Successful Saving: Disposable Income
Really, how necessary is that monthly expense that you so desperately think you need? Mindful spending and successful saving go hand-in-hand.
Successful Saving: Disposable Income
In this edition of the Personal Finance Project Newsletter:
The Personal Finance Identity
Ideal Disposable Income
Decision Making
Prerequisites
April 15th, 2023 - Successful Saving: The Beginning
April 1st, 2023 - Successful Saving: Building a Plan
Revisiting the Personal Finance Identity
The Successful Saving Series has centred around the spending/saving tradeoff previously introduced in The Financial Responsibility Spectrum. The idea is pretty simple - given a set amount of earnings, the decision to spend versus save is always present.
In Successful Saving: The Beginning this tradeoff was represented by the introduction of disposable income. Let's revisit the Personal Finance Identity:
The Personal Finance Identity
Gross Income
Less: PYF
Less: Taxes
= Net Income
Less: non-discretionary spending
= Disposable Income
Less: discretionary spending
Less: savings
= 0
Disposable income is the earnings you have available after deductions and necessary expenses. The tradeoff exists before and after the disposable income line, as necessary expenses limit the amount of disposable income that can be saved or used toward discretionary spending.
Activity
Review your April Financial Tracker (or scroll through your transactions list on your mobile banking app) and label each expense as “necessary” or “discretionary”.
Next, calculate these two ratios:
Necessary expenses/net income - displays income going toward necessities.
Necessary expenses/discretionary expenses - compares your necessary expenses to discretionary ones.
Alone, these ratios don't tell much of a story. Consider doing this for previous and future months to see changes in their relationship. Perhaps you will notice a growing portion of necessary spending or higher necessary spending than discretionary spending.
There are no objective targets for necessary spending, discretionary spending, and disposable income amounts. That being said, we can still look at the personal finance identity in consideration of real-world implications to determine what an ideal disposable income level looks like.
Disposable Income and Necessary Expenses
Theoretically, the ideal amount of disposable income is infinitely high. Higher disposable income = higher discretionary spending and/or higher savings.
In the real world, a world with limited resources, achieving a high disposal income requires high net income and/or low non-discretionary spending. This introduces the question - what expenses are necessary?
The term non-discretionary literally refers to expenses that are not exercised at one’s discretion (choice). This term is too strict because we almost always have an element of choice. Groceries are considered non-discretionary (because we need to eat), but the size of my grocery bill will depend on what I choose to buy.
For the sake of this post, necessary expense categories are food, shelter, transportation, and clothes.
Let’s assume, for a second, that we don’t have a choice. Specifically, our non-discretionary expenses are at their lowest possible amount. To achieve this absolute minimum, I would eat rice and canned tuna, live at my parent's house, walk and/or take the bus everywhere, and only buy clothes from the thrift store.
Of course, this is not a comfortable way to live and may have associated non-financial costs such as poor mental health. Though I don’t suggest this extreme level of frugality in the pursuit of high disposable income, we all need to recognize and compare what is absolutely necessary to what we define as necessary.
So why are things like salmon, car payments, and work boots considered necessary to us? I mean, isn’t only the absolute minimum truly necessary?
Our lives are unique and complex, and as we will explore in the next section, we each establish our own definition of necessary based on this uniqueness. Factors such as where we live, where we work, and how much we earn all play into our non-discretionary purchase decisions. Moreover, certain lifestyle expenses like social spending may be necessary for some of us and easily forgotten for others.
At the cheapest end, our necessary expenses align with the absolute minimum expense total that we could reach given our unique circumstances. At the most expensive end, necessary expenses cannot exceed net income. These two extremes form the non-discretionary spending spectrum, and the ideal spending level is somewhere in the middle.
To define the ideal level of disposable income, start with the absolute minimum non-discretionary spending and add expenses that support a comfortable standard of living. To cap these standard-of-living additions, consider how much disposable income is needed to satisfy your savings goals and discretionary spending desires. By starting at both extremes, you’ll find a comfortable middle.
The Ideal Level of Disposable Income
Overall, the ideal level of disposable income is where non-discretionary expenses support a comfortable standard of living, and disposable income is sufficient to reach your savings goals and provide some flexibility within disposable spending.
Decision Making
To make things more confusing (or exciting?), our necessities are subject to change. Not only do we have to define our necessary expenses, but we must also consider the role of time and how new commitments to non-discretionary expenses impact our future disposable income.
To explain this, let’s look at recent changes in my personal life.
This month marks a significant change for me as I transition from student life to working life. This change is causing profound impacts on my disposable income as I go from student budgets to full-time earnings.
Here are the notable changes:
Full-time employment earnings
Student debt repayment obligations (minimum payments are considered deductions, and additional payments are taken out of disposable income).
No rent payments
Minimal grocery payments
Elimination of school-related expenses
Introduction of work-related purchases (tools and equipment)
Introduction of car-related expenses (specifically gas and insurance, no financing)
This example focuses on the decision-making that went into purchasing a car.
First, I asked myself if the purchase was even necessary, and I did a cost-benefit analysis (a glorified pros and cons list) that derived the following conclusions:
Without a car, my job options as a carpenter are significantly limited. A car provides more opportunities and likely higher pay.
There is a high non-monetary benefit of freedom and flexibility.
With no rent and low grocery expenses, I have very few financial commitments aside from debt repayment. Given my steady employment income, reasonable car expenses shouldn’t be hard to maintain.
So car expenses are necessary for this new chapter of my life.
Then, I needed to determine how much I could afford without significantly limiting my disposable income. I concluded that:
I wanted to avoid financing beyond my current access to low-interest debt.
I needed a car that was cheap on gas, cheap to insure, decently reliable, and would likely survive for at least a couple of years. I’m not a car fanatic, so these were my only criteria.
Given my criteria and looking into the used car market, I figured a $6,000 car would satisfy what I’m looking for.
I had $4,000 in cash and figured I could afford to add $2,000 onto my outstanding low-interest student debt balance of $40,000.
Overall, it was clear that I could afford to purchase the car and endure recurring expenses without sacrificing too much disposable income.
The third important consideration I made relates to commitment. My overarching thought was that, in the case of some urgent need for access to cash, will the purchase of a car limit my ability to do so?
I figured that if it was necessary, I could sell the car and cancel the payments. This would impact my employment, of course, but the point is that I wouldn't be stuck making obligatory payments when I can’t afford them.
There’s no cut-and-dry formula for deciding if you can take on a new non-discretionary expense. As you can see, I needed to consider the real-life, non-financial costs and benefits of car ownership to assess true necessity. Then, I considered the implications that car-related expenses had on my disposable income, like if I could still reach my savings and debt repayment goals at this new income amount. I also needed to consider the commitment factor and my ability to drop these expenses if needed. This is unique to me but hopefully demonstrates the method behind making this type of decision.
Takeaway
If I had to leave you with only one takeaway, it would be to critically think about what you determine to be necessary exoduses in your life and to pursue the highest level of disposable income while satisfying a comfortable standard of living. Frugality will generate a high disposable income that can be saved, and we all know the importance of saving!
Signing off.