Budgeting thumb rules simplified

In the previous post, we discussed income, savings, and expenses. If you have not read that post you can read it here. In this post, we will discuss some of the common thumb rules for budgeting, resulting in increased savings.

These thumb rules are developed over time with data but are not sacrosanct and can change with time and individual lifestyle. Therefore readers are advised to understand the principle behind these thumb rules and develop their baseline based on their calculations of what suits them.

The 50-30-20 rule

The 50-30-20 rule is a simple and effective budgeting strategy that helps you manage your finances by dividing your after-tax income into three categories as described below:

50% for Needs: This includes essential expenses that you must cover to live, such as rent or mortgage, utilities, groceries, transportation, insurance, and healthcare.
30% for Wants: These are non-essential expenses that enhance your lifestyle, like dining out, entertainment, hobbies, vacations, and other personal indulgences.
20% for Savings: This portion is allocated to savings, investments, and paying off debt. It helps you build an emergency fund, save for retirement, and reduce financial liabilities.

This rule provides a balanced approach to budgeting, ensuring that you cover your essential needs, enjoy your life, and save for the future. The good thing about this rule it is quite conservative and accounts for people earning lower incomes. The cost of the needs in general remains the same for everyone as the necessities like food, clothing, utilities, and groceries almost cost the same if there is no variation in quality. Therefore a person earning less would be required to assign a larger percentage of his/her income for needs as compared to a person earning comparatively more.

Although being conservative this rule is not sacrosanct and may require modifications for different people, thus there are several variations and alternatives to the 50-30-20 budgeting rule that can be tailored to fit different financial situations and goals as described below:

Zero-Based Budgeting: This method involves assigning every dollar of your income to a specific expense or savings category, ensuring that your income minus expenses equals zero, as opposed to the 50-30-20 rule where you assign a fixed percentage to all three categories. It requires detailed tracking and planning.
Envelope/Bucket Method: This is a cash-based system where you allocate money into different envelopes or buckets for various spending categories. Once an envelope is empty, you can’t spend any more in that category until the next budgeting period. In this, you can carry forward what is left in that envelope or bucket.
60% Solution: In this approach, 60% of your income goes towards committed expenses (needs and wants), while the remaining 40% is divided into retirement savings, long-term savings, short-term savings, and fun money. This rule helps you to manage your wants and needs within a single bucket.
Priority-Based Budgeting: This method involves listing your expenses based on their importance to you and allocating funds accordingly. It allows for more flexibility and personalization. For this rule to work people should have their priorities set out right.
Reverse Budgeting: Instead of focusing on expenses first, this method prioritizes savings and investments. You decide how much you want to save each month and then allocate the remaining income to cover your expenses. This rule forces people to live very frugally.

The above is good if your income and expenses are fixed throughout a particular period. But what if your income and expenses fluctuate throughout the year, and you are not sure if the amount allocated for expenses will suffice, you can still effectively manage your budget by incorporating some flexibility and planning strategies:

Adjustable Budgeting: Regularly review and adjust your budget to reflect changes in your income and expenses. This could be done monthly or quarterly to ensure it stays relevant.
Seasonal Budgeting: Plan for seasonal expenses by setting aside money during months with lower expenses. For example, save for holiday spending or annual insurance premiums during months when your expenses are lower.
Emergency Fund: Maintain an emergency fund to cover unexpected expenses. This fund acts as a financial buffer, preventing you from disrupting your budget when unforeseen costs arise.
Variable Expense Categories: Identify categories in your budget that are variable, such as utilities or groceries, and allocate a range rather than a fixed amount. This allows for some flexibility within those categories.

Thus the 50-30-20 rule and its variations help us in budgeting prospering so that we can utilize the full potential of our income. As said earlier this rule can be modified to meet certain goals, if you want you can increase your savings percentage and reduce the wants percentage to meet your future corpus targets.

The 20-4-10 rule car

The 20-4-10 rule is a guideline for buying a car that helps ensure you don’t overspend on a vehicle. A car becomes an important part of the life of anyone having a family of more than 3 people. Therefore it is necessary to properly budget for it. Here’s how this rule works:

20% Down Payment: Aim to make a down payment of at least 20% of the car’s purchase price. This reduces the amount you need to finance and can lower your monthly payments and interest costs.
4-Year Loan Term: Finance the car for no more than four years (48 months). Shorter loan terms mean you’ll pay less interest over the life of the loan and avoid being “upside-down” on your car loan (owing more than the car is worth).
10% of Monthly Income: Ensure that your total monthly vehicle expenses (including loan payment, insurance, and maintenance) do not exceed 10% of your gross monthly income. This helps keep your transportation costs manageable and within your budget.

