If you’ve ever run out of money before your next paycheck or you wonder where that paycheck goes each month, a budget can be a useful tool. With a budget, you can see the amount of money you have to spend and exactly where you’re spending it. That information is beneficial for setting financial goals and making a plan to achieve them.
In many ways, the toughest part of making a budget is figuring out which budgeting method to use. The type of budget that’s best for you is the one you’ll stick with and continue to use. Get to know three popular budgeting methods and examine their benefits and drawbacks to help you choose the right one.
The goal of the 50/30/20 rule is to simplify budgeting. Instead of including a long list of different spending categories, this method has only three.
The 50/30/20 budget method can be ideal for those who’ve had difficulty with more complex budgeting methods in the past or those who want to feel like they have some financial flexibility and freedom.
Simplicity is the name of the game with the 50/30/20 budget. To start, calculate your total take-home pay after taxes. Then divide the amount of your take-home pay into three categories.
Let’s take a look at an example of the 50/30/20 budget in action.
Here are some of the benefits of following the 50/30/20 rule.
If you haven’t spent much time thinking about how you spend your money or where your money goes each month, the 50/30/20 budget can give you a reality check. For example, it can help you see if you’re spending too much in certain categories.
You can also use the budget to help yourself make financial decisions moving forward. If your take-home pay is $2,000 and your rent payment is $1,500, you’re already using over 50% of your income in the “needs” category. Taking a look at the actual numbers can help you decide if it’s time to find a less expensive rental.
Using the 50/30/20 formula, 20% of your take-home pay automatically goes toward savings or paying down debt. This method provides you with a concrete number so that you can evaluate whether you’re saving enough or not.
With this budget method, the minimum payments on your debts, such as credit card debt, student loans, and car loans, should go under the 50% “needs” category. However, depending on your financial situation, you might be able to also put some or all of that 20% you’re supposed to be saving toward additional debt payments.
Devoting some or all of your 20% toward additional debt payments, such as tacking on an extra $100 to your monthly student loan payment, can help you pay down debt sooner. It can save you money in the long run and allow you to start working on other financial goals.
Some people avoid budgeting because they think that budgets are restrictive. That’s not the case – especially with this budgeting method. You get a full 30% of your take-home pay to use toward the things you want. Those things can include any of the following:
Another benefit of the 50/30/20 method is that you don’t have to invest too much time or energy thinking about it. The method takes a big-picture approach, so you aren’t constantly keeping track of every little expense. Once you’ve calculated your needs and set your debt repayment and savings goals, you can sit back and relax, letting your money work for you. Just make sure you don’t go over budget in each category.
Although your budget should add up to 100% of your take-home pay, the budgeting system itself isn’t 100% perfect. Some flaws in the system mean it isn’t the right choice for everyone. Here are a few drawbacks of this method.
It’s not always possible for someone to stick with the 50/30/20 formula because of their income or the cost of living in their area. If you live in an area with a high cost of living, you might find that you need to put more than 50% of your take-home pay toward necessities, such as your rent or mortgage payment. A way to work around that might be to move to a more affordable area, but doing so might not be an option for you based on your job situation or your children’s schooling.
Your income level can also make it challenging to only dedicate 50% of your take-home pay to necessities or to allocate 20% of your income toward savings. Depending on your circumstances, you might decide to modify the formula to suit your needs. For example, you can put 60% toward necessities, 20% toward savings, and 20% toward wants.
The 50/30/20 budget gives you the option of spending 30% of your income on non-necessities, and that option might appeal to people who feel confined by other budgeting methods. For others, though, allocating 30% of take-home pay to wants can be too much. If you have a considerable amount of debt, or if you haven’t made any progress on your savings, spending 30% of what you bring home each month on fun things can get in the way of your financial goals or keep you in debt longer.
If your salary is higher than the median for your area, it may seem wasteful to spend 30% of your income on things you want rather than dedicating that money toward savings or other goals. If you earn less than the median for your area, it might not be feasible to allocate 30% of your income toward non-necessities.
For some people, too much flexibility can be challenging. The 50/30/20 method’s three categories are broad. If you feel lost on your financial journey, the 50/30/20 plan likely won’t give you enough guidance to set you on the right course or get you where you need to go.
Although digital tools, debit and credit cards, and online banking have streamlined and simplified finances for many people, some prefer the feel of cash. Physically handling money can make it feel more concrete and remind you that you’re actually spending your hard-earned income.
The envelope system traditionally relies on cash. To start, divvy up your income into categories, then put the cash for each category into an envelope. Once the envelope is empty, you’re done spending in that category for the month.
The envelope system works by giving you tangible spending limits. To use the system, calculate your take-home pay, then determine what your expenses are. You can pick the categories you use as part of the system and determine how much to allow yourself to spend in each category.
Then create an envelope for each spending category. For example, you might have envelopes for:
At the beginning of the month or whenever you get paid, put the designated amount of cash in each envelope. You might put $50 in the school activities envelope, $30 in your coffee out envelope, and $400 in your grocery envelope. As the month goes on, you pull money from the envelope to pay for corresponding purchases.
It’s possible to digitize the envelope system and use it with your debit card or credit cards rather than cash. For instance, if you’re a PSECU member, you can open multiple shares within your account. You can customize the names of these shares in online banking, and using our digital banking tools, easily move the money from your paycheck into the designated shares.
If you need a physical reminder of where your money is going each month, the envelope system might work for you. Here are some of the pros of this budgeting method.
