By Michael Dooley, Patriot Financial Group
Here are a few tips that will help take the bumps out of budgeting an unpredictable income and may even make budgeting a pleasant experience.
1. Use cash for out-of-control categories
Use cash for variable expenses that tend to get out of control. This is crucial for living within your means. You’ll be amazed at how much you can reduce and control your spending just by following this principle. Using cash will give you complete control over the total amount you spend in a given category. When the cash is gone, it’s gone. This is especially important when you need to make the most of each monetary inflow because you may not know when your next inflow will be.
2. Build up a short-term emergency fund (STEF)
Build up a short-term emergency fund equivalent to 4 weeks of expenses. This step alone could save you hundreds of dollars in late fees and will give your life a little more peace. It will also keep you from going into debt when an emergency hits. Most importantly for those with an irregular income, a STEF will allow you more flexibility in budgeting and will help compensate for lost income during periods of unemployment or under-employment. For detailed instructions on how to create and manage a STEF, click here.
What if your income varies drastically?
If your income varies drastically, you may want to increase your STEF to 2 or even 3 months of expenses. The more drastic the fluctuations the more of an emergency fund you’ll need. The goal with the emergency cushion is to store up funds in times of plenty to compensate for the times of scarcity. Start with a STEF of 4 weeks and adjust up as needed. However, don’t adjust down. A STEF should be a minimum of 4 weeks of expenses.
3. Create a “Timing of Expenses” list
A “timing of expenses” list simply shows all your bills and when you have to pay them. This will help in our next step to prioritize the order in which expenses should be paid. It will also act as a reference to help ensure you pay your bills on time. To avoid late fees, make sure all your bills are on auto-pay. If auto-pay is not available, highlight the bill so you’ll always remember to pay it on time. As you write your bills down, note on each item if the payment day changes from month to month. There are three main scenarios:
•Paid on the same day each month (e.g. on the 15th of every month)
•Paid every x number of weeks (e.g. paid every other Tuesday)
•Paid every x number of days (e.g. paid every 30 days).
Once you create this list, updating it every month should only take a minute. After a few months you should be able to predict within a day or two when each expense will occur.
4. Create a “Priority of Expenses” list
Note: The “priority of expenses” list and the “timing of expenses” list can be combined depending on personal preference.
When living on an irregular income, it’s important to have clarity ahead of time about exactly where your income will go when you’re paid. Having a pre-determined plan combined with a STEF will help you sleep well at night and decrease the feelings of impending doom and uncertainty that you won’t be able to pay the bills. The “priority of expenses” list is the main tool in helping you decide ahead of time where your income will go. It is essentially a budget arranged chronologically and by importance, rather than by grouping similar categories. You will refer to this list every time you are paid in order to determine where the money goes. Create your list by:
•First, listing out all your bills in chronological order
•Next, listing out the rest of your remaining budget categories in order of importance
For most, this list will probably start with necessities like grocery and clothing, followed by high-priority items like savings (STEF, retirement, long-term savings) and debt reduction. Of course, housing would also be considered a necessity but is probably listed under “bills”.
As an example, my list might be ordered like this:
Bills (in order of date due)
Mortgage - 12th
Utilities - Every third Wednesday
Car payment - 23rd
Allocations (in order of importance)
STEF (if needed)
This is an extremely abbreviated list but you get the picture. After the bills, the most important categories are first and the least important, last. In other words, I first need to make sure I eat and can pay for necessary travel. Then I want to make sure I pay myself (retirement savings) and replenish any STEF if needed. Expenses like medical and car maintenance may not be used every month but will accumulate over time.
Therefore it usually won’t matter when in the month I assign those allocations.
If I happen to be sick early in the month, I could either use medical funds already allocated in previous months or move that expense up on the list for just that month. Finally, I figure I can allocate my haircut last. If I have a bad month, I could go without one entirely.
Your “priority of expenses” list shouldn’t vary much, if at all, from month to month. Include all your budget categories, even if they don’t apply every month. If you have categories that don’t apply in a certain month (like birthdays), just skip it and move to the next category when allocating funds.
5. Create a sample budget as a reality check and baseline
Having an unpredictable income makes it hard to ensure you’re meeting all your financial obligations, not to mention your financial goals. Therefore, it’s important to create a sample budget based on averages to see if you can meet your obligations AND achieve your goals, despite fluctuating income. The sample budget will give you a baseline from which you will vary from month to month based on your actual income. You should update your sample budget whenever you have a significant change in overall income or expenses to ensure you’re still on track with your long-term financial goals. To create a sample budget:
• Calculate your average income over 6-12 months
• Calculate your typical monthly expenses including contributions to savings and other financial goals (e.g. debt reduction)
• Enter in budget amounts for a sample month including these income and expense figures.
