Could Your Finances Handle a Pay Cut?

Many people are tired of the shutdown caused by COVID-19. That’s why people around me are starting to slowly return to normal life because things seem just fine for them after so many months of hearing about the devastation of the pandemic on the news. I can understand that too. After all, it’s hard to see how bad things are out there if you don’t know anyone who was diagnosed with the disease. What’s harder to dismiss is the shock this pandemic already caused the economy though. We haven’t heard about mass layoffs just yet, as many companies borrowed money at record low rates to stay profitable. But if slow economic activity drags on much longer, there’s a real possibility that employers will start laying workers off on mass to keep their bottom line. That’s why no matter what your job is these days, you could be faced with the reality of a pay cut.

No matter why you end up with reduced income, the important thing is to make sure that your finances will survive if a pay cut happens. And, of course, if you are thinking of dropping to part-time to pursue other opportunities, or if you want to cut back on your hours in order to spend more time with your family, you will need to make sure your finances can handle the change, and maybe even downsize your lifestyle. Here are some things to do now to prepare for a pay cut later:

Pay Down Debt

This always seems to be at the top of any financial preparedness list – and for good reason. When you have obligations hanging over your head, your money is not your own. It’s money that’s already spoken for. If you take a pay cut, you end up with a larger portion of your income going to debt obligations, rather than paying for your day-to-day expenses. When times are tough, the debt could crush you mentally, even if you can handle the load on paper.

Pay down debt as much as you can when your finances can handle it. You’ll be in a better position if you make less.

Sock Away Extra While You Can

Don’t blow it all if you are earning good money now. Plan ahead instead by setting money aside while you are making it. Bank your extra money in a high yield savings account or some other liquid location. That way, you’ll be able to build up a stockpile of cash to draw on later. Back in my journalism school days, I had a professor who said it was important to have “F-U Money” so that if you decided you needed to leave, you could. While there’s nothing wrong with spending your money on fun stuff, don’t spend it all. That way, you’ll have the ability to handle a pay cut a little better.

Don’t Count on Everything You Have in The Stock Market

Stocks tend to rise in value, but only over the long term. When you are forced to take a pay cut, it’s often accompanied by a stock market crash. Values do tend to recover over time, but you benefit only if you don’t have to sell out at the lows. That’s why savings in a liquid asset is so important. In a pinch, you don’t have to sell your positions to pay for living expenses.

Don’t Borrow to Your Limit

When my husband and I were house shopping back in the fall of 2007, we had lenders willing to approve us for what amounted to a monthly payment of 40% of our income. We could have done it. We even had the opportunity to buy a house with a payment amounting to 1/3 of our monthly income, keeping with the popular rule of thumb. However, we wanted some breathing room. When we bought, our payment was roughly 1/4 of our income. Now, all of our housing costs are less than 1/5 of our pay. If we have to take a pay cut, it will take a true financial catastrophe to make our home unaffordable.

The same principle can be applied to car purchases and other major borrowing decisions. Just because you are approved for a loan, and just because you can afford the payment now, doesn’t mean you should go for it. If you have to stretch to “afford” it, or if the payments are just within the realm of comfort, you could see serious problems if your pay is cut.

Think twice even if you could comfortably afford it. Remember that the payment is $0 if you don’t buy it at all.

Bottom Line

Do an evaluation of your financial situation right now, and determine if your finances could handle an income reduction. If they can’t, it’s time to re-evaluate your habits. Which debt should really be extinguished? Where can you make some immediate cuts to build up your cash reserves? Take the time to shore up your finances so you don’t let the unexpected crush you.

Never say this time is different, but this time really could be different. It’s only prudent to be prepared for the unknown. You can never be too prepared. That’s for sure.


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