The 80/20 rule, also known as the Pareto Principle, might be the answer to managing your finances without getting lost in the weeds of detailed budgeting. This budget method focuses on paying yourself first and then living off the rest, making it ideal for those who want to prioritize savings without getting bogged down by complex financial tracking.
By flipping the traditional budgeting model on its head, the 80/20 rule ensures that your financial future is secure before you even start spending. But how does it work in practice? We asked a finance expert to give us their thoughts on it.
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What is the 80/20 rule?
The 80/20 rule, in the context of budgeting, is a straightforward way to manage your money that revolves around a core idea: Twenty percent of your income should be saved or invested, while the remaining 80% covers your expenses.
“It is important to pay yourself first because no one else will,” says Robert R. Johnson, PhD, CFA, CAIA, Professor of Finance at Creighton University’s Heider College of Business. “Set aside some money for the long run before you do any other spending. In essence, you are paying your ‘future self.’”
But what does “pay yourself first” mean, exactly?
- Prioritizing financial goals: By saving first, you ensure that your financial goals, such as building an emergency fund, investing for retirement, or saving for a large purchase, are met before anything else. This helps you prioritize your future well-being over present-day spending.
- Building wealth: “Pay yourself first” encourages consistent savings, which can accumulate over time. It emphasizes that you are the most important “creditor” in your financial life, and by securing your savings first, you are setting yourself up for long-term financial security.
- Automating discipline: By automating your savings (if possible), with the pay yourself first budget you remove the temptation to spend that money, ensuring that you consistently contribute to your financial goals.
In essence, paying yourself first is a mindset that frames saving and investing as non-negotiable expenses—just like rent or utilities—rather than something you do only if there's money left over.
“People move into a bigger apartment or buy a more expensive car or home to reward themselves for receiving a raise, and then they’re unable to improve their financial condition because they spend everything they make,” Johnson says. “[Instead], act as if you didn't receive the raise. That is, continue to live the same lifestyle you led before receiving a raise and invest the difference.”
Examples of the 80/20 budget in action
Let’s take out the “80/20 budget calculator.”
Example 1: Monthly income of $3,000
If you earn $3,000 per month, the 80/20 rule suggests that you should set aside $600 (20%) for savings or investments and use the remaining $2,400 (80%) for your living expenses, such as rent, groceries, and entertainment.
Example 2: Freelance income
For freelancers or gig workers with variable income, this rule can still apply. If you earn $5,000 in a busy month, you would save $1,000 (20%) and allocate $4,000 (80%) to cover your expenses. On slower months with lower income, the percentages remain the same, ensuring that your savings are always prioritized.
Another example will help illustrate how investing a raise can help build true long-term wealth: “Suppose one receives a $5,000 annual raise early in one's career,” Johnson says. “If you simply invest that $5,000 annually into an investment account growing at a 10% annual rate, you will have accumulated over $822,000 in 30 years. You will have invested a total of $150,000 and have earned $672,000 from those investments.”
The 80/20 rule is rooted in the Pareto Principle, which states that a small percentage of your actions (like saving) can lead to significant results over time. Let’s dive into this philosophical concept.
What is the Pareto Principle?
Named after the Italian economist Vilfredo Pareto (1848-1923), the Pareto Principle 80/20 suggests that 80% of outcomes come from 20% of efforts. In various areas of life, from business to personal productivity, the Pareto’s Principle can help identify where to focus energy for the greatest impact.
Applied to budgeting, the Pareto Principle 80 20 rule highlights that a small but consistent effort in saving can lead to significant financial stability. By automatically saving 20% of your income, you’re making a powerful move towards long-term financial success, even if the rest of your spending isn’t meticulously tracked.
What are the pros and cons of the 80/20 rule?
The 80/20 budgeting method has gained popularity for its simplicity and focus on saving, but like any financial strategy, it comes with its own set of advantages and challenges.
Pros:
- Simplicity: The 80/20 rule is easy to understand and implement. You don’t need to track every penny or create a detailed budget—just set aside 20% and spend the rest!
- Focus on saving: This method ensures that you’re consistently building wealth, regardless of your spending habits.
- Flexibility: The 80/20 rule adapts to your lifestyle. Whether you have a fixed salary or variable income, the percentages stay the same, making it a versatile approach.
- Less stress: Traditional budgeting methods can be overwhelming, especially if you struggle to stick to detailed plans. The 80/20 rule offers a more relaxed approach, reducing anxiety.
Cons:
- Not detailed enough: If you’re trying to pay off debt or manage specific financial goals, the 80/20 rule may not provide enough structure. You may need a more detailed budget to track progress.
- Requires discipline: If you struggle to save consistently, even the 80/20 rule might be challenging.
- May not work for low-income households: For individuals or families with low income, dedicating 20% to savings might not be feasible. In such cases, a more tailored budgeting plan may be necessary.
How to budget with the 80/20 rule in 5 steps
Ready to give the 80/20 rule a try? Follow these five steps to start budgeting with this finance strategy and see how it can help you prioritize savings.
1. Assess how much you earn
Start by determining your total monthly income. This includes your salary, freelance earnings, side gigs, and any other sources of income.
2. Set aside 20%
Once you know your total income, immediately set aside 20% for savings or investments. “Making retirement and savings contributions automatic is a wise approach; you should try and automate as many financial decisions as you can,” Johnson says. “If we are enrolled in an automatic savings plan, inertia and the inherent laziness of people tend to work in our favor. That is, once enrolled in an automatic savings plan, people tend to stay enrolled.”
3. Set aside 80% for expenses
The rest of your income should cover your living expenses, including housing, utilities, food, transportation, and entertainment.
4. Be flexible—but not too much
Life happens, and sometimes you’ll need to adjust your spending. If unexpected expenses arise, try to maintain the 20% savings rule as much as possible, even if it means cutting back on non-essential spending.
5. Review and revise
Periodically review your budget to ensure it’s working for you. If you find that you’re consistently overspending or struggling to save, you may need to make adjustments to your expenses or consider increasing your income.
Final thoughts: Is the 80/20 rule right for you?
The 80/20 rule can be a great fit for individuals who prefer simplicity and want to focus on saving without the hassle of detailed budgeting. It’s particularly effective for those with a steady income who want to build wealth over time.
However, it may not be the best choice for everyone. If you have specific financial goals, such as paying off debt or saving for a large purchase, a more detailed budget may be necessary.
Additionally, it might not work as well for individuals or families facing financial challenges. In these cases, every dollar counts, and a more granular approach to budgeting may be required to ensure that all needs are met.
If you’re intrigued by the 80/20 rule, there are several ways to enhance its effectiveness. For example, you could use the rule in conjunction with other financial strategies, such as the 50/30/20 budget or envelope budgeting, to create a more personalized financial plan.
Another way to maximize the benefits of the rule is to automate your savings. Setting up automatic transfers from your checking account to your savings or investment accounts can help you stick to the 20% savings target without having to think about it.