat up looking.  You think buying a home is a good investment and you get a loan for almost nothing down.  You eat out a lot because you’re busy, plus you don’t really like to cook.  You take some pretty awesome vacations that result in lots of likes on Instagram.

You don’t feel like you’re overspending, but at the same time, you’re not really paying close attention to where your money is going.  This goes on for a while, and you start noticing that you don’t have a lot of money left over at the end of the month.  In fact, some months you actually have to pull money out of your meager savings just to cover your bills. Or even worse, you’re relying on credit cards and you’re carrying a balance month to month. And the cycle continues.

WHAT IS YOUR SAVINGS RATE?

Like your net worth, your savings rate is a simple equation.

Savings rate= Savings amount/Total net pay (take home)

Some people say to save 20% of your gross pay.  Others include their pre-tax retirement contributions. Some only count savings towards retirement and nothing else (saving for down payment, kids’ college savings plans, taxable accounts, etc).

You can make this as simple or as complicated as you want.  It depends on what your financial goals are.  The whole point is that you’re saving something.  Anything.  Because something is better than nothing.

If you’re maxing out your retirement accounts, then maybe 20% on top of that is a bit of a stretch. That’s OK- maybe 10% is more doable for now, and you can work on increasing this percentage if you’re actively saving for other goals.

If your job offers no workplace retirement accounts, then you may need to think about saving much more than 20%. Look at your numbers, make some financial goals, and make a plan towards achieving your goals.

To keep this simple, just calculate your savings rate based off of your net pay without worrying about your pre-tax retirement accounts.  Then you can start playing around with your numbers.  Check out this great savings calculator by Physician on Fire. Shoot for a 20% savings rate, and once you get more comfortable with your finances, you can always adjust your savings rate as you see fit.  Just taking that first step is crucial to building momentum.

Have fun with your calculations, and I will be back with Part 2!

What do you think of the 20% rule? Too ambitious? Not enough? Comment below!