Friday, 30 March 2012

Frugal Friday: The 50 30 20 Rule

Have you heard of the 50 30 20 rule for budgeting? It's a simple way to calculate (and categorise) your spending. If you're not familiar with setting yourself a budget and sticking to it, this is an easy way to start. I'm not sure where it originates from but it's been doing the rounds for a while now.

Start with your after-tax income. 50% of this should be allocated to needs, 30% to wants, and 20% to savings. Did I mention that this is super simple? Oh, wait, there's a catch...

Wants versus needs:
Not everyone understands the difference between needs and wants. Needs are things you really cannot survive without. Shelter? Check. Food? Check. Mobile Phone? Nope. That's a want. You can tell me as many times as you like that you neeeeed your iphone but seriously, it's not essential to your survival. So be honest with yourself - there are very few items that belong in the needs category. This is the part of budgeting that a lot of people find hard to cope with. If you're used to buying yourself whatever you want, it can be a shock to the system to look at your spending realistically and cut out some of those "must have" items that you don't need at all.  

The average salary in my beautiful city is $80,000:
Which according to the Australian Tax Office website, is approximately $62,250 after tax.
That works out as:
$31,125 budgeted for needs (housing, groceries, medical costs, electricity, bare minimum of clothing, etc)
$18,675 budgeted for wants (new clothes, expensive haircuts, mobile phone, dining out, books, baking tins, wool for craft projects - whichever luxuries you love!)
$12,450 saved in a separate account for future financial goals and emergencies.

A note on debt:
Many frugal bloggers advocate the use of the 20% savings to pay down debt. I agree to a point, but if you've gotten yourself into a bad debt situation by giving in to your wants, I believe the best way out is to reallocate some of the 30% wants category towards paying down debt. If you've created the crappy situation, it's time to man up and get yourself out of it. I've been in that situation, and it felt great to finally get rid of that debt and start my new, responsible financial lifestyle.

My own budget:
I don't follow the 50 30 20 rule exactly. I'm happy to spend less than 30% on my wants, because whatever I shovel into my savings account will eventually get spent on wants or needs anyway. For example, I've been "saving" like crazy lately, but some of that money will get spent on my new dental braces and a holiday this year, and in the longer term, I'll be putting it towards all sorts of things Future Sophie will need or want - a larger car, a family home, an emergency fund to buffer myself against life's ups and downs. My budget is roughly 45% savings, 45% needs, 10% wants. That works for me. But I'm in a privileged position, in that my housing costs are well below average. Which brings me to my final point...

Here's the bad news:
Shelter, as mentioned above, is in the needs category. In Australia, we don't have widespread access to affordable housing. The median house price in Perth is hovering around the $460,000 mark, which is expensive considering that the average income in Perth is just under $80,000. What's my point? On an $80,000 income, take home pay after tax is $2,395 a fortnight. Given that financial advisers generally agree that spending more than 30% of your take-home income on housing means that you're officially in financial distress, let's say that a reasonable rent or mortgage payment on a take-home salary of $2,395 a fortnight is $718.50. Great. Except that the median rent in Perth is now heading above $820 a fortnight, and the mortgage payment on that $460,000 median house price? That's $1,568.00. (Check out the mortgage calculator on this site if you'd like to see mortgage payments based on loan amounts - this is a very addictive tool!). So while I'm a strong advocate for trying to keep your fixed costs as low as possible, you have to be realistic about your situation and what will work for you.

Extra credit:
The MSN Smart Spending website is worth a read - the articles are about American finance and economics, but much of the advice is relevant to Australians too. I've found some of my favourite finance blogs by seeing the bloggers featured on Smart Spending.

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