When you use the envelope system, you clearly set spending limits. If you have $50 in your dining out envelope, once you’ve spent that $50, you’re likely to avoid going out to eat for the rest of the month.
This method also helps you see exactly where you’re spending the most. Using the envelope system, you might realize that the $50 you’re spending on coffee or meals out each month could better serve you if it went somewhere else, such as in your savings account or toward paying down your loans.
When you commit to paying with cash, you’re giving yourself a natural limit. With a card, you can easily spend more than you intended and not even notice it. With cash, you can only spend as much cash as you have with you (or in the envelope).
The natural limit that cash puts in place can help keep you from making impulse purchases when you’re out shopping, as well.
While you don’t want to move cash from one envelope to another to help you get through the month, the envelope system does give you some flexibility. If you’re having a lean month, you can simply decide not to budget for certain unnecessary expenses. You also have full say over the categories in your budget. If you need a category to pay for your kids’ ballet classes or for painting supplies, you can create envelopes for them, too.
If there’s money left in the envelopes at the end of the month, you can decide what to do with it. You can leave it in the envelope, anticipating that you might need to spend more in that category next month. Or, you can move the money into savings, helping yourself build a bigger financial cushion.
There are some potential drawbacks to using the envelope system. Knowing what the cons are can help you see if it’s a good choice for you.
Although you can digitize the envelope budgeting method, it is, at its heart, a cash-based method. There are certain drawbacks to cash. It’s not as secure as other methods of payment, for one thing. If someone steals your cash, it can be very difficult to get it back.
Not every company accepts cash payments, either, and paying your bills with cash usually takes longer than paying by card or check. If you pay an electric bill with cash, for instance, you’ll most likely have to go to the utility office and wait in line to make your payment.
How complex you make your envelope budgeting system is up to you, but it’s possible to get too complex, especially if you create envelopes for very detailed categories. If the system becomes too involved, you might lose track of some money or want to give up using the method altogether.
When you pay for items with a card, it’s easy to track them. You can simply log into your account and review your transactions or look at your statement to see where your money went.
It’s a different story with cash. It’s easy for $5 here or $10 there to go missing, especially if you don’t collect receipts for each and every transaction. You might find yourself wondering how you spent all the money in a particular envelope at the end of the month.
With the zero-sum method, every penny you earn has a purpose. This method asks you to spend down your monthly income until you reach zero. For example, if you take home $3,500 per month, you should have $0 left by the end of the month.
Aside from giving every dollar you earn a specific role, the zero-sum method differs from other budgeting formulas in a few ways. For one thing, the method expects you to be one month ahead. Rather than living paycheck to paycheck, you live on last month’s income when you use zero-sum budgeting – which can work well for people who have irregular income, such as freelancers or small business owners.
With the zero-sum method, decide what every cent you earn is going to do. For example, if you earn $3,500 each month and your monthly expenses total $3,000, determine what to do with the additional $500. You can put it toward savings or debt repayment, or you might decide to use it for a larger purchase.
A key feature of zero-sum budgeting is that you plan your spending based on money that’s in the bank. It can take a while to adopt this budgeting method since you might need to save up enough to stop the paycheck-to-paycheck cycle. You also need time to track your expenses and make decisions about altering your spending to make the budget work for you.
One feature that zero-sum budgeting has in common with the envelope method is that you assign categories to your spending and choose amounts for each category. How many categories you have in your budget is up to you and is based on your particular needs. Unlike the envelope method, though, the zero-sum method doesn’t expect you to make all of your purchases in cash.
Here are some of the advantages of using a zero-sum budget.
Since you’re spending last month’s earnings when you follow the zero-sum budgeting method, you can break the cycle of living paycheck to paycheck. It’s also easier to build up a small financial cushion with this method since you’re one month ahead on paycheck spending.
Similar to the envelope system, the zero-sum method can keep you from overspending. If you set limits for each category, you can train yourself to stop spending once you reach the limit. Depending on your lifestyle and goals, you might find that combining the zero-sum method and the envelope method provides you with a budget that helps you reign in your spending.
As you prepare to use the zero-sum method, track your income and expenses for several months. Doing so lets you see where your money goes and can help you make adjustments to better reach your goals.
The idea of assigning every dollar or cent a job can also help you get and stay on track financially. If you have money left over at the end of each month, you can add it to your savings, put it into a retirement account, or use it to pay off debt.
This budgeting method does have some potential disadvantages.
Spending last month’s money this month can be a big issue for many people, especially those who live paycheck to paycheck. One option is to use money in your emergency fund to get you started on your first month. The income you earn from your paychecks during the first month will go toward the next month’s budget and replenishing your emergency fund.
If the idea of dipping into your savings makes you nervous, another option is to focus on saving up an additional month of income before you jump into using this method.
Another possible drawback of the zero-sum method is that you could miss expenses while following it, particularly if you have irregular expenses such as insurance that’s due quarterly or vet bills every so often. One way to account for those irregular expenses is to divide them up and treat them as monthly expenses. A $200 insurance payment due quarterly can become a $50 monthly payment. Set the $50 aside each month until the bill is due.
The budgeting method that works best for you depends on your goals, your lifestyle, and your income. You might want to experiment with a few different methods, weighing the pros and cons of each one before you settle on a budgeting method you like best.
At PSECU, we want to help you get the most out of your money. For more tips on money management, visit our WalletWorks page.