Smart Money Podcast: What People Get Wrong About Credit, and Self-Employed Budgeting

Welcome to NerdWallet’s Smart Money podcast, where we answer your real-world money questions.

This week’s episode starts with a discussion about what people get wrong when it comes to managing their credit — and how they can improve their credit the right way.

Then we pivot to this week’s money question from a listener’s voicemail. Here it is:

“Hi, I'm calling with a question about people that work for themselves and creating a budget for that.

My husband works for himself. He's a builder. He's kind of an inventor, does a lot of metal work. He knows how to do everything as far as remodeling a home.

He gets such a varying income. I get a consistent income because I’m a salaried employee for the company I work for. Unfortunately, we live paycheck to paycheck. Sometimes we can't actually make rent that month based on the fact that my husband's income is so variable.

I know exactly how to budget when it comes to my income because it's consistent. I know what's going to come in every month. I’m just wondering, how do people budget for themselves when they work for themselves and have a varying income? Thank you.”

Check out this episode on any of these platforms:

• Apple Podcasts

• Spotify

Our take

Believing credit myths can lead you to take missteps when trying to raise your credit scores. For example, checking your credit scores or credit reports does not hurt your credit score. In fact, reviewing your credit scores and reports regularly can help you find opportunities to better your credit, such as removing erroneous information from your credit reports. Also, carrying a small balance on your credit card does not help your credit. This misconception can lead people to pay unnecessary interest.

Budgeting with an irregular income can be a challenge. Typical tools like the 50/30/20 budget may not be as applicable as usual. But you can get a grip on your finances by understanding your budget baseline. That involves pinpointing your minimum fixed expenses so you know how much you need to earn monthly. Understand how to pay yourself as a business owner, too. You can pay yourself a salary or give yourself what’s called an “owner’s draw” where you pull money from your company’s profits.

And while saving might be hard on a varying income, prioritizing this financial goal can help you cover expenses in leaner months. Depending on how much you earn and your expenses, you might want to save upward of 50% of your income to account for things like taxes and to give yourself a cushion.

Our tips

• Know your budget baseline. If you have an irregular income, determine your bare bones budget to pinpoint the minimum amount you need to earn each month.

• Prioritize saving. As a business owner, you might want to save upward of 50% of your income to cover expenses like taxes and give yourself a cushion.

• Be flexible. No budget is static, so check in regularly and make adjustments as needed.

More about managing credit and budgeting on NerdWallet:

5 Tips for Lowering Your Credit Utilization

How Much Money Should I Spend Each Month?

The Entrepreneur Salary: How Much Should You Pay Yourself?

Have a money question? Text or call us at 901-730-6373. Or you can email us at [email protected]. To hear previous episodes, go to the podcast homepage.

Episode transcript

Sean Pyles: Welcome to the NerdWallet Smart Money podcast, where we answer your personal finance questions and help you feel a little smarter about what you do with your money. I'm Sean Pyles.

Sara Rathner: I'm Sara Rathner, filling in this week for Liz Weston. To send the Nerds your money questions, call or text us on the Nerd hotline at 901-730-6373, that's 901-730-NERD, or email us at [email protected], and hit that “subscribe” button to get new episodes delivered to your devices every Monday. If you like what you hear, leave us a review.

Sean: This episode, Sara and I answer a listener's question about managing their budget while self-employed. But first, in our “This Week In Your Money” segment, we are digging into a new NerdWallet study about what people get wrong when it comes to managing their credit. Sara, can you give us a rundown of the study?

Sara: We wanted to find out how Americans were managing their credit during the pandemic, so around March 2020 until now. We conducted a study online with the help of Harris Poll, and asked 2,000 adults age 18 or older about their credit habits.

Sean: OK, and what did we find out? What are people getting right, and what are they getting wrong?

Sara: Well, there's definitely a lot that people are getting right, but there are some pretty common credit score myths and credit myths in general that get passed down from generation to generation.

Sean: Inter-generational credit management trauma, or something.

Sara: Exactly, and those myths, some of them can be harmful. Not life-destroyingly harmful, but they'll cost you money where you don't need to spend money.

Sean: Yeah, or they can cause you to mismanage your credit. Like, the first one that we saw was that people think that checking their credit score will hurt it, which is just not true at all. We found that two in five Americans think that. That actually can hinder people's credit management, because they will not check their credit scores or reports, and then they won't know if something is erroneous on their reports, and then they will continue to have damage on their credit reports, which will make it so that getting future credit is more expensive and harder to qualify for.

