Personal finance is one of those fields which is riddled with rules of thumb to simplify what can be a highly complex field to navigate. I don’t think any of the rules has been as pervasive as the 50/30/20 rule, that was popularised by U.S. Senator Elizabeth Warren in her book “All Your Worth: The Ultimate Lifetime Money Plan”. The rule is quite simple; it argues to split your after-tax income into three categories of spending: 50% on needs, 30% on wants, and 20% on savings. Now so far this seems quite straightforward. And it is. You need to figure out what your income is after tax. And unless you’re self-employed, that is essentially your take home pay every month, so what actually ends up in your bank account. From thereon, start splitting. 50% on needs means that half your take home pay goes to things such as housing (mortgage, rent), utilities, insurance, health care, minimum debt repayments (at least according to Investopedia), groceries, and everything you as an individual NEED to live. No extras. No fun. Just meeting your obligations. 30% goes towards your wants. These are the fun things, so the clothes, the dining out, the partying, the xbox, the consumer tech (not work related tech) etc. This is where people live their best life. And where temptation tends to strike. 20% goes towards savings. Savings is a bit of a lose term, but this includes adding money to an emergency fund, making IRA (or any type of retirement) contributions to a mutual fund account, and investing in the stock market. According to Investopedia you should have at least three months of emergency savings on hand in case you lose your job or an unforeseen event occurs. After that, focus on retirement and meeting other financial goals down the road. Clear enough. Looks straight forward. In theory. Now let’s apply this to practice. Which is where things will start to tumble down.
Issue 1: What’s more important: savings or debt repayment?
I have checked a variety of resources on this popular rule and one of the issues is that they can’t seem to agree as to where the debt repayments sit. According to Investopedia the minimum debt repayments fall under the ‘needs’ category, but any additional repayments move onto ‘savings’. MoneyMe argues that all of repayments sit within the ‘savings’ category (you save to repay, essentially). Following a different tool, the financial hierarchy, we know that debt repayments are much more important than having savings, because holding debt is just very expensive, whereas savings can barely get you a decent interest rate at the best of times. So within the 50/30/20 rule debt repayments should have been prioritized over savings, if you really want to be well off.
Issue 2: Should ‘wants’ come before ‘savings’?
The inclusion of debt repayments raises another question: if you want to repay debt and build savings at the same time (co-holding), should they only be 20%? Or rather, should those categories be part of the last 20% to be allocated, or should they be come before wants?
Any financial advisor (I am not one), will first calculate your needs, which will include debt repayments that go far beyond the minimum debt repayment, before they even look at the things you want to spend money on. If you are 10,000$ in debt at an interest rate of 15%, the fact that you want to go out for dinner twice a week becomes utterly irrelevant. You cannot afford to. The debt has to be dealt with first.
Sure, financial advisors are attuned to the human condition, if they have to put you on an extreme repayment plan they are aware of the fact that people can’t last without any enjoyment (which often warrants spending) in life. But these things will be discussed in advance. They will be planned for. And they sure as hell won’t be 30%.
The idea that wants can (or even should) come before debt repayments or savings is a very dangerous idea indeed. If you have repayment goals (and/or saving goals) they need to come before. Not just from a financial point of view, but also from a behavioural perspective. What you allocate first is what you prioritize.
Issue 3: Can you live on 50% of your wage?
Let’s keep things 100. Wages have stagnated, prices have not. Rent has exploded so badly it’s become an exponential curve with a limit that may not exist mathematically. This is a problem. Obviously.
The idea that all the aforementioned needs (housing, utilities, insurance, healthcare, groceries, minimum debt repayments (?)) can be covered by 50% is becoming increasingly unrealistic for the upper middle class. They haven’t been realistic for the lower middle class and the lower classes (to use the British terminology) for a while now. And the reason is the aforementioned asymmetry in how both wages and prices have developed. Especially the housing prices (mainly rent, which disproportionality affects the poor(er)).
So what gives? If your needs already eat up 70% of your take home pay (which is likely not YOUR fault) then how are we going to spend an additional 50%? Well, we won’t. But with only 30% left – what’s the division? And this is the kicker: if it’s just you, you can make the choice to still save 20% and have 10% left for ‘wants’. Or go really hardcore for a couple of months and have no fun at all to make sure you have a good savings buffer (or clear out your debts). I commend it if you can, absolutely. You need to be mentally resilient to do it, but it can be done.
But what if it isn’t just you? What if you have dependents? Kids and/or elderly family members? Or if you support your community? Some of that will be covered in your needs. That may (part of) the reason your needs are at 70% (instead of the illustrious 50%). But how do you tell a 5 year old, or 15 year old they can never have anything beyond the bare minimum? And how about your grand-parents? Where is any of this senator?!
Issue 4: Is three categories sufficient?
Let’s calm down a bit. A rule is a simplification after all. But these 3 categories, are they sufficient? As a behavioural scientist I think simpler tends to be better. Because it gives good guidelines, which can then be tailored to individual situations. And I’m okay with that. As a personal finance nut, however, I don’t think this rule is doing what we think it’s doing.
First of all, saving to repay debt is not the same as saving for an emergency buffer or a holiday to Bali with the boys (Australian rite of passage, don’t question that too hard). I think debt repayments need to be its own category. So 3 categories isn’t going to cut it.
As already mentioned, wants need to come last, so with our new 4 (minimum) categories, wants get demoted to the last position, with needs coming first, debt repayments second and savings third (in my humble opinion, when following the financial hierarchy). Also, I just realised that although minimum debt repayments are captured (at least by Investopedia), that interest charges aren’t. Hardly a luxury those… But they need to be in the ‘needs’ bucket because not paying them will lead to fees (make sure you understand the debt you take on!).
There are further splits that can be argued to be necessary from a behavioural standpoint. If you’re consistently overspending on wants, you’ll need to figure out which category is causing that (eating out, drinking, shopping etc.)? It is really common for those on really tight budgets to use spending as escapism, which makes the (financial) situation worse, increasing the chance of escapism due to financial and cognitive strain. It’s a real problem for which the underlying motivators need to be identified.
So that’s a ‘quick’ review of the 50/30/20 rule. I get why it’s popular, I do. And as a guideline it’s not that bad. But from both a financial hierarchy and a behavioural perspective, this is not a good guideline for long-term money management. And it’s also clearly an older rule that may hold much better for people on certain incomes (read: privileged).
What are your thoughts on the 50/30/20 rule? Have you ever used it?
