Allocate and Automate Your Excess Income

Time + Money: Dollars Add Up!

What to Do with Excess Income

In the last post, we outlined, experimented with, and confirmed a budget that left a certain amount of money - your Excess Income - untouched every month.  Now, we’ll figure out what to do with that money as you continue to stabilize your financial health.

Automate Your Saving with Online Banking

As brilliant investor Warren Buffett declared: “Do not save what is left after spending; instead spend what is left after saving.”  The best way to follow this outstanding advice is to automate your saving.  Specifically, you can set up your checking account so that whenever your direct deposit pay is put into the bank, the Excess Income portion of that money is immediately and automatically transferred to savings and paying down debt.  USAA, NFCU, and all other major banks now have great online banking, and setting up automatic A) payments for credit card bills and loans, and B) transfers to savings takes only a couple clicks from the comfort of home.

Allocate Your Excess Income to the Right Places

Now that you’ve identified your Excess Income and know how easy it is to automate saving it, the next question to ask is, where should I save it?  In other words, how should I allocate my Excess Income?  At this point of the journey to financial independence, the goal is to stabilize your financial situation.  As such, there are two priorities: 1) paying down credit card debt and consumer loans; and 2) building your emergency fund.

The Debt versus Retirement Question

Before getting into the details of spreading your Excess Income, I want to address a frequently asked question: is it more important to tackle debt or save for retirement?  To me, this question is based on a silly premise - it implies that you can only do one of these at the same time. In reality, they’re not mutually exclusive, especially in the military.  Remember, your Excess Income doesn’t include the money you’re already putting towards retirement every paycheck in your TSP contribution (plus the government’s free 5% on top of that!).  Furthermore, paying down debt is a form of saving for retirement. By aggressively paying down high-interest consumer debt, every dollar of interest you don’t have to pay due to accelerated repayment becomes a dollar you can put towards saving for retirement.  In this way, paying down debt and saving for retirement go hand-in-hand.

Allocation 1: Pay Down Consumer Debt (75% of Excess Income)

With high-interest consumer debt, achieving financial independence is next to impossible.  For this reason, we’re going to allocate the largest portion - 75% - of your Excess Income to paying down this debt.  Revisit your budget and list out all of your monthly consumer debt payments (credit card, car loan, etc).  Now, next to each of these expenses, write down the interest payment. We’re going to tackle the debt with the highest interest first. So, let’s say you have $1,200 of credit card debt at 18% and $5,500 remaining on a 5% car loan, here are the steps to take:

  • Step 1: Multiply your Excess Income by .75 to determine the 75% that will be allocated to paying down debt.
  • Step 2: Confirm the minimum monthly payment for your lowest interest debt (the car loan in the above example.  Now, subtract this amount from the number in Step 1.
  • Step 3: The number from Step 2 is the amount of money that you will use to aggressively pay down your highest interest debt.
  • Step 4: Set up automatic payments.  In your banking app, set up monthly payments for the amounts in Step 2 and Step 3 that will automatically be applied to your different outstanding debts.
  • Step 5: Once the highest interest debt is paid off, update your monthly bill payment so that the entire amount from Step 1 is applied to the remaining, lower interest debt.  Congrats, you’ve automated crushing your debt!

***Note: this strategy for paying down debt completely depends on not adding more debt.  If you fall into this trap, you’ve gone backwards on your journey to financial independence and need to recalculate the above numbers.***

Allocation 2: Grow Your Emergency Fund (25% of Excess Income)

In the first post about an emergency fund, the focus was stopping your financial bleeding by getting to $500.  This is a critical milestone as a financial buffer, but it’s not enough to truly keep you safe in the event of a financial emergency. Remember, the goal of the emergency fund is to keep you from needing to rack up credit card debt in the case of something unexpected (e.g. air conditioner breaks, expensive and unexpected car repair, etc).  While financial advisors all seem to have different recommendations, for military members with the stability of TRICARE health insurance and regular paychecks, I recommend an emergency fund equal to three months of expenses.

Take a look at your budget - what are your monthly expenses?  Multiply this number by three, and that’s a good rule of thumb for how much money you should set aside in an emergency fund. Next, automate a 25% transfer of your Excess Income into your Emergency fund.  Example: if your Excess Income is $325 every month, multiple that by .25 and you get $81.25. Now, in your online banking app, set up an automatic transfer for that amount from your checking account to the savings account with your emergency fund for a payday (or divide the $81.25 by two and set up two automatic transfers each month - one for each payday.  Whichever option you prefer). You’ve now set this savings on cruise control!

Achieving the Above Goals

So what happens when you’ve paid off your debt or reached the emergency fund goal?  Reallocate the portion of your Excess Income that you’d been using for that priority to the other one.  If you’ve built your emergency fund, you can now allocate 100% of your Excess Income to paying down consumer debt.  If you’ve paid down your consumer debt, you can now focus on building your emergency fund. Once you’ve accomplished both priorities, you’ve completed Phase 2 and have successfully stabilized your financial health!  Next, you can move on to Phase 3 of the journey to financial independence and begin to grow and thrive!

Bonus - How to Think about a Raise or Windfall

Related to this post, an absolutely critical aspect of gaining financial independence is avoiding lifestyle creep.  When you come into more money, either through a promotion or unexpected windfall (e.g. big tax return, combat pay, reenlistment bonus, etc), do not look at that money as a free ticket for splurging on something.  Instead, do something nice with a small portion of this bonus as a way to celebrate, but apply the large majority to your Excess Income and related priorities for financial independence. If you’re able to embrace this mentality - that a raise in money doesn’t mean a raise in lifestyle - achieving true wealth is just a matter of time.  

Financial Independence is a Marathon, not a Sprint

The last thing I’ll say relates to time.  None of the above is going to happen quickly, but that’s okay.  Financial independence doesn’t happen overnight. But, if you’re disciplined and stick to a plan, it will happen eventually.   

Questions?  Thoughts? Recommendations for another topic?  Let us know in the comments!

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