Sara: Your credit score, it's kind of like taking your temperature. It could be an indication that something's up and you need to investigate a little bit further. It could just be a sign that, if anything, there might be errors on your credit report, which is shockingly common.

Sean: Yeah.

Sara: Just by resolving those errors and letting a few months pass, you might begin to see some positive changes to your credit score. It could also be the result of, maybe you forgot to make a payment on a credit card bill or another loan. It just slipped your mind. You didn't have autopay set up. If more than 30 days go by after your credit card due date, for example, that can lower your credit score by around a hundred points.

Sean: Yeah.

Sara: Sometimes if you missed the due date, that hundred-point drop could be the sign that you need to fix things. You want to keep an eye on that number, because it can be a sign of your overall credit health.

Sean: Yeah, and at this point there are pretty much countless services — NerdWallet included — where you can get your free credit score weekly.

Sara: I will say, getting free credit scores through different services like NerdWallet, it gives you a picture into how your credit score is doing, but if you are applying for a loan, like an auto loan or a mortgage, the lender might use different scoring models to determine what sorts of terms they're willing to grant you, so the credit score you see through different apps or different means might not match the credit score you see your lender using. That's just something to keep in mind. It's not that it's wrong, it's just that it's different.

Sean: Right.

Sara: Really, the important thing is keeping an eye on your score just to note changes and make sure that any fluctuations in your credit score have an explanation that's satisfying to you. That way, when you go ahead and apply for a loan, you have a general idea of where you are.

Sean: What's another myth that we came across?

Sara: Oh, this one breaks my heart. I hate this one. OK guys, I'm going to level with you. You do not need to carry a balance on your credit card from month to month to help your credit score.

Sean: This is a very pervasive myth.

Sara: I don't know where this came from. People seem to think that it shows lenders that you are "more responsible," and that way they will increase your score.

Sean: Yeah.

Sara: Here's the thing. If you carry a small balance from month to month, but you make at least a minimum payment on your bill every month, you're going to keep your account in good standing, and therefore you will keep your credit score intact or even improve it over time. Yeah, that does work. But, you know what also works? Paying your bill in full and not paying interest on a balance. Same result, you don't pay interest, and credit card interest is expensive. Why would you allow debt to roll into a bigger and bigger snowball every month when you can improve your credit for free?

Sean: Another thing that I found kind of surprising from this study is that there's a myth that people think their credit scores are on their credit reports, which intuitively you think that your score should be on your credit report, but in fact, they are two distinct but connected aspects of your credit profile.

Sara: Your credit score is based on information that appears in your credit reports. That being said, there are lots of ways to access your credit scores and keep tabs on them, and you also access your credit report for free. You do not ever want to have to pay to get your credit report, because you're entitled to receive copies of it from all the main credit bureaus.

Sean: Through April of 2022, folks can access their credit reports at AnnualCreditReport.com for free weekly.

Sara: You can check once a week if you want to, but at the very least just check a couple of times per year, especially if you're thinking of applying for a loan in a couple months.

Sean: You want to make sure that you don't have any wrong or outdated information, or information that should be off your credit report because it has aged past its time to be on your credit report.

Sara: If you notice any accounts that you don't think you opened, could be a sign of identity theft, so that's also something to report to credit bureaus to try to set things right.

Sean: We've talked about a few things that people misunderstand about credit. Now let's give them some tips for how they can truly and confidently build up their scores. What are your thoughts here, Sara?

Sara: Big one here, pay your bills on time. Credit card bills, other loan bills every month, so student loan, auto loan. Pay your rent and utility bills on time, because sometimes those also get reported to credit bureaus, and that could be a way to help build credit if you don't have a credit card. You want to keep up with on-time payments. If you struggle with this, set alerts, use autopay. Make it so that you basically can't screw this up, because that is huge.

Sean: Another good tip for folks is to use their credit lightly. That means basically using no more than 30% of your credit limits. Although, actually staying under 10% of your credit limit is ideal because this thing called credit utilization — how much of your available credit you are using — is a pretty big factor that can change from week to week, month to month, that will influence your score.

Sara: If you find that you're struggling with credit utilization and you're getting close to maxing out your card or spending above that 30% ratio every month, there could be some things you can do. First of all, you have to look at your spending honestly, and one thing you could do is use your credit card for a couple of your monthly expenses, but not all of them. Just charge a portion of what you spend every month, and then use your debit card or cash to pay for the rest. That way, you can use your credit card in a way that helps you build your credit, but you're still budgeting for expenses beyond your credit card usage. Then another thing is, if your income has gone up, it's good to report that to your credit card issuers, because you might be eligible to get a credit limit increase. If you have a credit limit increase but your spending remains unchanged, it becomes that much easier to avoid maxing out your credit card every month.

