Where does your marginal dollar go?

On Twitter the other day I had a short exchange with Noah at Money Metagame about a question that I find fascinating: what do you do with your next dollar in income?

Budgets are fine but don’t aid ongoing decision-making

For a little bit of context, here are my recurring monthly expenses:

• Rent
• Phone
• Internet
• Blog subscription service
• Google business account

I also have a few recurring annual expenses:

• Credit card annual fees
• Website hosting fee

Finally I have recurring weekly investments:

• IRA contributions
• Solo 401(k) contributions

All together these expenses add up to something like $1,604 per month (I can’t be bothered to crunch my credit card annual fees but those would add a few hundred dollars per year, perhaps adding up to as much as $50 per month).

So in a very concrete sense, it’s important that I earn, on average, $1,650 per month in order to meet those recurring expenses out of current income, i.e. without incurring additional debt.

When personal finance gurus tell you to create a budget, they are normally hectoring you to use that budget to restrain your spending. For me, the more interesting question is the one I posed to Noah: once your income meets your budgeted expenses, what do you do with each additional dollar you earn?

After all, it’s true that if my income fell I could move to a cheaper apartment, or buy slower internet service, or make smaller IRA contributions. But when my income rises, it’s less obvious what I should do.

I don’t care what you do with your marginal dollar, but it’s worth thinking about in advance

Noah had an immediate answer to my question: “Yeah, retirement accounts are maxed already. The marginal dollar gets swept into a brokerage acct ~monthly“

Noah is trying to achieve his goal of early retirement by making additional contributions to a taxable brokerage account with his marginal dollar, which is perfectly reasonable. But it’s not the only thing you could do with a marginal dollar of income:

• Pay down debt. Student loans, mortgages, car loans, installment loans and any other kind of debt without a prepayment penalty costs less the sooner you pay it off. By using your marginal dollar to pay down those debts you can get a risk-free rate of return that may exceed your other investment opportunities (note: many people will tell you that your risk-free return when paying down mortgage debt should be discounted by the amount of the mortgage interest tax deduction, but those people are part of the problem and should be ignored, if possible).
• Increase your budget. If your income regularly exceeds your budgeted expenses, you can increase your budgeted expenses by moving to a bigger apartment, buying faster internet, or signing up for more expensive credit cards. That would bring your budget up to your income, and minimize the question of the marginal dollar.
• Build up cash savings. Many people think that having a cushion of cash savings is important in order to prepare for or withstand unexpected events. If you’re one of those people, then your marginal income can be directed into a high-interest rewards checking account in order to maximize the interest you earn on your federally-insured savings (I personally use Consumers Credit Union due to the high maximum balances and easy-to-meet monthly requirements).
• Buy more/better/sooner stuff. One popular option for people who see irregular bursts of income is to buy stuff. This is so popular that it has become a kind of cliche around tax season when people receive tax refunds and quickly use them to upgrade older appliances or buy new ones.
• Invest. This was Noah’s answer, and involves moving his marginal income each month into a brokerage account to hopefully speed his progress towards early retirement.

This is a subject of frantic and unnecessary moralizing

I have attempted above to present the variety of things you could do with a marginal dollar of income as even-handedly as possible, but different readers are likely to attach different moral valence to each one. To one reader paying down debt is obviously a higher priority than upgrading a television set, while to another saving for retirement is clearly superior to moving to a more expensive apartment.

My primary concern is that if you don’t have an idea of what you would do with a marginal dollar of income, you’re exceedingly unlikely to spend it in the way you really want to. Spending a few minutes with a notepad thinking about where you’ll put your next “spare” $1,000, $5,000, or $10,000 doesn’t mean you’ll spend it more wisely according to somebody else’s idea of personal responsibility, but might make it marginally more likely that you’ll spend it in a way that you’ll feel good about once it’s gone, whether it’s gone into a savings account, a television, an index fund, or a trip to Vegas.