A rule of thumb is an approximate way for doing something. It's based on experience, not theory.
Personal finance is personal and so there are many rules of thumb: saving 10% of your gross salary for retirement or making a 20% down payment on a home (because you save way more doing that than paying for CMHC insurance).
Budgeting is an essential, yet dull, tedious, and arbitrary. If you set aside 5% of your budget on going out, and you spend it in the first week and a good friend pleads with you to go out to an trendy new bar, where they'll pay for everything but your Uber, are you sticking to your budget?
Enter the 50/30/20 rule.
What is the 50/30/20 rule?
The rule of thumb is simple: 50% of your after-tax income is allocated towards your needs, 30% is for your wants, and 20% is for saving and or paying down debt. It allows you to manage your money effectively and understand your limits.
How the 50/30/20 breaks down
The first step is to determine your net income. Your net income is the amount of your paycheque after all the deductions, such as Canada Pension Plan (CPP) contributions, employment insurance (EI) premiums, health insurance, and federal and provincial/territorial taxes.
Often, your take-home pay increases as you near the end of the year. That's because you've hit the annual maximum amounts for CPP and EI. So, keep that in mind when you’re trying to calculate your net income.
Use this income tax calculator to give you a reasonable estimate.
Set aside 50% for your needs: Defining your needs
Now that you know your after-tax income, allocate half of it for your day-to-day needs. Your needs include shelter, food, clothing, and sleep. In more direct terms, that's your rent or mortgage, utilities like gas, electricity, and water, groceries, transportation, and possibly childcare.
These are the expenses you’ll have no matter where you live or work. The thing to remember is not to go over the 50% mark.
If you're approaching, or going over the 50% mark, think of ways to reduce these costs, while keeping what you value most in mind. Should you move to a cheaper apartment or can you eat out less? Can you refinance your home with a better mortgage rate? Maybe you can sell stuff you don't need anymore? What about walking or riding a bike instead of using your car? If so, can you save a few hundred dollars a year comparing car insurance online? Can you throw on sweaters instead of cranking the heat? You can you time your showers to reduce water consumption. Are you earning rewards on your credit card? If not, can you find a better cash back credit card?
Have fun with 30% dedicated to your wants
If you think about it, 30% sounds like a pretty good amount for your wants. Dinner at a five-star restaurant every week? A first-class flight to Europe? A trip to the spa for a massage every month? Sounds nice, right? Maybe not.
Before you dream big, your wants aren’t just the best things in life.
Your wants are the internet and cell phone bill, dining out with your friends, your gym membership, your coffee & wine addiction, your streaming services, your never-ending list of subscriptions.
When you find yourself spending more than 30% on things you want, it’s time to look for ways to cut back.
Switch to a cheaper wireless provider, buy less expensive clothes, and do food prep for the week to only buy food when it matters. Do you need the gym membership or can you use an app on your phone? Can you make coffee at home? Invite your friends over for a pot luck?
If you’re able to get spending on your needs below 30%, you can put put more towards the final 20%.
Compare car insurance quotes from Canada's top providers
Set aside 20% for saving, investing, and paying down debt
The remaining 20% should go towards debt repayments, savings, and investing.
Yes, you can do all three at the same time.
It's about your mental health and money mindset.
Paying down debt
If you want to pay off debt faster, you can designate a higher percentage of the 20% towards credit card debt or student loans. You can use the snowball or the avalanche method. The debt avalanche is paying minimum balances on all your debts, and putting the majority of what's left towards paying off your highest interest rate debt first (likely your credit card). You pay less interest over time, but requires discipline.
The debt snowball is paying the minimum on all your debts, then paying off the debt that is easiest to tackle. It's good for mental health because you're checking an item off your list.
If you have multiple credit cards, consider a balance transfer credit card option.
Sinking and emergency funds
Sinking funds are diversified savings accounts for your goals. For instance, you could have a sinking fund to put $25 in per week to save for Christmas, another one for travel, and another one for car maintenance.
An emergency fund starts out as a bump fund. Set aside $25 per week and at the end of the year, it's $1,200. Emergency funds are great for your mental health because you can use it when your car brakes down and you need $800 for maintenance. Or, when your laptop dies, or when you're just sick and tired of your job, an emergency fund allows you to walk away knowing you have cash to sustain you.
Why you want to start investing now
Don't be intimidated. You can start with a robo-advisor that does the investing for you. You just have to fund the account, and then set up automatic payments.
A 10% gain on $1,000 is $100.
On $10,000 is $1,000
With $100,000, a 10% gain is $10,000.
A 10% gain on $1,000,000 is $100,000
Your start slow, but end up with big numbers. Your first hundred thousand is the hardest. But you can reach magical numbers passively with a robo-advisor. Once you're older, and care more about retirement, you will thank your younger self.
The bottom line
Without spreadsheets, you can do the 50/30/20 rule by just highlighting in your debit and credit card statements what's what. Then, add up the different categories, and see where you land and what needs adjusting.