What’s the percentage rule for budgeting?

The percentage rule is a term that has floated around for some time when it comes to savings, budgeting and managing money. However, it may not work for everyone and it often isn’t as black and white as it seems.

We spoke with head of money at smart money app Plum, Rajan Lakhani, and CEO of Marygold & Co, Matthew Parden, to discuss what exactly the percentage rule is.

What is the percentage rule?

It’s when you divide your income between different categories, for example, necessities, wants, and savings. Lakhani explains that there are different percentage rules available. “One of the most common is the 50, 30, 20 budget,” he says. “That means you spend 50 percent on things that you need to spend on, for example energy bills, housing costs, mortgage, rent or transport – all of your essentials. Then you have 30 percent that you spend on wants and things that you like to do, for example a holiday, eating out or going to the cinema. The final 20 percent you set aside for your future, a particular long-term goal or even your pension.”

“That’s one of the most common ways to do the split and the key thing to take away is, with that 20 percent, make sure you have cleared your debt. You want to make sure that’s reserved for your long-term future but before you can afford to put things aside for that, make sure you paid all your debt in advance.”

He adds however that when it comes to this rule, people shouldn’t feel like they haven’t achieved anything if they don’t quite meet the 50, 30 or 20 percent. “The key thing is to start,” Lakhani says. “Once you start that amount can build over time. 50, 30, 20 is ideal but your circumstances might not allow you to exactly achieve that and there is no one-size-fits-all approach.”

“There is also now another rule which is coming to fashion – the one percent rule,” Lakhani says. “This is where if you want to make a purchase, you see if it would cost more than one percent of your annual income. For example, if you’re earning the average salary which is around £35,000 – the item would be worth £350. This rule then says, you need to take 24 hours to think about whether it’s actually worth buying and that gives you some time to think and reflect. Ask yourself what else might that £350 get you. This is quite a positive rule and actually allows people to reflect on whether what they’re purchasing will help them or not.”

How effective is the rule?

Parden says: “It all comes down to the individual that’s trying to follow the rule or the principle. Everyone is unique and has their own financial personality.

“From a psychological perspective, it’s good and a useful tool for some, but not for others. Broadly, we’ve got a lot of research into this in terms of financial and savings personalities of individuals. For example, there are the confident strategic savers, anxious people, avoiders and spenders. You also have social economic reasons as to why it may or may not work, depending on where you are, what your costs are, and housing costs. Then there are socio-economic reasons such as depending on where you are in your career, what your earnings are and where you live.”

“I think the good thing about it is that it provides a framework,” Lakhani says. “It gives people a form of discipline in which they can then look at how they manage their money. However, people may have also found that the cost of essentials are now higher than 50 percent, so based on that and their circumstances, the key thing to do is ask how to make the most use of the additional money that they have beyond essentials.

“The rule provides some structure and provides some guidance but the key underlying thing is to make sure that you’re building up your emergency fund,” he says. “You’re building up that financial resilience and if the worst was to happen, you’re in a much better position than if you had no savings set aside.”

Where would you start when using the rule?

“The first thing is understanding your own situation,” Parden says. “If you’ve got the motivation to start doing this then you really need to understand your net income in the first place.

“Then you need to understand where those costs are going. How many people really understand how much a month they’re spending on their essentials and their non-discretionary spend?” he asks. “The first port of call is to understand yourself, your own financial background and situation.”