Investment Glossary – Income
When discussing how to build a budget, there are two key components that determine whether you’re going to be cash-flow positive. Income represents money that is earned by you or your family, and expenses represent money that is spent by you or your family. You can break these large categories down into smaller components, separated by type of expense, frequency of expense, or necessity of expense, but all of your cash flows are going to fall into these categories.
As mentioned above, income refers to any money that comes into your possession in a fixed period of time. Income can be earned in a number of different ways. You or your spouse could be an employee of a company and earn W-2 income. In this case, you earn a regular paycheck based on the work you do, most typically paid out on an hourly basis or a fixed annual salary, though commissions and bonuses can factor in as well. You could be a freelance contractor who earns 1099 income, and in this situation, you may be paid for specific projects and work that you are contracted to do, rather than a fixed amount per pay period or per hour.
But income does not have to be earned just through work that you do on either a regular or unpredictable basis. Income can be earned through rent – either of property or intellectual property through licensing. For example, if you were a landlord who owned a two-unit property and collected rent every month from your tenants, that rent represents income you have earned. Likewise, if you had developed a proprietary piece of software that someone paid you for on a monthly basis, that would be income as well, even though it is not in the form of conventional wages.
On another level, borrowing influences a family’s budget as well. Let’s say that you want to buy a home for $300,000, but you only have $60,000. It’s pretty unlikely that the owner of that home is going to accept $60,000 as the total payment for the property – they’re not here to subsidize your life. So you likely turn to borrowing, in this case, applying for a mortgage, in order to be able to pay them the $300,000 up front. So in the case of taking out a mortgage, your income for the month would show the $240,000 that you gained from closing on the mortgage, and your future months would then show your monthly mortgage payment going out as an expense. Your overall net worth would be unaffected by the mortgage, as the $240,000 you gained to buy the property would be offset with your liability for needing to eventually pay the $240,000 back. However, for the purposes of budgeting, we are simply looking at cash flow and not your household balance sheet, and as such, that money would technically show as income for the month, even though most families don’t look at it that way.
Income is obviously a critical part of your budgeting process. While you can borrow to pay for expenses in the short-term, eventually, you get to the point where lenders will no longer finance your purchases if you don’t provide them with a clear path to paying those purchases back over time. So additional income can either be the answer to how you pay back those purchases, such as paying down credit card debt, or how to stay out of debt to begin with by keeping your income above your expenses.