Despite my relatively stable income, maintaining a healthy, consistent savings rate has always been a difficult test of my will. Either I'd find a new, shiny toy I just couldn't live without or I'd find myself in an emergency situation where spending was my only option.
I've always been under the impression that credit cards were to be used sparingly, but I never considered the ramifications of making interest payments and how disempowering "buy now, pay later" really is on your psyche. And, when you don't have a savings plan, rainy days quickly turn into credit card balances.
In 2012, I spent most of the year catching up with my 2011 tax payments. I jokingly refer to 2012 as my lost year, akin to the Japanese Lost Decade. Recognizing the error of my ways, I sought to find a methodology which would ensure this type of catastrophe would never happen again.
When receiving money, whether by way of your paycheck, a gift, or a garage sale, the typical procedure is to put it in our wallet or bank account and then spend it with mild to medium discretion. As long as we spend less than our income, we'll come out okay, right?
This strategy would suit us fine if we knew, with utter certainty, that our income will always exceed our necessary expenditures. Unfortunately, such casual treatment of our income doesn't account for a grave flaw in human nature: our tendency to justify wreckless spending because we'll make more money later.
In recognizing this pattern of earning and spending, I realized the only solution was to formalize a process around my income. Now, rather than simply depositing my income into my checking account and transferring an arbitrary amount into my savings account (usually only to be transferred back so I can buy "shiny new toy X"), I apply a series of filters to my income:
- 25% is set aside to pay my income taxes
- 15% is deposited into my savings account
- 10% is reinvested into my business (this pays for things like my Internet access, business cards, conference fees, etc)
- The remaining 50% is "mine".
I'm self-employed and withhold my own taxes, so of the items in the schedule above, only #2 might apply to you. I've found that saving 15% of my income is the sweet spot where I have enough liquidity month-to-month without having to habitually dip into my savings account to maintain my standard of living.
I use a spreadsheet to track every penny of my income and how it should be appropriated. By establishing consistent process for your income, you'll find yourself saving more and spending less.
Your new rewards card
When you save a percentage of your income rather than feebly saving arbitrary amounts each month, a pretty sweet thing happens: all of the sudden you accumulate a sizable balance and realize those credit cards you carry in your wallet suddenly feel less useful. Most people use credit cards "for the rewards" or "in emergencies." The truth is, carrying a high savings account balance yields astronomically higher rewards. Consider the following scenario.
Jane has a Chase Freedom Visa with a 15.99% APR and a $5,000 credit limit. She also has no savings account. Jane only carries a balance on the card in emergencies. Last night, her dog Sparky woke her up howling in the early morning and, startled, she took him to the animal hospital. Sparky needed emergency surgery. She swiped her Visa and incured a $1,683 charge overnight. Assuming she pays back her credit card bill using approximately 15% of her $4,000 income each month, she'll pay it off in three months and incur $45 in interest charges.
Sally, on the other hand, is carrying a $5,000 savings account balance and does not have a credit card. When Sally's dog Spunk needs to go to the animal hospital, she pays cash. Her savings account balance is now $3,317. Even if she only maintains her 15% savings rate, she'll have replenished her savings account in three months. The difference between Jane and Sally? While Jane was busy repaying the bank and incuring $45 in interest, Sally had been earning interest on her positive savings account balance. Jane will end up broke when Sally is worth $5,000, even though they both earn the same amount.
Don't trust yourself, fool
It's important to recognize that, when it comes to spending, humans have little to no self-control. By implementing safeguards into your income stream, you can ensure you're ahead of the inevitable emergencies that will arise. And believe me, it feels damn good. Fool.