Wow, I really went cryptic on this one didn’t I?
It is a great rule that, if applied from when you first start out in the working world, will hold you in good stead for the rest of your life.
So, moving on from the tax we pay, let’s talk about the rewards we get paid! Most of us will hopefully get a chance to be rewarded for our hard work by getting promoted with a corresponding pay rise, and some of us will also be lucky enough to get a bonus or commission above our base salary.
Both of these are fabulous.
The trouble is that, when these things happen, very few of us take a moment to consider what we should do with the extra money. In the case of a pay rise, the increase is spread over the year’s pay cheques and, while the increase is really exciting at the time, it gets forgotten within a matter of weeks when we get back on with our day-to-day lives.
I call this the “handbag rule of money”. Sorry gents, I may leave you out in the cold on this one, but stick with me. Most women find that no matter what size handbag they have, they manage to fill it. They may start with a little over the shoulder number but, as they increase the size of the bag, the amount they put in it increases to the point where they are lugging around what should be classified as luggage. Then they have so much junk in their bag they can never find anything.
The same goes for your pay cheque. For lots of people, each pay rise they get is somehow absorbed in to their spending. They don’t really know where it goes, but with every increase they manage to adjust their spending to the point that they are now spending double what they used to, but would struggle to tell you where the new money is going.
So how do we consciously manage an influx of cash? Simple – follow the “quarter rule”. Any time you get a pay rise or bonus, simply apply at least three quarters of it to either reducing your debt or building your savings.
Before explaining the rule in more detail, I should clarify that it only works if you take a breath to actually allow the pay rise or bonus to be paid.
Don’t spend a pay rise/bonus before you get it
The first reason not to spend a bonus before you get it should be clear, but is worth stating here – nothing is certain. Just because you have been notified you will receive a bonus doesn’t mean that an unforeseen problem could mean it gets delayed, or doesn’t come at all.
Even worse is assuming you will be paid a bonus just because you were paid one last year (and assuming that bonus will be the same amount, or more, than last year’s one). Economic cycles are a true roller coaster ride and, through no fault of your own, an economic downturn, sales slump, or poor company investment decision could affect whether or not you get a bonus, or whether the bonus you do get is what you were expecting. If you feel you can predict accurately when your employer’s business is guaranteed to do well, then I would imagine you have no need for this book and are simply enjoying some light reading on your private island in the Bahamas.
The other reason for not spending a pay rise or bonus before you get it is because purchases that seem like a good idea in the rush of excitement after hearing your pay is going up frequently dim in the light of a new day.
Give the evil minions a boot up the ...
If you are working your waterfall of cash, then I would apply any bonus or increase to demolishing your debt.
For a bonus, figure out how much your bonus is after tax, and then send it all to the credit card on the top of your list. SHAZAM! You have given that sucker a killer blow.
For a pay rise, simply calculate the extra amount your pay rise works out to each month after tax, and add that to the total amount you committed to pay off your cards.
I cannot overstate how powerful an effect this will have on your credit card debt.
Assuming you pay off your credit cards every month, when you get a pay rise or bonus there are broadly three places that the money could go:
Other debt – like paying down your mortgage.
Savings – whether that is a savings account, an investment account or even a retirement account.
Spending on Actual Wants – these could be either short- or long-term wants.
Of course this assumes that you have a hold on your needs versus wants, and aren’t tempted to go nuts with some Childish Desires, or perhaps even an Unrealistic Desire, like buying a car way out of your price range.
The lovely thing is that, if you have been noting down the things you really want, then when a windfall like this occurs you know exactly what would give you the greatest pleasure, rather than your eye being caught by something that has never even entered your head before.
The “quarter rule”
So, here it goes ... any time you get a pay rise or bonus (and you no longer need to apply the waterfall of cash method), then apply at least three quarters of it (or 75%) to either reducing your debt, or building your savings account. In the case of a bonus, this is easy as these are generally paid as a lump sum and you can literally take 75% of the amount you received to pay down your personal loan or your mortgage. If neither of those exist, simply zap it into your savings account.
Making this effective for a pay rise takes a few more steps:
Work out the increase in your weekly/fortnightly/monthly pay cheque after tax.
Multiply that increased amount by 75% or three quarters.
Set up an automatic transfer of that amount to occur, say, three days after your pay goes into your account. This can go towards loans, or into a savings account.
This may seem a little full on. However, if you think back to when you started work, and then step through the pay increases you’ve had since then, what position do you think you’d be in now if you had simply applied that rule?
Before you got the pay rise or bonus, you were hopefully making ends meet. You could have continued on at that level and been happy.
So, by using only a quarter of the increase you would still have been better off than you were, and you would have definitely been better off than if you had just blown all of it without knowing where it went.
What do you do with the remaining quarter?
Well, the one thing you don’t do is let it become petty cash. Don’t let it slip through your fingers, as all that hard work you applied to get the pay rise will never feel like it is worth it if you can’t remember something you enjoyed as a result of the extra dough.
Pay rises match short-term wants
If you have received a pay rise, then the quarter you have left over is best applied to an item, or some items, on your short-term wants list. Having waited for those items until you could afford them will make purchasing them now so much sweeter.
Bonuses are perfect for long-term wants
Due to their lumpy nature, annual bonuses are more in sync with those long-term wants that you had hoped and imagined you could one day do or buy. When I talk about bonuses here, I am not talking about commissions that get paid almost as regularly as your salary, as they should be handled more like a pay rise.
I am talking about a lumpy amount that you get once or twice a year.
Now, this amount may not be enough to actually buy or do one of your long term wants; however, if it isn’t, I would encourage you to put that money into an account you are building for that very purpose. How inspiring that account will be each year as part of your bonus goes to funding your dream ... a trip to Paris, a sports car ... whatever it is you will certainly have worked hard for it and, by applying this rule, you will have judiciously reduced your mortgage or increased your other savings before applying any money here.
Take the trip or buy that beautiful jewellery. If you have gotten all the way to this point then you absolutely deserve it.
There is some fine print
It all sounded so good, didn’t it?
Well I promise it still is; however, I figured it was worth covering the following situation ... you get a pay rise, or receive a bonus that is actually an increase of over 40% of your current salary. I know this may seem ridiculous, but there are some professions where this actually happens and I would prefer you were armed and ready for such a fantastic windfall.
An example of this situation would be being on a base salary of $50,000 per annum, and being paid a bonus of $22,000 (woohoo, right!).
The thing about massive pay rises is that they are far more likely to be sucked up into meaningless purchases and spending. We get caught up in the excitement of it all and think nothing of massive increases in our spending via new car leases or other commitments, and don’t take a breath to consider a more sensible approach.
In the case of a bonus or pay rise over 40% of your current salary, a different rule applies. Rather than the ‘quarter rule, we apply the ‘dime rule’.
In this case, you calculate 10% of the increase, and that amount can be spent on Actual Wants, with the remaining 90% of the increase going to reducing your mortgage or increasing your savings.
If we then apply this to the awesome bonus I mentioned above of $22,000, the figures look like this:
$22,000 bonus after tax paid into your back account;
10% or $2,200 can go towards Actual Wants; and
90% or $19,800 is to be applied to debt or put into savings.
This twist on the rule will ensure you maximise the benefit you receive from such a massive increase in your income. It also ensures that, if this is a short-term situation, such as this being the only year that you will get such a big bonus or such a massive leap, you have taken full advantage of that money for your future.
I know, I seem like a Grinch, but I promise that you will thank me later.