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"Am I spending too much?": the 50/20/10 rule

When you get into financial planning, whether for yourself or someone else, it's easy to get caught up in the numbers. When you have a question like "should I pay off my mortgage early?" or "should I take Social Security at 70 or 65?)?", you've got your Monte Carlo simulations and straight-line projections to give you a nice, numerical answer.

It's clean and clear, but it's not the whole picture.

Straight-line projections just look at expected returns; Monte Carlo adds volatility to the mix, but that's it. If you can borrow money at 5% and the expected rate of return is 6%, both of these would cheerfully tell you to leverage yourself to the hilt. Want to make your projections look happy on the surface? Invest in as aggressive a portfolio as possible and borrow every red cent you can!

Intuitively, you can see that this isn't a good thing. Why not? Because if 90% of your income is going to debt payments and something unexpected comes along, you don't have the flexibility to handle it. Maybe you find a great new job...but it requires a pay cut. Maybe your friend invites you on a vacation...but you don't have the discretionary income to go. Or maybe your car breaks down, and you don't have the funds to pay the deductible to get it fixed.

Not only is flexibility important because you never know what the future might bring, but it's also critical because of a key flaw in our thinking: we consistently underestimate just how much we ourselves will change. It's a documented cognitive bias called the "end-of-history illusion". If you take an average 20-year old and ask them how much they will change over the next decade, they will report an amount lower than the average 30-year old says they actually changed over the prior decade. The same holds true for those in their 30's v. 40's, and so on.

In order to combat this, we need to be intentional about having "dry powder"; we need to cultivate the flexibility to respond not just to changes in our environment, but to changes in our wants and desires. How do we balance that with taking on fixed costs like debt or rent? How do we balance that with saving? Enter the "50/20/10" rule.

50/20/10: the mechanics

There are a couple variants of the "50/20/10" rule, but they all have the same basic idea: setting aside certain percentages of your income for certain types of expenses. Before we get started, let me be clear: this is not a hard and fast rule! It's a guideline and a long-term target. If you can't even imagine saving 20% of your income, just set it as a goal; try increasing a little bit each year until you get there.

Below are the mechanics of how it works, and we'll talk about the why's and wherefores further down.

Spend no more than 50% of your after-tax income on non-discretionary expenses. This includes rent, utilities, minimum required debt payments, and the like. While it obviously excludes eating out and entertainment, the line gets fuzzy around groceries -- does Whole Foods count as a discretionary expense? I lean towards putting things in the non-discretionary bucket when it doubt, because this encourages you to move towards more flexibility, but as I said earlier, this is a guideline; pick a bucket and move on.

Save no less than 20% of your income. "Save" includes 401(k) withholding, funding your emergency savings, and any debt payments above and beyond the minimum (for example, extra mortgage payments). This includes extra payments towards prior months' credit card balances, but does not include paying off your current months' balance -- that counts towards either non-discretionary expenses above or "whatever" below.

Give away no less than 10% of your income. Yes, I'm serious: tithe. Not necessarily to church. Not necessarily to a charitable organization. Just give away 10% of your income.

Spend the rest on whatever you like. Eating out, vacations, whatever.


So that's the guideline, but why?

You've probably already guessed where the 50% non-discretionary limit comes from: the other 50% is flexible and fungible, but this is the stuff that has to go out. By limiting non-discretionary expenses, you give yourself the flexibility to handle threats and opportunities as they come. Maybe you limit savings this month so you can take that trip, or cut back on discretionary spending to handle that breakdown. What once was a huge decision or a major emergency becomes a straightforward choice or a minor hassle.

The save-no-less-than-20% rule probably also makes sense to you. If you're just starting out, there's a lot of noise in cash flow projections; sure, a Monte Carlo may show you having an 80% success rate, but that's making a lot of assumptions about your income and expenses that simply aren't going to hold up. If you're just starting out and don't trust projections that look six decades into the future, you can just set a target to save 20% (which includes paying down debt over and above the minimum), which helps to ensure that you start from a good place without making undue assumptions about the future. Another way to think about it is that this improves your flexibility -- the sooner you start saving, the wealthier you'll be as the years go on, which translates into more flexibility later on.

But why tithe? How does giving your money away help you financially, at all? The answer is that it doesn't -- not financially. Rather, it helps you in other ways.

For one, giving makes you happier. Apparently, we're wired that way. But it's counterintuitive, so it's not natural for us to do. Also, us engineers like doing cost-benefit analyses...but how do you do the cost-benefit analysis for giving your money away? This is where the 10% rule comes in; it gives you a somewhat-arbitrary but time-tested target that you can start with. Once you've discovered the joy of giving, you'll then have your own personal framework and dataset for analysis!

Not only is giving connected to your brain's pleasure centers, but it forces you to do some internal work. (Apologies, engineers, but I'm going to get a little spiritual for a moment.) If giving makes you afraid, why is that? What hidden, internal scripts are running that you need to bring into the light and take a good, hard look at? Who are you going to give to, and why? Why, in fact, are you here? What does money mean to you? If you're theologically-minded, what does stewardship mean to you? These are questions that are worth digging into and answering; you'd be surprised at how intertwined your relationship with money is to your core self!

And if you already give, but you find your debt mounting, you're not off the hook -- you need to take a hard look at your abundance theology and make sure it's up to snuff.

A starting point

That's 50/20/10. As I said before, it's a starting point, a heuristic -- something that can be useful as a datapoint, but shouldn't be the only measuring stick you use when looking at your cash flow. Feel free to tweak to fit your own situation and values!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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