Phil writes in:
I recently switched jobs very suddenly when a spectacular opportunity came a long to double my salary. I’ve been working at my new job for three months and the regular paychecks have started rolling in. I have maxed out my 401(k) at the new job and there is much more being taken out in taxes but I am still bringing home about 75% more than before. What can I do so I’m not tempted to waste it?
Phil has his head on straight – he knows there’s temptation to spend money unwisely when there’s suddenly a lot of money put on your plate. My recommendation for Phil is as follows.
Increase your budget a bit, but not nearly as much as your raise. Let your spending go up a little bit, seriously. You now have a lot more breathing room than before. This doesn’t mean abandon frugality and start buying Dom Perignon by the case, but you should enjoy at least some of this newfound income. If you are bringing home 75% more than you were before, take your old monthly budget and increase the spending by 20% or so in a few areas. This will greatly lessen the temptation to go crazy and still leave you a lot of money to use to take care of business.
Build up an emergency fund. What about that other 55%? Focus on using it responsibly, and for starters, that means building up an emergency fund in a savings account somewhere. My rule of thumb is that for each dependent on your taxes, you should have two to three months worth of budget to save you during a job loss. So, whatever you spend in an average month, multiply that by the number of dependents you have and multiply that by two to see how big your emergency fund should roughly be.
Pay off every debt you have. Once that fund is in place, start paying off all of your debts. Start with the one with the highest interest rate and dump all of that extra 55% into that debt. Then go on to the next one, then the next one, then the next one, until you’re free of all debt. Some people might argue that you should invest at this point, but I have found that for people who have experienced a debt load, the psychological freedom of being out of debt is incredible and well worth it.
Define your goals. Once your debt is entirely paid off (or close to it), spend some time determining what your goals are. Are you interested in starting your own business? Perhaps you want to retire as early as possible. Figure out what your goal is, then identify an investment plan that matches it (if it’s short term, keep it in cash; if it’s long term, put it in a diversified portfolio, for starters).
The key thing is to not drastically change your lifestyle because of an increase in pay. The best way to do this, if at all possible, is to make some financial moves automatic. In Phil’s example, he should see if he can have a certain percentage of his check (about 30%) deposited in a completely separate place from his regular income and then use that money solely to put himself in better long-term financial shape.