Millions of Americans earn incomes that vary from month to month and paycheck to paycheck. Whether you work on commission, an hourly basis or as a freelancer, it can be difficult to determine financial priorities.
Workers with a set salary know exactly how much they'll bring home and can plan accordingly. With a less predictable income, however, you must estimate your earnings. Using median yearly income as a baseline means half the time you'd be earning less than your estimate. Instead, pick a baseline that you won't dip below, except in the harshest circumstances.
Here's how to do that: Look over your past five tax returns and pick the lowest year. When it's time to plan your budget, divide total income from the bad year by 12 and use that value for your monthly income. Next, add up monthly expenses and compare that with income. If your income is lower than your expenses, find a way to reduce spending or risk getting in trouble in a down year.
A danger of unpredictable income is building up consumer debt. If you earn less than your baseline income in a given year, you may turn to credit cards to make ends meet. As soon as things look up, the No. 1 priority should be to pay down your balance -- even at the expense of savings. Why? The 3% interest you stand to gain on savings in a money market account is paltry compared with credit-card interest.
A home equity line of credit (HELOC) is a better choice. With a line of credit, you pay interest only on the amount borrowed. And it's tax-deductible. That means you can leave the line of credit open and untouched without having to pay any interest, and when you do have to tap it, some of the interest you pay can go toward lowering taxes. What's more, this money is often available at a much lower rate than that of credit cards. The national average interest rate for a HELOC is about 5.5%, compared with 11% or more for credit cards.
To help avoid debt, build a bigger safety net. Those with regular salaries are encouraged by financial advisers to save three to six months of expenses in an emergency fund. But with a less predictable paycheck, aim for a year's worth. Stash it in a low-risk account that will earn some interest, such as a high-yielding savings or money market account. Having access to an emergency fund can help cover a shortfall in a bad month, as well as unforeseen expenses if you lose income due to illness or a family emergency.
Most freelancers must save for retirement on their own. For them, a simplified employee pension individual retirement account (SEP-IRA) or a Solo 401(k) are as beneficial as funds offered to regular-wage earners. Many of these accounts allow flexibility with contributions -- more in a good year, less in a bad year.
But what's the fun of a good year if you can't treat yourself to a little reward from time to time? Once you've set yourself up to weather an unforeseen drop in income, put the remaining money toward long-term goals such as buying a home or a new car or heading off on a relaxing vacation. You can also use a portion of that surplus to shop to your heart's content. And best of all, this splurging can be entirely guilt-free if you've covered all of your bases.
Peter McDougall is a freelance writer who lives in Freeport, Maine, with his wife and their dog.