Could your budget handle a drop in income?
One of the most difficult situations to deal with is a drop in income, as most people adjust their lifestyles to use up all of what they bring in. In fact, too many of us live right up to the limit of what our income buys, allowing lifestyle inflation to strangle our budgets no matter how much we bring in.
Unfortunately, that can be a real problem because life sometimes throws us a curveball. Once you are used to spending a certain amount, it's tough to deal with changes when income drops.
So what can you do?
The Importance of Income Diversity
One of the best ways to deal with a potential loss of income is to build up income diversity. This is important because you don't want to rely on one source of income for everything. If you make less with your "day job," being able to rely a little bit on a side hustle, or having some other type of income to fall back on can help. That's why you need to make sure you bank some of your extra income when times are good in order to create a passive income stream by the time the next crisis hits.
Do You Know What You Would Cut?
Another approach to dealing with a drop in income is to know which budget items you would cut in a pinch. It's a good idea to understand the situation ahead of time and figure out how to approach the problem before you are forced into a decision. This is because some people get so scared when their income drops that they can't think clearly until the storm dissipates a little.
Look at your spending patterns, and figure out what needs to be taken care of. Things like groceries and bills need to be covered as much as possible, even if you make less. However, you might be able to drop the cable subscription and eat out less.
Take the time to look at your spending now and be prepared. In fact, you could take it a step further and make some of those cuts now. You don't have to stop having fun, but you could consider cutting back some spending now. Then, take the savings and set them aside in your emergency fund so that you are prepared for the possibility of a drop in income.
Do You Have an Emergency Fund?
I know I sound like a broken record now but it really does help to have an emergency fund. Your emergency fund is designed to be a backstop in the event that your income drops and you no longer have the money to meet your current obligations. If you save up for a rainy day, you will be better equipped to weather an income storm.
With a little bit of a buffer, you also reduce the risk that you'll be mentally paralyzed by the big event that a drop in income usually accompanies.
Still, your emergency fund won't last forever. That's why you will need to make it a point to look for higher income later on. This of course changes if you are willing to cut spending back to match your lower income, but working your way up to a higher income is probably a better way to go long term.
Putting It All Together
Imagine a plumber making $150,000 but also saved diligently through the years. He's built up a $500,000 dollar portfolio that throws off $20,000 in dividends a year.
He also has a $50,000 emergency fund he can tap into just in case.
Now contrast this with a small business owner who runs a house cleaning business clearing $300,000 before the pandemic. Given the choice, no one has ever picked to be the plumber before because the small business owner makes twice as much and he never needed to get his hands dirty because all he does is manage his people.
But then the pandemic hit. His income drops to $100,000 overnight because many people are afraid of having non-family members in their house. He has no savings, which means that he's had to make drastic spending cuts in the past few months. And despite all the sacrifices, he's had to tap into his credit cards just to make ends meet. It didn't help that he was frozen stiff with fear the first few weeks and didn't cut any expenses, losing precious time, and putting his finances even deeper into the red.
He's even thinking of selling his house now because he simply can't afford the mortgage payments for much longer if the slowdown persists.
The plumber lost income too, in the tune of $50,000 a year. He now makes $100,000, just like the cleaning business owner. He had everything planned out though. He immediately sold his second car because it was his weekend car, and it's not like anybody went out during the pandemic anyway. He also cut off his cable TV because there were no live sports anyway and his gym membership, before those businesses were forced to shut down. With less work, he's had to eat out less so he's getting by just fine because his income plus the dividends from his portfolio is enough for him to weather this storm.
That's not all the good news for the plumber though. Because he could still make ends meet, he put $30,000 of the $50,000 to work by investing that sum into the stock market at the start of the shutdowns, and his $500,000 not only recovered but is worth $550,000 now. That's why his dividends are still projected at $20,000 a year, even though many companies already planned to reduced their dividend payouts in the future.
Congratulations if you've made it this far. Some people think what we suggest day in and day out are things they already know, and they will usually glance at these articles and just click onto another place. But how many of those people know the basics but don't practice it? The will to implement a plan today could be the difference between a lifetime of wishing for more money versus a comfortable living. That's why you need to really dig in, and then take the time to do something to better your future.
Want more ideas to help you achieve financial success? Get connected with a banker at FirstMidwest.com.