Thursday, February 28, 2013

The Pareto Principle of Personal Finance

The Pareto Principle or also known as the The 80/20 Rule is simple:
"Roughly 80% of the effects come from 20% of the causes"
A quick glance at the wiki article above sums up that the 80/20 rule is applied to different areas from economics to nature. I suggest we apply the same rule to personal finances. 20% of your income should generate 80% of your wealth.

How is this possible? Live off of 80% of your income and save the other 20%. That 20% should then be divided according to your family needs. Do you have an emergency fund? If you don't, you should take that 20% and build a 3 month one first. Have debt? After you have an emergency fund, take that 20% and pay off debt. Once you finish those steps then save 10% of that 20 for retirement (especially if your young). If your older save 15% for retirement out of that 20%.

The rest of that twenty should go into saving for items that you may want like a new car, furniture, vacations, college, and so on. This method will allow you to pay in cash for items, and gives you negotiation room when haggling. It will free you from using "90 days same as cash" or other financing scams that will put you in the hole. 

The very act of paying off debt is equal to getting a raise. The money you spend every month on credit card minimum payments could go to savings. Once the debt is go, you can pay using cash for the things you want.

I suggest using YNAB to start you off on the road of financial management. Once you have a buffer, then move to Quicken to maximize the money you earn and keep.

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