If you can’t meet all your obligations AND financial goals on your current average income, you’re due for a change. Otherwise you will never get ahead and always be flirting with increased debt. You need to eliminate unnecessary expenses or find additional income streams until you can meet all your obligations, necessities, AND savings goals on your average income. In some cases, a dramatic change in lifestyle may be in order.
6. Creating your actual budget - tips and tricks
Now it’s time to create your actual budget. All the steps until now have helped you create a solid set of reference materials to help you make budget decisions. In fact, you’ve basically made all the decisions about your budget already. Now you simply need to adjust the timing of payments and allocations based on when your income is available and how much there is.
Dealing with income
There are two ways to deal with income depending on how frequently you’re paid. If inflows are infrequent - roughly once or twice a month - treat each check individually and allocate it only for the time period until your next check. If inflows are frequent - roughly more than four times a month - group the inflows and allocate them once or twice a month.
Allocate infrequent inflows check by check
If you’re paid once or twice a month, it’s most efficient to allocate each check individually for the time period until your next check.
An example: Let’s assume you are paid $2,000 on the first of the month and you anticipate you’ll be paid again in ten days. Refer to your “priority of expenses” list, determine which bills are due in the next ten days, and allocate the $2,000 accordingly.
If the $2,000 doesn’t cover all your bills, or it doesn’t cover the bills and your necessities (e.g. food) for the next 10 days, use funds from your STEF and allocate it as needed. In this case you would designate the STEF amount used as “income” on your budget.
If the $2,000 covers all your bills and necessities for 10 days, continue on down your “priority of expenses” list allocating until the $2,000 runs out. Remember, after your necessities are allocated, replenishing your STEF should take top priority.
Allocate frequent inflows in chunks
If you receive inflows more than four times a month, it’s easiest to allocate your income in chunks rather than each inflow individually. If you receive your income in the form of checks, save them up and deposit them twice a month. If your income is automatically deposited into a bank account, just wait and allocate it all every two weeks. It’s easier to allocate a larger chunk of income twice a month than to constantly be allocating fragmented deposits. With your full STEF in place, you’ll be able to safely deal with income twice a month without worrying about negative bank account balances. The STEF acts as a shock absorber, allowing you to budget almost as though you had a regular income.
Split up single budget categories and allocate them in smaller pieces to create a “just-in-time” budget
Occasionally you may want to split up a single category, allocating part of it with the current inflow and part with a later inflow. If income is tight, this type of optimization will help you squeeze every penny out of a paycheck. By doing so, you create a “just-in-time” budgeting system, allocating only what you need, when you need it.
For example: Let’s say you have an inflow of $2,000 at the beginning of the month. $1,000 may go to a housing payment, $200 to utilities, and $300 for a car payment leaving you with $500 to allocate. Even though you could fully fund a $300 grocery budget category with the remainder, doing so wouldn’t leave enough for other categories like gas, personal, and cushion. Instead, if you think your next inflow will be in two weeks, just allocate what you think you’ll spend in the next two weeks on each budget category. Instead of allocating the full $300 for grocery, you might be able to get by on $150, leaving you more money to allocate to your other important categories and making it less likely you’ll need to dip into your STEF.
Allocate bills/obligations first, then everything else
Every time you allocate money for a period, follow the “priority of expenses” list, first allocating your bills and obligations and then allocating the rest to your other expense categories according to priority. Your allocations may vary from month to month but having the “priority of expenses” list should make the process much easier.
What if I make more than average in a month?
If you make more than average in a month you should have already referred to your “priority of expenses” list and funded all your budget categories. With the remaining income you should fully replenish your STEF to prepare for future months when you receive less than average income. Allocate the rest however you want.
What if I make less than average in a month?
First cover all the expenses you can from your allocated categories. Hopefully you will already have most of your expenses allocated already. If you run out of income to allocate, you can either take money from your STEF or skip the remaining categories if they are optional (like “haircut”). Fortunately, by the time you run out of income to allocate you should be near the end of your list where the categories are less important. Depending on how much your income varies, you may need to dip into the STEF quite a bit. It’s ok, that’s what the STEF is for. In the worst-case scenario, you should be able to cover a whole month of expenses on NO INCOME.
With a little planning and a methodical approach, budgeting on a self-employed or irregular income can be just as easy as budgeting on a regular income. By using the techniques above, you can take much of the variability out of your planning and know ahead of time exactly where your money should go.
The Patriot Financial Group, an MAR Benefit Partner provides comprehensive financial planning and wealth management for individuals and businesses. By virtue of membership to MAR you can receive a complimentary Financial Needs Analysis and access to group rates on multi-life disability insurance by calling Michael Dooley at 978-921-4104 Ext. 5.