One of the key principles of increasing your wealth over time is living within your means. This is no different than a successful business. If a business has more revenue than expenses, it makes a profit and increases its equity. As an individual, if you spend less than you make, you increase your wealth.
The 20% rule is another tool for your toolbox to help you improve your financial situation. If you follow it you are ensuring that you spend less than you make, which will put you on a path to building wealth. The rule says that whenever you get money, you always put at least 20% away for saving and investing before using the rest for spending.
How to apply the rule
For example, if you receive $100 as a gift, save $20 before spending $80. This is the epitome of paying yourself first and living within your means. You should enjoy spending the $80, but also enjoy the feeling of financial security saving and investing the $20 will bring. The same goes with getting a bonus at work, found money, rummage sale proceeds, etc. Put 20% away before spending the rest. You get the picture.
By following this rule you are, by default, building a favorable gap between your income and your expenses. You might also decide to set part of the 80% aside towards the purchase of a bigger dollar item. In that case you will accumulate portions of the 80% of spending money over time until you have enough to buy the item you want. This means you have the money BEFORE you buy an item, rather than putting it on a credit card to pay for with future earnings.
If you are currently living paycheck to paycheck (0% savings rate) or you have a low savings rate, start by using the 20% rule for money you did not plan on (gifts, rummage sales, an unexpected bonus, side hustle money). It will be tougher to do this with your main paycheck right out of the gate. However, start somewhere. Even if you are just saving 2%, start there. Build some momentum. Add 1% more savings every few months or so and you won’t even notice as you slowly creep toward the 20%. It may take months or a few years to get there, but you can do it!
I should note that some choose to save much more than 20%. The more you can save, the faster you may get to financial security! We are talking about rate and time (how large of a savings rate which will dictate how long to hit your goal). There is no right or wrong answer. Some have savings rates that approach 50% or more. It’s all relative to what you are trying to achieve and how you want to live to get there. I wanted to mention this so that you realize that 20% is not a magic number, but rather a healthy target for most.
Once you get to a 20% savings rate on all income you will really start building wealth. Use this 20% to first build attitude money, then an emergency fund, and finally investing for your future. It will feel really good as you continue to build wealth. You got this!