How to deal with a drastic change in income

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Whether you’re dealing with a drastic increase or decrease in income, the key to mastering your income is a good budget. This may sound simplistic – a budget isn’t any good if you don’t have any money, you might think. But here’s the thing: you don’t actually know how much money you have unless you build a budget and actually stick to it.

Once you have a grasp on how much money you have, and whether your change in income can cover your current needs and lifestyle, you can start making choices on how to proceed.

##Step One: Make your budget

Every budget-making process should start with one question: What do I need to spend money on this month? The answer to this question will be different for everyone, but there are a few things we can assume. You probably pay rent or have a mortgage. You probably eat a few meals every day. You probably have bills for utilities or your cell phone or your health insurance.

During your budget-making process, you need to sit down and ask yourself not only what you need to spend money on, but exactly how much. Remember that this isn’t what you want to spend money on – while creating this section of your budget, you should only look at what you need to spend to make it by this month.

If you’ve always made enough money to comfortably cover your minimum expenses and more, you might not be aware of how much you actually need to spend every month, leaving you nervous about an income cut. On the other hand, if you’ve previously struggled to pay for your minimum necessities, a sudden increase in income may cause a totally different kind of anxiety.

My personal favorite budgeting tool is You Need A Budget (YNAB for short). The best (and worst) part about YNAB is that it doesn’t work if you spend more money than you actually have. Love running up restaurant bills on your credit card? YNAB is going to kick you in the jaw.

No matter what your financial situation, you need a realistic budget that you strictly follow. It may take some time to settle on the “realistic” part – for example, you might think you can get by with only a certain amount for groceries, but you actually wildly underestimated how much you spend. While a tool like YNAB can be tough on overspenders, it’s also flexible. You don’t have to stick with the budget you initially created. As long as you actually have the money you’re spending, you can move it around to different spending categories.

##Step Two: Use/Build your emergency fund

Suddenly have more income than you need? A good portion of that should go towards building yourself an emergency fund. Popular wisdom says you should save anywhere between three and six months worth of income in an emergency fund, but that’s pretty daunting. If you’re just starting out building an emergency fund, read our article on how to build a smarter emergency fund.

Once you actually have an emergency fund, you’ll probably find that it’s easier to survive a drastic decrease in income. It’s okay to dip into an emergency fund to cover those basic needs you outlined in the last step. However, you should try not to use your emergency fund to pay for lifestyle choices, such as an expensive dinner out. Using your emergency fund intelligently will help hold you over until you get a better understanding of your finances.

What do you do if you don’t have an emergency fund? First, try to cut as much out of your budget as possible. Going into debt – whether with a bank loan, credit card, or a loan from a personal friend – is the worst-case scenario in this situation, and you want to avoid it if possible. If you can’t, however, at least try to avoid accruing interest on your debt. For example, you could get an interest-free credit card, or ask family or friends for an interest-free loan. Additionally, if you have a Roth IRA, you can pull your original contributions out tax-free in some situations.

##Step Three: Set yourself up for financial success

The worst thing you can do with a sudden increase in your paycheck is waste that money on frivolous purchases, especially if you’re not laying down the groundwork for future financial success. With that extra income, you should look at doing three things:

  1. Build up your emergency fund, which we already discussed.

  2. Pay off your debt, including consumer debt like credit cards, and student loans.

  3. Max out your retirement plans, including a 401(k) if you have one and a personal IRA.

Utilizing your income to build financial safety net is the best thing you can do to protect yourself if your income suddenly decreases. Paying off debt reduces your necessary monthly budget, making it easier to live on a leaner income. And maxing out your retirement contributions as early as possible in your life just makes sense – that money will have years and years to grow, regardless of what your future income looks like.

But what if you just lost a big portion of your income, and now have to make do on that leaner budget? Ultimately, you should be looking for a way to go back to your former income, either by looking for another job or by starting a side hustle. Many people use side hustles – a.k.a. second jobs, usually with flexible hours – to help make up for a smaller income from their main gig. This could something as simple as driving for Uber on the weekends. If you’re the creative type, you could sell your services on Fiverr or a similar platform.

If you can’t get a higher paying job or do a side hustle, the next best thing is to make that budget and stick to it strictly. It’s not always easy – in fact, you’ll probably end up having to make some tough choices – but living by a budget that makes sense for your income is a great way to build a strong financial base.

Have you recently experienced a drastic change in income? Tell us how it changed your financial plan in the comments below.