Stubbornly high inflation? Above average interest rates? Sketchy economic data? It’s no wonder that 63 percent of Americans say that their finances are a significant source of stress; according to a study by the American Psychological Association.
While there are certainly some financial and economic indicators to take note of, the truth is that most of it is just noise! What happens on a day-to-day basis with your money has very little to do with the outside world. In fact, the grand majority of successful financial behavior can be attributed to focusing on just a handful of important areas.
This is true not just for money but also for many other fields. It’s a phenomenon known as the 80-20 rule, and in this post, we’ll explain how it can be used to help improve your financial well-being.
The 80-20 Rule
Simply put, the 80-20 rule is an observation that 80 percent of the effects come from 20 percent of the causes. It’s also sometimes referred to as the Pareto Principle, named after the Italian economist Vilfredo Pareto who first developed it.
In the 19th century, while studying income distribution, Pareto recognized that 80 percent of the land was owned by only 20 percent of the population – hence they controlled most of what was happening in the country. This theory can be generalized to say that only a handful of the inputs determine most of the outputs. It’s applied to many fields of study including economics, business management, quality control, time management, and productivity.
Focus on the Top 20 Percent
One of the main benefits of using the 80-20 rule for personal finance is that it demonstrates that you don’t have to be an expert money manager or stock-picking wizard. All a person needs to succeed with their finances is to really hone in on a few key critical activities.
1- Budgeting
The root of many money problems comes down to a simple discrepancy between how much money a person thinks they spend in a month versus how much they actually spend. As humans, we’re really bad at estimating this figure, and that usually leads to more money going out than coming in.
We could all learn something by modeling our household finances after successful businesses. Profitable companies regularly prepare budgets to ensure they’re making money. If you adopt the same strategy of tracking and planning your finances, you’ll be more likely to stick to your budget and stay within the confines of how much you earn.
There are plenty of good ways to budget. You can use a helpful app like Buxfer, or you can do it manually by making a list of your expenses. It may be helpful to think of them in categories such as:
- Fixed expenses – Regularly recurring monthly expenses such as your mortgage/rent, mobile phone, utilities, insurance, etc.
- Variable expenses – Costs that are subject to change such as entertainment, groceries, household needs, auto maintenance, etc.
- You can even factor in some monthly buffer for unplanned expenses such as a bill that’s larger than normal or a necessary repair.
Compare the total of these expenses against your income and see if you’re making money or losing money every month. If you’re ever in the red, then there’s work to be done. Look through your spending and determine where cutbacks can be made.
2- Debt Reduction
Debt is usually a negative force working against your financial well-being. Because nearly all debt incurs interest, you’ll end up paying far more for the thing you purchased than you would have originally if it had just been bought with cash.
What’s worse is that when left unchecked, that interest will build on top of itself. This can lead to situations where even though you’re making payments, the balance never seems to go down – feeling like you’re stuck with this bill forever. People with high-interest credit card debt often get stuck in this type of vicious cycle.
When it comes to debt, the first thing to know is the terms of your loans. Whether it is a credit card, loan, or pay now pay later arrangement, make a list of the following:
- The remaining balance
- The minimum payment amount and when it’s due
- The APR (i.e., interest rate) you’re being charged. If it is currently zero, find out when that is set to change
- Any applicable late fees or other misc. charges
To get on track, ensure that you’re always making at least the minimum payment. This will help ensure that your credit history doesn’t take a hit.
From there, make a plan for how you’ll eliminate each debt you have one by one. A good place to start is by focusing on high-interest debt. The longer this accumulates, the more detrimental it will become. Devote all available resources to paying down the principal as quickly as you can. Rinse and repeat this process with every debt on your list.
3- Investing for the Future
Setting aside money is great. However, to really make it grow, you’ll want to do two things:
- Avoid taxes
- Invest it for compound growth.
Despite how complicated those objectives may sound, it is really just as simple as joining your employer’s retirement plan, such as a 401(k), and then contributing as much as possible. Chances are they have a matching incentive, which is basically being rewarded for saving your own money with even more money.
If your employer doesn’t have a retirement plan, you can always open a Roth IRA at any brokerage offering one. Pick plain vanilla funds like a stock market index and contribute regularly.
Until the Federal Reserve decides to reverse interest rates, high-yield savings accounts are also a great place to save for emergencies. With many of them currently paying interest as high as 5%, that’s not a bad return for just letting your money sit there.
4- Credit Rating
Credit is something that most people don’t think about until they really want to buy something big (like a house or vehicle) and need a loan. However, the problem is that if your credit score isn’t already that great by the time you want to apply, then it’s already too late.
Working on your credit score (specifically your FICO Score) is something you need to be doing now and always. This can be done by managing your credit as follows:
- Find out your FICO Score. Go to Experian and check it for free.
- Download a copy of your credit report and check it over for errors.
- Sign up to auto-pay your credit cards (as well as your other bills) every month approximately one week before they’re due. Then check on them a few days later to make sure the payment went through.
- Use your credit sparingly. Try to keep the utilization to less than 30 percent of your credit limit.
- If possible, pay your credit card balance in full each month. This will not only help prevent you from being charged interest but also keep the utilization ratio down.
For more great credit improvement tips, check out this article here.
5- Insurance
Finally, there’s going to come a time when you’ll be faced with a medical dilemma or home repair that you can’t pay for on your own. For these situations, you’ll need the help of insurance to provide you with the right coverage.
There are many different types of insurance policies. The top ones to carry are:
- Healthcare – Medical, dental, and vision.
- Auto – Protects you and your vehicle in case you’re in an accident.
- Home (or Renters) – Helps pay for any damage to your home caused by fire, wind, or other perils.
- Life – Provides a death benefit to your loved ones in case the worst was ever to occur.
Similar to your credit score, most people don’t think about insurance until it’s already too late. Therefore, get all the protection you can afford now so that you’re ready for whatever life throws your way.
Start by checking on what your employer provides. Most offer health and even life for a discount. For auto and home coverage, it helps to bundle with the same provider because you’ll get a lower price and only have to work with one agent.
The Bottom Line
Money doesn’t have to be as complicated as everyone would like you to believe it is. Use the 80-20 rule to focus on the top activities influencing your financial health. This will not only help to reduce your stress but also do more for your financial future.
Featured image credit: Unsplash
Buxfer Blog 