Learning how to successfully manage your surplus income is key to financial freedom. But before you can begin managing this income, you need to start by determining exactly how much of your income is surplus or disposable.
The finance industry usually calls this income disposable. Or income that can be easily spent. Or income, that if spent, won’t get you into trouble. It is true, this income could easily be disposed of. But I find it a bad mindset. This is surplus income, and should be used for your future good, not just disposed of.
What is your disposable income?
Surplus income, or “disposable income”, is the money left over after you have paid for all your essential living expenses. This is the amount that you can use to save, pay off your debts or invest.
Correctly managing your surplus income will help you avoid the common pitfalls that many people get to when it comes to personal finances. This surplus is often spent, frittered away or in other words, disposed of without much thought.
For some, it is even worse. For instance, if you spend more than your surplus income buying things or paying debt, then you will almost inevitably run out of cash and be forced to live on borrowings, which might in turn throw you into a vicious cycle of debt.
The key to financial security; is what you do with this surplus income over your lifetime. This small shift in thinking right here; away from disposable to surplus, is the difference between the people who are comfortable in retirement or the ones, that are in debt and broke at retirement.
Calculating Your Disposable Income
To calculate your surplus income, you need to take into account these two factors:
Your total monthly income – To calculate your total monthly income, add together all the money you receive from all your income streams each month. This includes your wages, child benefit payments, pension payments, tax credits, income from your businesses and so on.
Your total monthly expenses – It’s very important that you get a figure that is as accurate as possible because if you miss out on anything, then you will end up overestimating your living expenses and come up with a wrong figure for your disposable income. There are some online tools in the market that you can use to do this with a comprehensive list of all the possible living expenses.
To work out your monthly disposable income, simply deduct your monthly living expenses from your monthly income. If the figure is less than zero, revisit your living expenses and see where you can make some savings. Read more about budgeting here.
Investing Your Surplus Cash
Once you determine your disposable income, it is important to open a separate account for this money. This is the money you can use to pay off your debts, invest, save, or buy big ticket items. We cover this in more detail in the next article.
1. Paying Your Debts
To determine whether you should pay off your debts or invest your surplus income, you need to ask yourself what the potential gain is for each option. This is because in some cases you can invest the money you would have used, to make extra payments off your debts, and earn a much bigger return than the interest you are paying on the debt, thus making it a more economically viable choice.
You need to compare the debt interest and the investment interest. You should remember to account for the tax you pay on your investment income. An investment return of 8% may only yield a net return of 5% or 6% depending on the tax rate.
Paying debts has its merits, though. Unlike the investment return which is not guaranteed, paying off your debt is guaranteed to improve your financial position. Moreover, things like credit cards carry a very high interest rate of approximately 20%. There are not too many investment returns that will yield well above 20% to justify putting your money there instead of paying off your credit card debts. Read more about bad debts here.
Then of course there is the thorny issue of getting a bad credit scores for non-debt payment, which makes it harder for you to get loans, mortgages and so on.
If paying off all your debts is your first priority. Thens it’s advisable to pay your debts and loans starting with the ones with the highest interest rate first, down to the ones with the least interest. This is known as the avalanche effect.
2. Investing your Surplus Income
Investing is one of the core pillars of personal finance. There are many different ways that you can invest your savings pool of surplus income. The right method for you will depend on your investment goals (you should have this mapped out here), and the amount you are planning to invest. You also need to understand the risk/reward profile of each investment type.
Although this is not an article about investing, which I will cover at another time. I will cover a few basic points.
It’s usually a good idea to talk to a financial planner to help you choose your investment strategy wisely.
The best strategy for many people is to have a mixture of;
- short-term investments (1-3 years),
- medium-term investments (3-5 years),
- long-term investments (more than 5 years).
There are many investment choices available today. You can invest in stocks, bonds, exchange traded funds (ETFs), managed funds, binary options and so on.
Many people prefer investing in stocks because they are easy to understand. Long-term investing in stocks is usually a good strategy that yields much better returns than holding your cash in the back. The best thing when investing in stocks is to invest in companies you understand and diversify your portfolio.
Diversify across various asset classes to minimize the underlying risk for your portfolio.
- Investing in 3 or 4 stocks for a start is usually a good idea.
- Bonds carry a much lower risk than stocks, but yield a poorer return in general.
- ETFs are made up of many stocks and help to diversify your portfolio to minimize risk.
- Binary options are relatively new investment instrument. They are easy to trade, but require constant monitoring so they might not be ideal for everyone.
When choosing an investment instruments, consider 4 factors:
Risk/Return Ratio – Generally speaking, the investments with the highest returns are often the most risky. You should therefore try to balance your need for good returns with the need to preserve your capital.
Liquidity – The ability to turn your investment back into cash as short notice. Stocks, bonds, and ETFs are considered quite liquid because they can easily be converted to cash. For long-term investing, however, liquidity is not a major concern.
Tax Issues – When you buy shares, the dividends paid are subject to income tax. When you sell them, you will pay capital gains tax for any gains you have made on your investment. The capital gains tax, however, can be reduced by 50% if you hold your investment for more than 12 months.
Depending on the product, you can start investing with as little as $1,000. Talk to a financial advisor and let them advise you on the best investment to make with your money.
Using your surplus income, by first saving and pooling. And then investing it into assets that return both, capital appreciation or capital gains (they go up in value over time) and residual income (interest, dividends etc), is the secret to long term wealth. Even if your income is low, and you only have a small surplus, this strategy over the long term will reap rewards beyond your wildest imagination.