Minding the Gap Between Spending and Income

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This article originally appeared at US News and World Report Money.

Spend less than you earn.

That one sentence could very easily be the core rule of personal finance. If you abide by that one rule consistently, week after week and month after month, you will find lasting financial success in your life.

Of course, this success comes from two directions, both of which appear in this rule. “Spend less” is obvious – it’s a call to control your spending. The other part – “than you earn” – is the hidden part. It’s a call to increase your income.

The difference between the two is what I call “the gap.” The gap refers to the difference between your income and your spending. When that gap is large, you’re heading in a great financial direction.

I could write endlessly about how to spend less money and also how to earn more income, but what I’m more interested in today is how to manage that gap.

Here are the six steps I recommend for managing your gap. At the end of each pay period, this is what I would do with your gap. Go through this checklist and use your money to cover the first thing that’s not fully covered.

First, build a small emergency fund. Everyone should have an emergency fund of $1,000 sitting in a savings account that they can access in the event of an emergency. You should never trust a credit card as your emergency fund because you’re relying on a bank to extend credit to you at your exact moment of greatest need.

Why not more than $1,000? Most emergencies we face in life can be handled with $1,000 or less. A larger emergency fund is useful, but there are higher priorities to take care of first.

Second, pay off all high-interest debt. You can decide for yourself what constitutes high-interest debt, but I’d call anything that’s more than 4% higher of what home mortgages are to be high interest debt. Today, that would be around 8.5%.

Pay these off in order of interest rate, starting with the highest interest rate. You should use your gap as an extra payment on the highest interest debt, then when that one is paid off, move to the next one.

Once you’re free of high-interest debt, start contributing to your retirement. I would suggest contributing 15% of your gross income to retirement.

While this isn’t a retirement post, a quick rule of thumb to follow for the typical American income is to put money into your 401(k) up to your company’s match, then contribute to a Roth IRA up to the limit, then contribute more to the 401(k).

Next, build your emergency fund much higher. A good rule of thumb is to have two months of family living expenses for each dependent you have sitting in the bank.

Why should you have so much cash? Cash is king, and having cash on hand will solve countless problems that come your way. The more dependents you have, the more likely it is for you to have overlapping life problems – one person loses a job while another person is ill – and the more likely it is that there will be a dependent who can’t earn income.

After that, head for complete debt freedom. Eliminate your lower interest debts, such as your car loans, your student loans, and your mortgage.

If you’re in the situation where this is your highest priority, don’t sweat the “tax benefits” of holding onto these debts. You’re only gaining some tax benefits from the interest on the debt and that interest overall is not helping you even with the tax benefits. Pay it off and you’ll drastically improve your monthly cash flow.

The final step in the process is to start saving for big expenses that you know are coming up. Start saving for your next car, for example, or for your next summer vacation. These goals really depend on your personal life.

If you’ve managed to complete all of those things, you have a healthy emergency fund, a well-funded retirement, and no debts at all. If that’s your situation, you’re far ahead of most Americans.

The final step is really up to you. What are your big life goals? Spend some time thinking about what you want out of life. You now have plenty of resources to start working toward those goals very quickly.

Life is now your oyster, and it’s all thanks to the gap.

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