Having a budget is the foundation of managing your money. Making budget is easy when you have a dependable income that’s the same every month. But what do you do when your income varies from one month to the next? This is the case for many contractors and freelancers. Your expenses remain the same, but your income doesn’t. You still need a budget and you can make one. You have to go about it differently.

Total your expenses

When you’re making a variable-income budget, start by totalling your income as you would if your income was fixed. Add up the things you spend money on every month. This includes rent/mortgage, utilities, car note, car insurance, health insurance, life insurance, phone bill, loan payments, credit card payments, and taxes. You should even calculate how much you’ll spend on variable expenses like gas and food.

Average your income

If you had a variable income last year, too, use your last tax return to come up with an average monthly income. Just divide your gross income by 12 to come up with an average monthly income. If you don’t have a year’s worth of income, average the months you have. For example, if you’ve been freelancing or contracting for 7 months, add up the last 7 months of income and divide it by 7. This will give you an average income to base your budget on.

Does your average monthly income exceed your expenses?

Your average monthly income needs to meet or exceed your expenses. If not, you’re going to run into a cash flow problem. Adjust your expenses to fall below your average monthly income. Some examples of places you can cut back are: gas, food, utilities (save on electricity), and entertainment. For more ways to cut your expenses, go through each category and decide whether it’s a need or a want. Wants can be cut out.

Your budget in practice

You’ll need to have at least three accounts – one checking account and two savings accounts.

The checking account will hold your monthly income that you use to cover bills and other expenses.

One savings account will hold your income then be used to “pay” yourself at the end of the month.

The other savings account will be for savings. You will only deposit money into this account. You will never withdraw money from it unless it’s to invest it in a higher interest rate account.

Start your budget at the beginning of the month. Your checking account needs to have enough in it to cover your expenses for the month.

As you get paid throughout the month, put the money into Savings Account #1. You shouldn’t have to touch your savings account during the month. If you do, then you didn’t budget enough for your expenses or you’re overspending (or you ended up getting paid less than average, see below). At the end of the month, around the 28th, transfer $2500 (or what you need to cover your expenses) into your checking account.

Less than average months vs. higher than average months

When your income varies, some months will be less than average and some will be higher than average. Once you’ve been using this variable-income budgeting method for a few months, you won’t notice the ups and downs of your budget as much. The surplus months will build up your savings account to help offset the “famine” months.

However, if you experience a “famine” month in the first 1-2 months of using this variable-income budgeting method, you might have trouble meeting all your financial obligations. In this case, you have a few options. Cut back on some of your expenses (the best option). Pull from your emergency fund (which ideally has 6-12 months of living expenses). Pull from your savings (only when options 1 & 2 don’t work).

Don’t let a famine month discourage you. Like I said earlier, once you have a couple of months where your income is at or above your average income, your savings will build up and the bumps will smooth out. Give it six months and you’ll be happy you did.

In a broad context, prudence is a virtuous principle that brings to mind careful consideration and foresight-among other things. In terms of economics or accounting, prudence is a fundamental principle that facilitates estimation in an uncertain context. It advocates that you should not overestimate your possessions or underestimate your liabilities and expenses.

As such, we can understand how prudence plays a significant role in a retirement calculation. A retirement calculation uses the premise that you can use present information for planning purposes. No one can argue that the future is certain. Since a retirement calculation requires you to determine or estimate a number of variables, it is important that you avoid creating a pretty picture by favourably overstating and understating critical variables in the calculation.

==Your salary/ salary increase ==

It is generally easy to use a fair estimate from you salary, especially if your salary or salary increases are consistent and predetermined. However, some persons have variable income and/or variable salary increases. In cases like these, it is important to be prudent. If you are in a commissioned job, you should use an average commission, since using your lowest or highest will skew your retirement calculation. For those who do not have preset salary increases, it is better to use a salary increase rate that is on par with inflation at minimum.

== The rate of inflation ==

The rate of inflation is a critical aspect of the retirement calculation as well. It determines whether you can maintain purchasing power with your retirement income. However, inflation fluctuates regularly, making it necessary to use a projected average for future inflation. According to the principle of prudence, since inflation has a negative effect, it is better to overstate it, so that you can easily adjust to worst-case scenarios.

== Your average accumulation rate ==

Many persons would love to get rates of return of 12% and 14%. Indeed, it is tempting to use such ambitious figures when performing a retirement calculation. However, a sensibly diversified retirement portfolio would do well to return those figures on average over a long period. Therefore, it is actually better to understate your accumulation rate, instead of overplaying it when plugging in your figures.

== Target percentage of pre-retirement income ==

When you retire, you should have an idea of what percentage of your retirement income you wish to receive. For example, if you have ambitious retirement plans, you might wish to retain 100% of your last income before retirement. Since many pre-retirees do not properly consider this aspect of planning, they often call an arbitrary percentage or one that is understated. Since there are many risks of retirement, it is far better to reclaim a higher percentage of your pre-retirement income (closer to 100%). Although some of your retirement expenses may be reduced, you have post-retirement inflation and health risks with which to contend.