Sean: If you're in a position to do this, paying off your credit card balances in full each month will also help keep your credit utilization low, and it's a great way to save on interest too.

Sara: It is, and it's helpful for another important ratio, which is your debt-to-income ratio. If you're thinking of applying for any other sort of loan, it's very helpful if you don't have a ton of debt relative to how much money you earn. That can help you qualify for better loan terms too, which will save you money.

Sean: One last tip that I think people may not fully appreciate, is that it's great for folks to keep their oldest credit accounts open. Sara, can you explain why that is?

Sara: You want your credit accounts to age like a fine wine, because the average age of your accounts can help improve your credit score. If you have a credit card you don't use anymore, it might be tempting to Marie Kondo your wallet and cancel it and cut it up, instead of keeping it in a drawer and keeping the account open. But, by keeping the account open and just maybe using the card a handful of times per year to keep the account active, you can let that average age of your accounts continue to get higher. That's really good for your credit score. If you don't want to keep a card open because you're paying an annual fee on it and you don't think you're getting a lot of value out of the card, you can see if it's possible to downgrade your account to a no-fee version of the same card. It lets you keep the same account open, but you stop paying that annual fee. All right, with that, I think we can get on to this week's money question.

Sean: Let's do it.

Sara: This episode's question comes from a listener's voicemail. Here it is:

Listener voicemail: Hi. I'm calling with a question about people that work for themselves and creating a budget for that. My husband works for himself. He's a builder. He's kind of an inventor, does a lot of metal work. He knows how to do everything, as far as remodeling a home. He gets such a varying income. I get a consistent income because I'm a salaried employee for the company I work for. Unfortunately, we live paycheck to paycheck. Sometimes we can't actually make rent that month based on the fact that my husband's income is so variable. I know exactly how to budget when it comes to my income because it's consistent. I know what's going to come in every month. I'm just wondering, how do people budget for themselves when they work for themselves and have a varying income? Thank you.

Sean: All right, and to help us answer our listener's question, we are joined by small-business Nerd Kelsey Sheehy.

Sara: Welcome to the podcast, Kelsey.

Kelsey Sheehy: Thanks for having me.

Sean: Great to have you on. I know there's a lot going on in our listener's question, but I wanted to start off by talking about some of the unique challenges of managing a budget as a self-employed person. What kinds of things are they experiencing and troubleshooting?

Kelsey: This is a great question. First, though, a couple things I want to point out that your listener is doing right. First, she has a budget. That's great. She's already setting money aside. The problem that she's running into is that traditional budgets often just don't work for freelancers and self-employed people, because you don't know when money is going to come in, or if it's going to come in at all in a given month. You're kind of at the mercy of your customers, to a degree. Whether they buy your product or even pay their invoices on time. That makes it really challenging.

Sean: I imagine that having an irregular income would make budgeting really difficult, in part because your income is changing one month to the next, but your expenses are not changing that much from one month to the next.

Kelsey: That's right. You still need to pay your bills and put food on the table, whether you have a good month or a lean month, and seeing data that supports this being really difficult for people who have volatile income. A Federal Reserve study showed that, among those whose income vary from month to month, 37% struggled to pay their bills at least once in the past 12 months. That's a lot.

Sara: It's not just people who are self-employed who experience this. There are lots of industries where workers have income volatility. Right?

Kelsey: Absolutely. It's not just self-employed. You think about people who work on commission or tips, who have seasonal jobs, or who have jobs that are subject to having their hours cut from one week to the next. This covers a lot more than just self-employed people.

Sean: Right. Thinking about traditional budgets versus budgets for people who have volatile incomes, I'm thinking about the 50/30/20 budget, where half of your income would go to cover things like needs like rent and your car payment, 30% goes to wants and 20% goes to debt payments and savings. How do you think this structure would apply to someone with a volatile income?

Kelsey: The 50/30/20 rule works really well if you know what your income is every month, that steady, known income. It doesn't work as well for people who have maybe no income in a given month. What you need to consider as you're then putting together your budget, is to really prioritize savings, including for taxes if you're self-employed. This will sound crazy, but sometimes you're going to want to save as much as 50% of your income each month, because that's going to give you a cushion for those lean months where you have no income coming in. Also, let you set aside money for quarterly taxes, because if you're self-employed, you need to save at least 20% of your income for taxes.