This rule is designed to help you make a financially sound decision when purchasing a car. Buying a used car can be a great way to save money, but it’s important to approach the process carefully.

As with the previous rule, there are a few variations and alternative guidelines to the 20-4-10 rule for car buying that can help you manage your finances effectively:

15-3-8 Rule: This rule suggests making a 15% down payment, financing the car for no more than 3 years, and ensuring that your total car expenses do not exceed 8% of your monthly income. This approach emphasizes a shorter loan term and lower monthly expenses. This is more conservative than the 20-4-10 rule.
25-5-15 Rule: This variation recommends a 25% down payment, a 5-year loan term, and keeping car expenses under 15% of your monthly income. It allows for a longer loan term but requires a larger down payment to offset the extended financing period.
10-4-10 Rule: This guideline advises a 10% down payment, a 4-year loan term, and keeping car expenses within 10% of your monthly income. It offers a lower initial payment but maintains the same loan term and expense ratio as the 20-4-10 rule.

These variations can be adjusted based on your financial situation and goals and the predictability of your income.

But what is the role of loan duration in purchasing a car? Shorter loan terms are generally recommended for several reasons:

Lower Interest Costs: With a shorter loan term, you pay less interest over the life of the loan. This is because the interest is calculated over a shorter period, reducing the total amount you pay.
Build Equity Faster: Shorter loan terms help you build equity in your car more quickly. This means you owe less on the car compared to its value, reducing the risk of being “upside-down” on your loan (owing more than the car is worth).
Financial Discipline: A shorter loan term encourages more disciplined financial planning. It requires you to make higher monthly payments, which can prevent you from overspending on a car and help you stay within your budget.
Reduced Depreciation Impact: Cars depreciate quickly, especially in the first few years. By paying off your loan faster, you minimize the impact of depreciation on your finances, as you own the car outright sooner.
Flexibility: Once the loan is paid off, you have more financial flexibility. You can redirect the money that was going towards car payments to other financial goals, such as savings, investments, or paying off other debts.

Being “upside-down” on a car loan as mentioned in one of the points above, also known as having negative equity, means that you owe more on your car loan than the car is currently worth. There can be multiple reasons how this can happen and why it matters:

Depreciation: Cars lose value over time, often rapidly in the first few years. If your car depreciates faster than you pay down the loan, you can end up owing more than the car’s market value.
Low Down Payment: If you make a small down payment or no down payment at all, you start with a higher loan balance, increasing the risk of becoming upside-down.
Long Loan Terms: Longer loan terms mean lower monthly payments, but they also mean you pay off the principal more slowly. This can lead to negative equity if the car’s value drops faster than you pay down the loan.
High Interest Rates: Loans with high interest rates can also contribute to being upside-down, as more of your monthly payment goes towards interest rather than reducing the principal balance.

Being upside-down affects people in the following ways:

Selling or Trading: If you want to sell or trade-in your car while you’re upside-down, you’ll have to pay the difference between the loan balance and the car’s value out of pocket.
Insurance: If your car is totaled or stolen, insurance will only cover the car’s current market value, not the loan balance. This can leave you with a remaining loan balance to pay off.
Financial Flexibility: Being upside-down limits your financial options and can make it harder to manage your finances if you need to change vehicles or face unexpected expenses.

To avoid being upside-down, consider making a larger down payment, choosing a shorter loan term, and being mindful of the car’s depreciation rate. Luxury cars tend to depreciate faster than mass-market cars as they are already priced relatively high.

The 4% rule

The 4% rule is a popular guideline for retirement planning that helps determine how much you can withdraw from your retirement savings each year without running out of money. Here’s how it works:

Initial Withdrawal: In the first year of retirement, you withdraw 4% of your total retirement savings. For example, if you have INR 1 Crore saved, you would withdraw INR 4Lakhs.
Adjust for Inflation: In subsequent years, you adjust the withdrawal amount for inflation. This means if inflation is 6%, you would increase your withdrawal by 6% to maintain your purchasing power.
Sustainability: The rule is designed to ensure that your savings last for at least 30 years, even through market fluctuations.

The 4% rule was developed by financial advisor William Bengen in 1994, based on historical data on stock and bond returns. While it’s a useful starting point, people should project their own retirement life and calculate the corpus required based on this projection.

