Mastering the Ins and Outs
In my previous post, I mentioned about the need to know our financial circumstances as a starting point to chart our financial journey from. If you are someone who would like to have clarity on where your money goes to, tracking your income (inflows) and expenses (outflows) is what you need to do! The goal is to start tracking them before making improvements through using a budget, i.e., a spending plan that you can follow. Simply put, we would want our inflows to be consistently higher than outflows to see our savings grow.
In this post, I will be covering the different types of income and expenses that we may encounter and a budgeting rule that is gaining huge popularity because of its simplicity.
Inflows
Active Income is income received from a job or business that we actively participate in. In other words, it will be the paycheck that we receive for the hard work that we put into our job. As we are required to actively trade our time for money, this source of income ceases when we stop working; be it voluntarily, e.g. in-between jobs or retirement or involuntarily, e.g. due to a disability, illness or retrenchment. For most people, active income tends to be the main monthly inflow.
On the other hand, Passive Income is income earnt without active participation. Instead of trading our time for money, we trade other things instead. It can come in the form of financial capital where we get paid interest for depositing our money with a bank or earn dividends through investing in a company. I will cover the topic of investment in a future post. It can also be in the form of knowledge where we earn royalties from publishing and selling books or creating digital content through platforms like YouTube and Facebook. Or in the form of physical asset like renting out a property to generate rental income. Ideally, we would like to build up our passive income over time.
From time to time, we may also receive a Windfall, i.e., a one-off sum of money that we receive unexpectedly. This could be a result of getting a huge bonus, receiving an inheritance, or winning a lottery. Given that a windfall is unexpected, we may not know what to do with the money and often it could be gone in no time if left unmanaged. For instance, 70% of lottery winners lose or spend all their winnings within five years of receiving the monies. Therefore, instead of spending the windfall, consider using it to pay off debt and invest prudently.
Outflows
Fixed Expenses are essential expenses that we need to incur on a regular basis. This category of spending tends to be predictable and doesn’t change significantly with the level of activity (therefore the term “fixed”). It includes money spent on essential items that we need to survive. For example, groceries, shelter, transportation, and utilities (not forgetting WIFI). Apart from that, we will also need to consider lumpy expenses such as insurance premiums and taxes that must be paid at certain times of the year. Do average out lumpy expenses if you are not paying on a monthly mode.
On the flip side, Discretionary Expenses are non-essential expenses that we incur to satisfy our wants. These are often associated with having a higher quality of living, e.g., dining out in restaurants, buying the latest tech gadgets or luxury goods. I think we can all agree that life can be tough; and it is fair to reward ourselves with a good meal or an occasional splurge from time to time. However, frequent overspending on our wants can be disastrous in the long run. It may not only hinder us from reaching our financial goals, but it could also land us in debt.
Unforeseen expenses are ad-hoc expenses that may catch us by surprise (a nasty surprise). These are expenses that we usually would not expect to incur in a regular month. For example, it can come in the form of medical emergencies, major home, or car repairs. Such expenses highlight the need for one to have emergency funds to pay for unforeseen expenses.
Surplus vs Deficit
After tracking your income and expenses, you can sum up the total inflows and outflows for a month. Following that, you can subtract the total outflows from the total inflows to derive your net cashflow.
Total Inflows – Total Outflows = Net Cashflow
If it is a positive number, it means you have a surplus as you spend less than what you earn. Theoretically, your bank balance should be growing each month. If it doesn’t, it could mean that you are spending more than what you have tracked. If it is a negative number, it means you have a deficit as you spend more than what you earn. Mathematically, we can either increase our inflows or decrease our outflows (or do both) to address the deficit. But in the short term, reducing expenses is something that we have control over and can take immediate action on. While growing our active and passive income can be something that we can work on over time.
50-30-20 Budgeting Rule
Be it a surplus or deficit, we can chart our way forward through using a budget. The “50-30-20” budgeting rule is a simple budgeting method popularised by US Senator Elizabeth Warren in her book, All Your Worth. The rules states that we can spend up to 50% of our inflows on fixed expenses; we need to cap our discretionary expenses to 30% of our inflows; and this would leave us 20% for us to save or invest. Depending on how much you are currently spending in each category, lifestyle sacrifices will have to be made to operate within the thresholds.
In the past, I found tracking my income and expenses a daunting exercise. It was not only tedious, but I was also fearful of confronting reality. The reality that I was spending too much and saving too little. But am I glad that I decided to confront this fear. After tracking my inflows and outflows for a few months, I was able to identify the main causes of my “financial leakage”. My discretionary expenses exceeded the 30% threshold as I was dining out too often and making unnecessary clothing purchases (bane of online shopping). By cutting back on these expenses, I am now able to set aside more than 20% for savings and investments each month.
Ok enough said. Get started on tracking your cashflows and working on a budget today if you have yet to do so (take action now, yes right now). I will suggest using a mobile app to make tracking easier. I personally use a free app called “Money Manager” to record my monthly income and daily expenses. In any case, you will find plenty of options out there by Googling. Go try them out and I am sure you will find one that works best for you!