Sean: I think it would probably be helpful for folks who are in the situation to have a very designated savings account for things like taxes, and maybe even health-care expenses, that they can put money into every single month. That way, if they have a month where they make a little more than usual, they can begin to build up that cushion, put that much more in. That way, when there is a lean month, they don't have to worry about whether they'll be able to cover those expenses.

Kelsey: Beyond just having a separate account, it's really important to have a business account. You want to treat your business like a business, and have a business checking account, have a business credit card, so you can keep your business income and expenses separate from your personal finances. That's going to make it a lot easier to track your expenses and possible tax deductions, but also set aside money for those quarterly taxes, and build up a reserve that's going to cover you in those lean months. Keeping it all in a separate business account makes it easier to manage the ebbs and flows of your income.

Sara: If you have irregular income, but you haven't budgeted yet, how can you get started?

Kelsey: The first thing to do is really look at how much money you make in a given month. If you're not already tracking this, go back and look, because you want to base your budget if you're just starting out off your leanest month, or even your average month, and then establish a baseline for your expenses. You want to calculate a bare bones budget, so you know the minimum you need to earn each month. Our listener, she has one advantage here. There's one person in her household that has a steady income. To the extent possible, use that known reliable income to pay those non-negotiable expenses like housing, electricity, food. Then, her partner's income, kind of help with the savings and discretionary spending like cable, dining out, other fun things that aren't necessary to keep the lights on.

Sara: One that stood out to me in the question from our listener is that they're having trouble making their housing payment sometimes. I'm wondering how you think they could begin to maybe stabilize their expenses, or increase their income to try to account for that, and have a more reliable way to cover their housing.

Kelsey: It's such a stressful position to be in. The number one thing if you're having trouble making your necessary payments each month is to go back and look at all of your expenses, really comb through your spending, and find any ways to cut back. That's always going to be the first place to look is, can you lower your expenses? The next thing is, can you increase your income? With her partner's volatile income, are there ways that he can track what's coming in and what's going? Are there outstanding invoices? Can he work to get paid for projects on a shorter timeframe or quicker schedule? Maybe even looking to get paid some of the commission upfront, versus everything at the end, if that's how his payment schedule's working.

Sara: That's a huge thing when you're self-employed or a freelancer, hunting your clients down and getting paid can be tough. That means that there's money that you're owed that you can't spend on your life or on your business, because you haven't received it yet. I really like the idea of shortening the timeframe a client has to pay you, or having a client put down a deposit before any work is done.

Sean: I'm loath to recommend people getting into debt when they don't need to, but I'm one wondering if something like a business line of credit would be a good option for our listener's partner who does have an inconsistent income from their business. What do you think about that?

Kelsey: There are advantages to a business line of credit if you need startup capital or working capital. But you really want to make sure you get down to just having your spending in order, because you can take out a business loan or a line of credit to help float expenses or to purchase supplies, but you still need to have your personal budget in order. That sounds like this is really the struggle for our listener, is that personal budget and being able to pay household expenses, which you really can't do with a business loan.

Sean: Yeah, you don't want a loan to try to make up for the fact that the foundation of the personal finances aren't quite where they need to be.

Kelsey: Exactly. The key thing is going to be to get those expenses evaluated and under control, and work on the billing and the flow of money coming in. If you don't already have a system where you're tracking every single project, every outstanding invoice, set that up so you know exactly who owes you money and when it's due, and you can really be strategic about making sure that those invoices are paid on time.

Sean: The word “system” really stood out to me in what you just said, because I think that's something that they would benefit from greatly, is being able to track their income and expenses more closely on the personal finance side, and then also on the business side, because it seems like right now they're not entirely sure what's coming in, what's going out, and at the end of the month, they're a little strapped for cash.

Kelsey: It doesn't have to be complicated. Something as simple as a Google Doc that has each project listed, when the payment is due, and what the status is — if it's been paid or not. That makes it a lot easier to go and look and see, "OK, here's what's supposed to come in this month. Let's follow up and make sure those get paid on time."

Sara: It's really important to set aside time to do this, too. When you run a business, it's because you are good at your craft, but that doesn't mean you're necessarily good at the things you need to do to run your business. Sometimes you hire that out, but if you can't or you choose not to, it is really important to set aside a half hour a week, even, just to look at that spreadsheet and make a couple calls or send a few emails, just to remind your clients that they owe you money.