Several other instances might require you to apply prudence when performing a retirement calculation. The important thing is to avoid presenting an unrealistically favourable estimate of your financial readiness for retirement and allow you to perceive a realistic worst-case scenario. When doing your retirement calculation, you are free to juggle certain figures, such as your average accumulation rate. You should juggle as many variables as you could to provide a worst-case estimate of your financial readiness for retirement.

Think about all the pre-retirees and retirees who did not make any provisions for the economic downturn of 2007/2008. Those who were prudent would have understood that such things can happen. Even though they were still affected, they would likely have limited their losses by managing their risk carefully. Retirees who were optimistic instead of prudent suffered substantial losses and had no idea how to recover. Establishing prudence in your retirement calculations prevents you from unpleasant surprises arising out of a harsh reality check.

Most people (including myself) would insist that Equity Investing is the most difficult to master. After all, that is the venue for: erratic price fluctuations caused by an endless supply of social, economic, and political variables; the standard Wall Street misinformation, corporate malfeasance, self- serving financial gurus, and product sales persons; a myriad of popular and market moving speculations from IPOs to Option and Margin strategies; thousands of media talk shows and their financial markets’ experts. When you think you understand the stock market brother, you are in serious trouble.

But more devastating than everything that has been done to turn Equity Investing into a product shopping mall of some kind, is the bottom-line/market-value brainwashing that has taken the calm, secure, and smiley-faced world of Income Investing and turned it upside down. I get more phone calls and e-mails from confused Income Investors than I ever receive from a simple plunge in Equity prices. Admittedly, very few Equity investors get to that special place, shouting “Eureka!” as they first realize that corrections in the “Shock” Market are every bit as lovable as rallies. But not recognizing that slowly rising interest rates is as much a boon for both fixed and variable Income Investors as it could possibly be a temporary set back for a struggling economy… well, that’s just another example of irresponsible investor counter-education from our much too respected enemies in the financial institutions.

Income Investors must learn to hold these truths to be self evident:

(1) More interest on your invested dollars is just plain better for you than less income on your invested dollars, and the amount you have allocated to Income Investing should never change because of market factors.

(2) A change in the Market Value of the Fixed Income Securities you already own has absolutely no bearing on any assumptions that could possibly be made about the credit worthiness of the issuers of the securities themselves.

(3) A change in the Market Value of your Fixed Income holdings will rarely have a negative impact on the regular recurring income that you receive and, after all, you bought these securities for the income in the first place.

(4) Buying fixed income securities in a rising interest rate environment has a positive, compounding effect on portfolio yields and, at the same time, plants the seeds for future capital gains as interest rates recede.

(5) Many fixed and variable income securities can be added to as interest rates rise both to increase the average yield AND to decrease the average cost of the securities.

Why is this not easy? It’s not easy because financial professionals and pseudo-professionals alike won’t let it be. If you have a properly designed Investment Portfolio, you must view each segment separately and with an understanding of the purpose of each. Avoid advisors who consider the bottom line market value of such a portfolio as anything other than an “expectation corroborator” (and your just going to have to call me if you don’t know what that is). Your portfolio market value should never be a surprise and, more importantly, it should never be looked at as something to be particularly concerned about… at least not immediately. For example, you had to be living in a cave somewhere and smoking something really special to think that your Interest Rate Sensitive (or Investment Grade equity) portfolio would be up in market value from June of 2007 through mid-January of 2008.

You really have to learn to love the simplicity of Income Investing. Interest rate sensitivity is a given (and, by the way, interest rate expectations themselves are sensitive to inflation expectations). Price movements are both predictable and meaningless. We actually have an investment condition that approaches certainty. This is an investment nirvana, people! Don’t let those guys in the pinstripes get you confused. Don’t panic, don’t switch, and don’t cry in your beer. Look at the income number on your statement and go “hmmmm” when you see no meaningful change in either direction. (Actually, if you’re doing this properly, the year over year Base Income figure should have increased.)

So the recent bad news (all of it) is really good news for investors and yes, just as higher interest rates are actually better than lower ones to a certain extent, so should lower stock prices be welcomed with more smiles than tears. Only those speculators who haven’t taken their rally profits are unhappy with corrections… and that is true in both Equity and Income Securities Markets. Dealing with both events at the same time can make your bottom (line) a bit uncomfortable, but only until you recognize that smaller numbers are better for buying and that their larger cousins are best appreciated with sell orders.

During all types of corrections, some investment professionals will play to your fears, encouraging you to cut your losses, and to switch to something else… generally something that is cycling upwards. You don’t have losses UNLESS you fall for this switching advice. Don’t be pushed into such decisions no matter how smart the arguments seem. All fixed income investments (with the exception of open end Mutual Funds) are created equally and switching just doesn’t work. An unhappy investor is Wall Street’s best friend, so don’t allow interest rate movements in either direction to affect your investment mood.