A recent conversation with a middle-aged family member reinforced the importance of margin to me. They were relaying how stressed they were over a $1,200 expense they were facing. An article I recently read stated that 40% of Americans can’t cover a $400 expense without going into debt. This highlights that my family member’s situation is a lot more common than you might realize. Although $1,200 isn’t an insignificant amount of money, it shouldn’t be enough to cause stress, fights, and depression. Their situation reminded me of the importance of always creating margin in your life.
In this post, I’d like to talk about some guidelines I’ve followed over the years that for most part, have kept me out of trouble.
Anticipating Life Events
Murphy is real. His Law is indisputable. Car repairs, household appliance breakdown, unexpected medical treatment. I’ve had to deal with all 3 of these at some point in my life. Last year when the compressor in our refrigerator broke down, we were without it for almost 4 weeks. All the food we had spoiled. The reason it took 4 weeks for the repair is because the necessary parts were on national back order. Talk about fun times.
The need for some sort of refrigeration caused us to invest in one of those expensive coolers coupled with dry ice purchases every few days. All in, the ordeal cost us well over $1,500 between the price of the cooler, dry ice and refrigerator repairs.
I share this story to impress upon you that life happens. Something will break and will cost you more time and money than you anticipate. It highlights the importance of having a Murphy Money account to get you through these situations. Let’s cover a few strategies you can use to continuously build your defense against Murphy.
A big reason why most people never have any extra capital is due to lifestyle inflation. They get a new job or receive a promotion and the additional income is immediately allocated for additional expenditures. Vacations, cars, electronic gadgets; the list is endless. When you spend almost everything you earn, it’s difficult to cover unexpected expenses, much less get ahead financially.
It’s Not What You Earn, it’s What You Keep
I recently read an article on Financial Samurai that really highlights that a large income isn’t the most important aspect of creating financial margin. How would you like to earn 1 million dollars per year and only have $54,000 left when December 31st rolls around? Luxury cars, housing, private school tuitions, and expensive dining are just some of the items draining this family’s income. Outside of annual 401k and HSA contributions, the family does no other investing. Kinda depressing when you really think about it.
Here’s what I do to combat this nasty tendency.
When I receive a raise, I only allow myself to spend 30% of it. The remaining 70% is put into a combination of savings and investments. You’re probably saying to yourself “Only spend 30% of my raise?!?!? How can I live like that?”. Well think about it. Before you received the raise, you were probably living just fine right? You had a roof over your head, food, clothing, and your fair share of toys. Once you look at it that way, spending 30% of your raise doesn’t seem nearly as bad.
As I said earlier, I split the remaining 70% of my raises between investing and savings. If you don’t have a Murphy Money account, you’ll want to use the entire 70% to build this up. Everyone’s number is different but having quick access to $5,000 works well for me. This amount allows me to handle most unexpected events. For any larger expenditures, I also have access to my after-tax investment accounts. Whatever number helps you sleep well at night is what you should go with.
Creating Margin with the “5X Spending Rule”
The best solutions often result from attacking the problem from multiple angles. We’ve already covered creating margin by preserving income. Let’s consider the opposite side of the spectrum; spending. It doesn’t take a rocket scientist to realize that you can’t regularly spend more than you earn and expect to have a surplus. That said, the question of luxury purchases still needs to be addressed.
Managing your spending on luxury items is an important aspect of creating margin in your life. It’s important to ensure that the money you have tied up in non-cash flow producing items are a relatively small part of your financial world. The best way I know to measure this is what I like to call “The 5X Spending Rule”. Stated simply, “If you can’t afford 5 of them, then you can’t afford 1 of them.” I apply this rule whenever I’m about to purchase an expensive item that I want but don’t necessarily need.
Using the Rule
For example, say that luxury watches are your thing and you settle on a $5,000 Grand Seiko. Unless you have the money (actual cash, not your credit limit) to purchase 5 of the watches (at a total of $25,000), then you really can’t afford one of them. Applying this rule to luxury items, prevents you from having too much money tied up in things that don’t produce additional cash flow. Following this rule also creates a mindset shift where more importance is placed on growing and preserving capital than on consumption.
This applies to small luxury items, too. An example I use often is Starbucks. I am probably going to get a lot of hate about this one, but hear me out. Sure, by my “5X Spending Rule”, I can buy 5 Starbucks lattes. Although affordable, this falls into luxury spending because there are plenty of other good-tasting alternatives that represent better value. This small luxury can easily turn into a large luxury habit when you actually add up the costs. This isn’t to say you can’t enjoy the occasional treat, but be mindful of what you label a necessity (food) or luxury.
Multiple Income Streams
Remember that 70% of your raise that you didn’t spend? We’re going to invest the portion you don’t put into savings and use it to create additional cash flow. Improving your cash flow makes it much easier to create margin in your life.
There are several options for doing this. Some people like rental properties. Others start a profitable business. I personally invest any additional capital into dividend paying stocks. At a few thousand dollars, the cost of entry is pretty low in comparison to rental properties. There’s also much less of a hassle factor. I structure my investments so that every month they produce income that is largely reinvested to create even more income.
If you’d like to learn more about how I invest, check out my article on how to get started with investing.
Always Thinking Net Worth
A question I regularly ask myself when I’m about to make a financial decision is “How will this affect my net worth?”. I don’t make this suggestion because I expect every single decision I make with money to be one that creates income. I do it because it reminds me that a decision made in one area has consequences in others. It’s a constant game of balancing wants against the sacrifices required to make financial progress.
I hope my thoughts have highlighted the importance of creating margin in your life. Feel free to incorporate the ones that resonate with you. I’d love to hear your thoughts. Does the “5X Spending Rule” seem about right? Too conservative? Not conservative enough?
Let me know in the comment box below!
A great FREE tool I personally use for tracking my portfolio is Personal Capital. When you click this link to sign up for your free account, both you and I will receive $20. Every little bit helps right?