Sequence-of-returns risk is a crucial factor to consider when applying the 4% rule for retirement withdrawals. It refers to the risk that the order and timing of investment returns can negatively impact your retirement savings, especially in the early years of retirement. Here’s how it works:

Early Losses: If you experience significant market losses early in retirement, your portfolio’s value can drop substantially. Since you’re withdrawing a fixed amount each year, these withdrawals will represent a larger percentage of your diminished portfolio, accelerating the depletion of your savings.
Compounding Effect: Negative returns early on can have a compounding effect, making it harder for your portfolio to recover even if the market performs well in later years. This can increase the likelihood of running out of money.
Withdrawal Impact: Consistent withdrawals during periods of poor market performance can further erode your portfolio. This is because you’re selling assets at lower prices, locking in losses, and reducing the amount of capital available to benefit from future market gains.

There are several steps you can take to mitigate Sequence-of-Returns Risk:

Diversification: Maintain a diversified portfolio to reduce the impact of market volatility on your overall savings.
Flexible Withdrawals: Adjust your withdrawal rate based on market performance. For example, withdraw less during market downturns and more during good years.
Buffer Assets: Keep a portion of your savings in less volatile assets, such as cash or bonds, to cover withdrawals during market downturns without selling stocks at a loss.
Delay Withdrawals: If possible, delay the start of withdrawals to allow your portfolio more time to grow and recover from any early losses.

Understanding and planning for sequence-of-returns risk can help you better manage your retirement savings and increase the likelihood that your funds will last throughout your retirement.

The 1% rule of luxury

The 1% luxury rule is a guideline suggesting that you should spend no more than 1% of your net worth on luxury items. This rule helps to cap your spending on non-essential items, ensuring you don’t overspend and can continue to build your wealth.

For example, if your net worth is ₹5,00,00,000, you should limit your luxury spending to ₹5,00,000 (1% of ₹5,00,00,000). This approach encourages you to increase your net worth if you wish to spend more on luxuries.

Luxury items are non-essential products that are highly desired for their quality, craftsmanship, and status symbol. Some examples of luxuries include Haute couture clothing and fur coats, Jewelry and high-end watches, Designer handbags and luggage, High-end automobiles, such as sports cars, Yachts, Fine wines and spirits, and Luxury homes and estates.

Emergency Fund rule

The emergency fund rule is a financial guideline suggesting that you should save enough money to cover three to six months’ worth of living expenses. This fund acts as a safety net for unexpected events like job loss, medical emergencies, or major repairs.

Some key points associated with the Emergency Fund are as follows:

Amount to Save: Aim to save between three to six months of your essential expenses. This includes rent/mortgage, utilities, groceries, medical emergencies, and other necessary bills.
Where to Keep It: Store your emergency fund in a liquid and easily accessible account, such as a high-yield savings account.
Building the Fund: Start by setting aside a small amount regularly. You can also use any financial windfalls, like bonuses or tax refunds, to boost your fund.

Having an emergency fund provides peace of mind and financial stability. Calculating your essential expenses involves identifying and summing up all the necessary costs you incur each month. Here’s a step-by-step guide to help you:

1. List Your Essential Expenses

Essential expenses are those you must pay to maintain your basic standard of living. Common categories include:

Housing: Rent or mortgage payments, property taxes, and home insurance.
Utilities: Electricity, water, gas, internet, and phone bills.
Groceries: Food and household supplies.
Transportation: Car payments, fuel, public transportation, and car insurance.
Healthcare: Health insurance premiums, medications, and medical bills.
Debt Payments: Minimum payments on credit cards, student loans, and other debts.
Insurance: Life, health, and disability insurance.

2. Track Your Spending

Keep track of your spending for a month or review your bank and credit card statements to identify your essential expenses. This will give you a clear picture of your monthly outflows.

3. Calculate Monthly Totals

Add up the amounts for each category to get your total monthly essential expenses. For example:

Housing: ₹30,000, Utilities: ₹5,000, Groceries: ₹10,000, Transportation: ₹7,000, Healthcare: ₹3,000, Debt Payments: ₹5,000, Insurance: ₹2,000.

4. Review and Adjust

Review your totals to ensure they accurately reflect your spending. Adjust as necessary to account for any changes in your expenses.

5. Use Budgeting Tools

Consider using budgeting tools or apps to help you track and manage your expenses more efficiently. These tools can automate the process and provide insights into your spending patterns.

By calculating your essential expenses, you can better understand your financial needs and ensure you have enough saved in your emergency fund. Do you have any specific expenses you’re unsure about, or would you like help with a budgeting tool?

So these are some of the popular thumb rules that can be followed if you have not developed your own rules for budgeting for different expenses and milestones in life.

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