Managing the Gap Between Spending and Income

Follow these six steps to spend less than you earn.

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Trent Hamm
Trent Hamm
Spend less than you earn.

That one sentence could easily be the core rule of personal finance. If you abide by that one rule consistently, week after week and month after month, you will find lasting financial success in your life.

Of course, this success comes from two directions: "Spend less" is obvious. It's a call to control your spending. The other part – "than you earn" – is the hidden part. It's a call to increase your income.

The difference between the two is "the gap." The gap refers to the difference between your income and your spending. When that gap is large, you're heading in a great financial direction.

This post could focus on how to spend less money and how to earn more income, but we'll focus on how to manage that gap. At the end of each pay period, take your paycheck and use the money to follow these six steps for managing your gap.

1. Build a small emergency fund. Everyone should have an emergency fund of $1,000 sitting in a savings account they can access in the event of an emergency. You should never trust a credit card as your emergency fund because you're relying on a bank to extend credit to you at your exact moment of greatest need.

Why not more than $1,000? Most emergencies we face in life can be handled with $1,000 or less. A larger emergency fund is useful, but there are higher priorities to take care of first.

2. Pay off all high-interest debt. You can decide for yourself what constitutes high-interest debt, but anything that's more than 4 percent higher of what home mortgages are can be considered high-interest debt. Today, that would be about 8.5 percent.

Pay these off in order of interest rate, starting with the highest interest rate. You should use your gap as an extra payment on the highest-interest debt, then when that one is paid off, move to the next one.

3. Allocate for retirement. Once you're free of high-interest debt, start contributing to your retirement – many financial experts advise contributing 15 percent of your gross income to retirement. A quick rule of thumb to follow is to put money into a 401(k) up to your company's match. Then contribute to a Roth individual retirement account up to the limit.

4. Build your emergency fund higher. A good rule of thumb is to have two months of family living expenses sitting in the bank for each dependent you have.

Why should you have so much cash? Cash is king, and having cash on hand will solve countless problems that come your way. The more dependents you have, the more likely it is you'll have overlapping life problems – one person loses a job while another person becomes ill – and the more likely it is you'll have a dependent who can't earn income.

5. Head for debt freedom. Eliminate your lower-interest debts, such as your car loans, student loans and mortgage. If you're in a situation where this is your highest priority, don't sweat the tax benefits of holding onto these debts. You're only gaining some tax benefits from the interest on the debt, and that interest overall is not helping you even with the tax benefits. Pay it off, and you'll drastically improve your monthly cash flow.

6. Save, save, save. The final step in the process is to start saving for big expenses you know are coming up. Save for your next car, for example, or for your next summer vacation. These goals really depend on your personal life.

If you've managed to complete all of those steps, you'll have a healthy emergency fund, a well-funded retirement and no debt. In that case, you'll be far ahead of most Americans.

The final step is really up to you. What are your big goals? Spend some time thinking about what you want out of life. You now have plenty of resources to start working toward those goals.

Life is now your oyster, and it's all thanks to the gap.

Trent Hamm is the founder of the personal finance website TheSimpleDollar.com, which provides consumers with resources and tools to make informed financial decisions.