Managing finances with fluctuating incomes
You may choose the satisfaction of working on your own terms over the comfort of a regular salaried job. However, this choice typically comes with the uncertainty of not receiving a predictable income each month. Most prudent financial actions such as budgeting, savings and investments work on the assumption of a predefined regular income, out of which you will meet expenses, save and also invest for future goals.
If your income does not fall in the pattern of regular, defined receipts then you may have to make a few changes in how you go about to reach the desired outcome of a secure financial future.
Track and fix to budget
It is not enough to track just your expenses to be able to draw up a workable budget. When your income is unpredictable, it is also necessary to track the trends in past income to be able to estimate future income.
One way to do this is to take your average income over the last 12 months. Another, more conservative, view is to take the lowest income over the previous 12 months. This approach will eliminate the risk of the average income coming up higher because of a few months of very high income, which is not representative of the actual income being earned.
Either way, these are just estimates and therefore it is important to apply rigour in estimating expenses and sticking to the budgeted levels. Track expenses over a few months and categorize them as necessities that have to be met each month, priorities that you would like to meet when income is available and discretionary expenses that can be cut back or eliminated completely, if necessary.
The necessities include: housing (whether rent or mortgage), food, transportation, expenses related to the family, insurance and health expenses. This is the minimum level of income you need in a month. The aim should be to limit fixed and mandatory expenses when income is variable. If you are starting your earning career with variable income, then add fixed expenses—such as mortgages—only after you have built up your cash flows to some level of predictability. If you are switching from a stable income profile to a variable income one, then take the time to pay down your debts so that there are fewer mandatory expenses to be met once you switch. Include taxes in the list of expenses to be met.
Another precaution is to set aside each month the sum of money required for any expenses that are due annually, such as taxes. If you do not do this, you are likely to be faced by a large outflow in one month, without having the funds to pay for it.
Build a cash reserve to normalize volatility
You will know only at the end of the month whether you actually made the minimum income you require to meet expenses. A cash buffer will help bridge the gap, if any. It will also help meet expenses if the cycles for income and expenses are different. You can draw from this cash buffer when you need to but make sure to replenish it as and when you receive any income. The cash buffer should not be seen as an additional income stream. Do not confuse it with an emergency fund. The cash buffer is only for you to manage any temporary shortfall or delay in expected income.
Apart from this buffer, you need to have an emergency fund to meet other conditions such as: loss of income-earning opportunities, medical emergencies or other large expenses that were not budgeted for. If you have time to plan your move to a variable-income situation, then build your cash buffer and the emergency fund before you make the switch.
If you have already made the switch , then create the buffer by allocating funds to it each month and make it part of the essentials till you have an adequate corpus. Start with a 6-month buffer initially. Increase this if you find that your income fluctuates more than expected.
Giving savings their due
A fluctuating income is not a signal to switch off saving and investing for your goals. Since you would be giving up on employer's contributions to your retirement corpus and other financial benefits, it becomes more imperative that you start early and stay the course.
Make the savings component a part of your base needs and pay it out to yourself before meeting any other expenses. Don't let go of your goals. In fact, set specific ones. It will keep you from splurging that extra income in the months that you are flush with funds. Break down large goals into monthly saving targets. Track your progress regularly so you can make up for any slips.
Define your savings as a percentage of your expected income and increase the percentage over time as income moves up. While a portion of the savings should be invested with a focus on long-term goals, some portion of the savings should also be invested with liquidity in mind. This is important till adequate cash buffer and emergency fund are built up.
Consider building a portfolio to generate a passive income stream from dividends, interest and rental receipts to augment your income. This will help stabilize the income to some extent and help in managing finances better.
Have a system in place
It is important to have a system in place to manage your finances efficiently. Designate a bank account to hold the income from your professional or business services as and when you receive it. Pay yourself a monthly salary—as fixed in the budgeting exercise—into a separate personal account and use this account to meet your expenses and make investments.
There may be periods in which income levels may be high and the business account may be flush with funds. Don't consider this as money available for splurging. Use it to stock up your cash reserve as much as required, then ensure your emergency fund is adequately funded, and then meet your investment targets; before considering the amount to meet any expenses that is already listed as priority.
Not knowing how much you will earn from month to month can be overwhelming. Discipline is the key to making your finances work with a fluctuating income. You need discipline to stick with the budget, to exercise restraint in expenses when income levels are high and to resist the urge to use the cash buffer as an extra stream of income. It will give you a feeling of control over your finances as well as your life.
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