When your paycheck lands, you pay the taxman and cover your rent, groceries, and bills. This leaves you with money that is yours to spend as you wish – but what exactly should you do with it? This article explains the concept of discretionary income and how you can put it to good use.
What is discretionary income?
To understand discretionary income, we must understand disposable income. Disposable income is the amount left over after you pay tax.
Discretionary income is what is left over from your disposable income after you have taken care of necessities like:
The formula is thus:
Discretionary income = Gross Income – Tax – Necessities.
(Here is a spreadsheet you can use to track your discretionary income.)
Now that we understand what discretionary income is, let’s look at a few ways to put it to good use.
4 smart ways to spend your discretionary income
1. Bills and other necessities
- Leave some income to cover next month’s rent and utilities, for example. This reduces the burden of bills on your next paycheck.
- Help family members in need.
- Buy things around the house that you absolutely need, like a first-aid kit.
2. Save it
- Increase your emergency funds: A rainy day fund lets you access funds quickly to pay for unexpected expenses. These include: car accidents, hospital bills, loss of employment. The higher your emergency funds, the safer you are.
- Put some of it in a high-interest savings account: A high-interest savings account lets you earn more on each buck you save. They work by locking in your money for a period of time, allowing the bank to use your money to invest or give it out as loans. These accounts usually come with minimum deposit amounts and different fees than a standard savings account. A fixed deposit account also works this way.
- Open a foreign currency account and save in hard currencies: Hard currencies are a hedge against exchange-rate volatility and can protect your wealth in the long run. Popular hard currencies include the US Dollar and the British Pound. So if you lived in Nigeria, where the Naira can be volatile at times, buying US Dollars would give you peace of mind as the Dollar is considered more stable than the Naira.
3. Invest it
- Buy shares listed on a stock exchange: A share is ownership in a company. When the company does well, its share price goes up, and you benefit.
- Invest in mutual funds: A mutual fund is pooled money from different investors used to invest in the financial market. Mutual funds are more diversified than individual company stocks.
- Put it in short-term money markets accounts: The money markets are short-term, highly liquid investments that give you higher returns than a bank savings account. This is how they work:
- You put your money in a money market account with a bank
- The bank loans out your money
- The bank pays you interest for putting up your money with them
- The excess rate between what the bank gives you and what it got from the loan is its profit.
Good thing about money markets is that their returns are compounded. This means that you receive interest on your balance (which is your capital plus already accrued interests).
4. Pay down more of your debt
Paying a higher debt installment instead of the minimum amount required by the bank helps you clear your debt faster and saves you money on interest payments.
For instance, let’s say you have an outstanding study loan of $50,000 that accrues interest of 5% a year, which you’re servicing with a $500 monthly payment. At that rate, it would take you roughly 130 months (10 years and 10 months) to clear that debt.
Let’s now say you’ve got $200 extra in discretionary income each month. If you added that $200 to your $500 monthly payment (for a total of $700 each month), you could pay off your entire loan in just 85 months instead of 130 months – that’s almost 4 years shaved off your repayment period! You’d also save $5,500 in interest payments.
But what if you’re paying off multiple loans? There are two ways to handle debt repayment in that scenario: The Snowball Method and the Avalanche Method.
With the snowball method, you pay off your debts from the smallest balance to the largest balance. When you’ve paid off one debt, you assume you are still paying that amount and add that amount to the next debt. This larger amount for this next debt will mean you are paying more than the minimum, thus finishing it sooner. You do this until you clear the largest debt.
For example, say you have 3 loans you’re paying off:
Loan 1 needs $100 a month
Loan 2 needs $300 a month
Loan 3 needs $500 a month
You’d start by paying off Loan 1 with $100 a month. Once that’s done, Loan 2 would need $300 a month – but instead of just paying $300, you’d add the $100 you were paying towards Loan 1 to Loan 2. This means you’d be paying #300 + $100 = $400 for Loan 2. Because you’re paying more than the minimum, you’d end up finishing Loan 2’s repayment earlier.
With Loan 2 out of the way, you can focus on Loan 3, which needs $500 a month. But because you’re on a roll, you take the $400 you were paying towards Loans 1 and 2 and apply it to Loan 3, which means you’d be paying $900 a month towards Loan 3. Such a huge repayment will help you clear that debt even faster.
This is how a snowball works in real life. As it rolls down the mountain, it gets bigger and bigger and can cause more damage. When you apply this concept to your loan repayments, you can make a bigger impact with each subsequent loan and finish paying them off faster.
Alternatively, you can use the avalanche method, where you pay the highest-interest debt first and roll over those payments into the second-highest interest-bearing debt and so on until you clear the lowest-interest debt. The reason here is that the highest interest debts are the most costly, so removing them frees you up from high-interest payments.
Spend your discretionary income wisely
Track what your monthly spending looks like from here on out to assess your discretionary income. With this number in mind, use any of the above tips to maximally benefit from your extra cash each month.
And if you need some help, reach out to a financial advisor who will help you budget your gross income so you can have higher discretionary income. They can also advise you on where best to invest your money to increase your net worth.