When I first began to learn about budgeting, I was absolutely clueless. I was totally new to the concept of budgeting and it was a daunting task to choose the best budgeting technique that suited my needs.
After having played around with 3 different types of budgeting techniques, I wanted to share with you how each one of them works and explain the merits and drawbacks of each approach. By the end of this post, you should have enough information to choose the technique that appeals to you the most.
1. 50/20/30 budget
This budgeting technique was originally popularized by Senator Elizabeth Warren in her book – All Your Worth: The Ultimate Lifetime Money Plan.
The concept behind this technique is very straight forward. You basically take your money after taxes and split them up into 3 different buckets.
This is the first bucket into which you will allocate 50% of your after-tax money. This is meant to cover all of your needs. Needs would include stuff that covers your monthly living expenses like Housing, Child Care Expenses, Groceries, Utilities, Insurance Premiums, Cell Phone, Internet Services, etc.
This doesn’t include any of the items which can be done away with if you are in the middle of an emergency or if the cash flow dries up. This should only include your absolute minimum amount to survive each month.
Needs lets you calculate how much money you should save in your emergency fund. It’s usually recommended to save 3-6 months of your living expenses i.e. Needs, in an emergency fund.
If you are looking at how to maximize your emergency fund savings, check out my post 5 ways you can make the most out of your emergency funds.
This is the second bucket into which you will allocate 30% of your after-tax money. This usually involves all the lifestyle items like your Netflix subscriptions, Hulu, Cable TV, your Gym memberships, Dining out, etc.
The idea is to give you the freedom to spend on these items without any guilt while at the same time being flexible on what items you want to spend the money on. For some people Dining out can be very freeing and they can spend a lot of money on that. For others shopping, till they drop can be therapeutic. You are free to spend the next 30% of your money however you want. No strings attached!
This is the 3rd bucket into which you should allocate 20% of your after-tax money. This can be a combination of savings, investments, and debt payments. This includes contributions made towards an emergency fund in a savings account, investments in retirement accounts like 401(k) or a Roth IRA. If you carry debt which could be a student loan or a credit card, you can even allocate this money to pay off your debt.
Use the money in this bucket towards anything that can help you grow your net worth!
- If you are looking for a simple budgeting technique without worrying about all the individual categories and subcategories to allocate money to spend every month, this is the best technique for you.
- It can help you establish a great savings rate at 20%, which puts you well above the national average in America, in terms of saving rate. The average American household saves about 6% according to this report. I love this technique for this reason alone.
- When you don’t have a clear allocation of funds for a specific item inside each bucket, you can easily overspend on an item. E.g. You could overspend on Dining out in a particular month while running short on another expense in the same month.
- Most of the budgeting apps and tools aren’t tailored to support this kind of budgeting. So if you are looking to utilize some popular budgeting tools out there like EveryDollar, Mint or YNAB, you might feel out of place. The recommended way of using these apps doesn’t play well with a 50/30/20 technique.
2. The Envelope Method
If you are someone who believes cash is King, this is the best budgeting technique for you
- Identify all the different budget categories you wish to spend money on each month. E.g. Rent/Mortgage, Groceries, Electricity, Transportation, etc.
- Based on how much money would be coming in each month, start allocating the money you wish to spend on each category. Some of these categories like Rent, Cell Phone bills, Insurance premiums could be recurring expenses and hence they tend to remain almost fixed every month. However, items like Groceries, Transportation, Clothing, etc can vary from month to month. Make sure you take all the different categories into account while budgeting.
- Once you allocate money to be spent in a certain category, you should stick to your plan and not overspend in any category. If you are someone who splurges on certain categories and need a way to control it, this is the best technique to help you control it.
- If you are someone who loves to dive deep and know where and how each dollar should be spent, this method would be the best one out there.
- This is a great way to track how much money is being spent on every single category each month and you can then decide whether to increase or cut back spending on a certain category.
- Most of the budgeting apps work very will this technique. The most famous one being the Every Dollar app. You can also look at YNAB, which supports this style of budgeting but with a slightly different philosophy.
- If you follow the YNAB philosophy of budgeting, you can manage your budget, even if you are paid irregularly. It can help you break the cycle of living pay-check to pay-check.
- This budgeting technique needs a high level of discipline and effort to track your spending and keep it within the budget. You are the boss only until you write the budget but once you do, the budget dictates where the money goes.
- If you like a very hands-off approach to budgeting, this may not be the right technique for you since you constantly need to track if you are within a budget for a certain category or not. However, if you use apps like Every Dollar or YNAB, this can make your life a lot easier.
- If you are paid irregularly it can be hard to budget using this technique
Goal Based Budgeting
This budgeting technique is a hybrid technique of the methods listed above. The primary objective of this budgeting technique is to identify all the goals you wish to accomplish and allocate money towards each one of them every month.
- Identify all the goals you wish to accomplish. It can be short term, medium term or long term goals. E.g. A vacation you wish to take or a home remodeling project or pay off student loans.
- With each paycheck, break down your expenses and allocate the remaining money to fund each goal. From your take-home pay, set aside 30-40% of you the money to meet your recurring monthly expenses. The remaining money can be budgeted to fund all the different goals like retirement savings, vacation fund, house downpayment fund, etc.
- In order to keep things clear, you can choose to go with a bank which offers you to open a sub-savings account. This helps you to automate your funding towards each of the savings goals. Check out some of the online savings accounts with a reasonable interest rate and start stashing away money towards achieving those goals.
- It is very easy to tackle any goal since it can be broken down into small monthly contributions. You can conquer any goal with this simple savings formula.
Total Amount To Save = No of Months To Save * Contribution Per Month
- It helps you make progress on all of your goals simultaneously than following a very linear approach. Some people like this approach since it makes them feel like they are on top of all of their goals.
- If you are familiar with Dave Ramsey’s Baby Steps, which recommends you do one step at a time and tackle one goal at a time. This approach goes against that advice by asking you to budget for every goal simultaneously, every month. This can sometimes slow down the progress on all of your goals. Each goal will fight for its share from your paycheck every month and can cause the overall process to slow down.
- If you have too many goals in parallel, tracking them all by funding each one of them can be counterproductive. You definitely don’t want to have more than 3-4 goals at any given time. E.g. Retirement Savings, Vacation Fund, Kid’s 529 Plan, House Down payment Fund, etc can be example of goals which can all be attacked in parallel.
Now that you learned about the 3 popular techniques of budgeting, which one do you think is the best?
I would definitely not hand out a single winner here since all of them have their fair share of merits and drawbacks. However, I will leave you with a framework to arrive at the answer.
- Choose a technique that doesn’t make budgeting and tracking your spending a headache. I don’t want you to spend every waking minute of your life trying to balance your budget.
- Choose a technique that lets you meet your goals in a reasonable amount of time without feeling demotivated in the process. If you are on a debt payoff plan, choose a technique that lets you become debt free in the shortest possible time.
- Finally, remember that personal finance is more personal than finance. Your goal is to learn how to manage your money well and the techniques are just a means to the end. So pick something that appeals to you and gets started. Don’t be stuck analyzing the nitty gritty details of each technique. Once you master a technique you can explore other techniques.
What is your budgeting technique?