Kelsey: Rather than hiring it out, there are also a lot of great free bookkeeping tools that will help you keep track of invoices, payments, all of the money coming in and out of that business account, and set you up for a position where you can start paying yourself a salary. Even though your income changes from month to month, where you can get yourself into a position where you can pay yourself a salary each month that's going to cover your baseline, that bare bones budget, plus any discretionary spending like dining out, and also your savings. If you base your budget off that leanest month, any excess income you get in a given month can go towards building that buffer, paying down any toxic debt and also building up your savings goals.

Sara: I like the idea of paying yourself a salary too, because it goes back to that separation of business accounts and personal accounts. You know you have a set amount of money coming into your personal account to pay your bills, while you maintain money to reinvest in your business too, and they don't mix.

Sean: Well, from a legal standpoint too, aren't there certain advantages of keeping your business finances distinctly separate from your personal finances, if you are a business owner?

Kelsey: It does make it a lot simpler to do your taxes. If you want to take out a business loan, for example, you're going to need to show your income, your expenses, all of these financial reports. You can't run those very easily if all of that is going through your personal account as well. Having a separate account set up allows you to treat the business like a business, and pay yourself eventually. That's the goal. Rather than taking money in as it comes to be able to pay the bills, you know this is what I'm paying myself each month. If there are adjustments that are necessary, you can make those along the way, but it's easier than trying to adjust on the fly and realizing you don't have the money to cover things like rent.

Sean: It's also important when people are trying to work through what their budget could look like to realize that budgets aren't static. Check in maybe quarterly or maybe twice a year, once a year, whatever works for you, to see how your income and expenses have shifted over the past few months, and then make adjustments as needed.

Sara: You mentioned discretionary spending too. You can work fun things like dining out, entertainment, travel into your budget so you don't don't have to deprive yourself of those things, but you simply plan in advance for them.

Kelsey: That's right. It's even more important when you are self-employed or you have that volatile income. You're working hard. You want to be able to do fun things. But, it's a good idea for anyone, plan for those things, so you're not dipping into savings or going into credit card debt to do that. Then, as Sean mentioned, budgets are not set in stone. You should revisit them quarterly, semi-annually, but you should also be checking on them every month throughout the month, not just at the end of the month to see if you went over or if you were under budget. You need to be touching base with your budget on a weekly basis, even, so you know if you need to make adjustments and say, "OK, we actually can't go out to dinner next week because we're really tight this month." Or, like, "Hey, we've got a little bit of extra money. Let's put some in savings and then treat ourselves."

Sara: A lot of people I've spoken to told me that something that helps them is not to think of a budget as a monthly thing, but to think of it on a week to week basis like you've mentioned, because so many bills are charged monthly, like utilities, cell phone, things like that, but sometimes it's easier to wrap your head around a budget if you break that down into four distinct pieces and you think of your money on a week to week basis, especially if you're paid every two weeks, even every week.

Sean: Having a budget is really like a daily practice of understanding and directing where your money is going.

Kelsey: Sometimes it's helpful to think of it more as a spending plan than a budget, which can feel constrained. If you miss your budget one month, well that didn't work for me, and you have the urge to just scrap the whole thing if you miss your budget one month. You're not going to get it right the first time. It's going to take some tweaking and adjusting, and you need to check in with your spending and your savings regularly throughout the month to know if you're on track and if you need to adjust. Rather than reacting to changes, you can plan for them and be prepared for them.

Sean: Well, Kelsey, thank you so much for talking with us.

Kelsey: Thank you for having me. This has been a great discussion.

Sean: With that, let's get on to our takeaway tips, and I'll kick us off. First up, know your baseline budget. If you have an irregular income, know your bare bones budget to pinpoint the minimum amount you need to earn each month.

Sara: Next, prioritize saving. As a business owner or freelance worker or seasonal worker, you might want to save upward of 50% of your income to cover expenses like taxes and give yourself a cushion.

Sean: Lastly, be flexible. No budget is static, so check in regularly and make adjustments as needed.

Sara: That's all we have for this episode. Do you have a money question of your own? Turn to the Nerds and call or text us your questions at 901-730-6370. That's 901-730-NERD. You can also email us at [email protected]

Sean: Here is our brief disclaimer, thoughtfully crafted by NerdWallet's legal team. Your questions are answered by knowledgeable and talented finance writers, but we are not financial or investment advisors. This Nerdy info is provided for general educational and entertainment purposes, and may not apply to your specific circumstances.