If you have income left over after paying taxes, it’s important to avoid common disposable income mistakes.
However, there is a big difference between disposable income and discretionary income.
Disposable income is your personal income minus your current personal taxes.
For example, if you make $60,000 a year and pay 20% in federal, state, and local income taxes, you have $48,000 in disposable income.
According to the OECD Better Life Index, “In the United States, the average household net adjusted disposable income per capita is $45,284 a year.”¹
Some make the mistake of seeing an average of $45,284 a year as an excuse to spend $45,284 a year.
However, it is not disposable income that determines one’s lifestyle. Instead, it is discretionary income.
Let’s go back to the example of $48,000 in disposable income and take out all of your other essential spending, such as housing, food, utilities, insurance, and other necessities.
The remaining money after all these essentials is covered is your discretionary spending.
In other words, the best way to avoid disposable income mistakes is to distinguish between your disposable income and your discretionary income.
If you spend your disposable income as if it’s discretionary income, you may find yourself in a financial pickle.
Don’t squander your discretionary income. Instead, avoid these 7 common disposable income mistakes.
#1 Not Budgeting
At the top of the list of disposable income mistakes is the lack of budgeting.
As discussed above, some people mistakenly treat disposable income like it is discretionary, and essentially, throw it away.
Instead, budget your disposable income.
Account for all of your essentials, such as transportation, insurance, mortgage, utilities, and school debt. The leftover number is discretionary.
Instead of treating yourself to lunch every day or buying a new phone every time a new model hits the market just because you can, budget your expenses. Because these little splurges add up if you aren’t careful.
We’re not saying you shouldn’t enjoy your hard-earned money.
We’re just saying you should budget for fun and extras.
And don’t forget to account for entertainment and shopping. And stick to it.
#2 Not Paying Attention to Credit Cards
Some people believe credit cards are dangerous, but it’s how we use them that results in disposable income mistakes.
Credit cards make it easier and safer to shop online, which is how most Millennials are shopping according to Global X.²
Credit cards also help build your credit score.
But, too many people get themselves into trouble when they use their credit cards to buy more than they can afford.
If not regularly paid off each month, you’ll wind up spending your disposable income on interest.
Also, many fail to research credit cards that work best for their personal needs.
It is wise to compare interest rates and reward programs for credit cards before signing up for one.
This ensures you get the credit card that works best for your lifestyle.
It is also worth asking if your credit card company will offer a lower interest rate.
If you have a good credit history and pay on time, they may lower your rate.
#3 Misplaced Spending
You may have more disposable income because you no longer have to pay for a mortgage or have kids at home.
Or you may have more disposable income because you are a Millennial.
According to a Pew Research Center report, “After bottoming out in 2011, incomes are rising for American households – and those headed by a Millennial (someone age 22 to 37) now earn more than young adult households did at nearly any time in the past 50 years.”³
And 43% of Millennials reported making a little or a lot more money than needed to cover their expenses.⁴
However, a report from Epsilon found, “Younger generations aren’t shy about spending.”⁵
And this comes in the form of either large luxury splurges or a series of small hobby splurges.
Some people feel as if they deserve luxury items, such as boats or timeshares, because they’ve worked hard for their money.
But these luxury items cause people to spend even more money, such as having to cover additional costs beyond the purchase price, like maintenance and insurance.
It’s not just large misplaced spending that becomes disposable income mistakes. It’s also spending money just because you can.
For instance, adults with disposable income are a gold mine for toy marketers.
According to Zephoria, “With more disposable income than ever before, Millennials are deciding to use that income to treat themselves to new toys that tap into their sense of nostalgia and that provide them creative ways to ease their high rates of stress and anxiety. This has led adult Millennials to invest hundreds of dollars every year on toys.”⁶
This phenomenon has led to the creation of LEGO sets designed specifically for adults and Fisher-Price Little People special collector sets (such as He-man and the Masters of the Universe) created to appeal to adults’ sense of nostalgia.
#4 Not Preparing for Emergencies
One of the biggest disposable income mistakes is not using extra cash to build an emergency fund.
Instead of using the money left after essentials have been paid for emergency savings, Americans spend money on the here and now (i.e., entertainment or everyday splurges).
A GoBankingRates survey found “69% of Americans have less than $1,000 in savings.”⁷
As 2020 proved, it is critical to save for emergencies.
Hopefully, another global shutdown won’t happen again in our lifetime, but you never know when you will lose a job, face a natural disaster, or experience a medical emergency.
When creating a budget, factor in using some of your disposable income to build up your emergency savings.
#5 Not Planning for the Future
Another disposable income mistake is not planning now for your financial future.
The earlier you start paying yourself first, the better.
Let’s say you’re in your mid-20s. If you ignore your 401(k) now and fail to at least get the employee match, you may miss out on a lot of money come retirement.
Let’s run the numbers.
You earn $50,000 a year and put 10% in your 401(k) with the employer matching it at $2,500.
If your 401k earns an average 8% return, your 401K can reach over $2,000,000 after 45 years.
Start investing in your future as early as possible.
If you have waited, take advantage of catch-up contribution limits (available for those 50 and older).
#6 Not Prioritizing Your Own Financial Health
One of the most common disposable income mistakes is not prioritizing your own financial health.
Instead, many people spend their disposable income taking care of the financial needs of their kids or grandkids.
A survey by Empty Nesters found, “According to respondents, nearly 40 percent are still financially supporting their children in some way. Of those, parents still spend an average of $254 per month on their child or children. Some of the top expenses that respondents said they still pay for include cell phone (24 percent), rent (19 percent), groceries (18 percent) and student loans (15 percent).”⁸
As much as you want to take care of your loved ones, you must pay yourself first and make sure your financial health is on the right track before you take care of someone else.
If not, it may backfire, and your loved ones may be stuck helping you cover expenses later in life.
#7 Spending beyond Your Needs
The last in our list of disposable income mistakes is spending beyond your needs.
As discussed, people often confuse disposable and discretionary income.
However, the danger doesn’t end there.
Even if you have a decent amount of discretionary income, it doesn’t mean you should spend it frivolously.
A common example is home buying.
When you apply for a mortgage, you may be approved for a home loan that is more than you need.
Rather than maxing out and buying a home at the top of your budget, choose to live within your means.
And that includes covering all the essentials, savings, and lifestyle needs.
Only after you have budgeted your disposable income should you consider a new home loan, auto loan, or other major purchase.
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This content was originally published here.