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Debt is Different for the Self-Employed

Is debt different for people in different employment situations? I think so, certainly as it relates to the self-employed versus the salaried population. Does this sound preposterous? Maybe on the surface, but look a little deeper.

If you’re on a salary, your income and your personal finances are separate: you’re job provides one (the income) and you manage the other (your personal finances) outside the job. Even if your personal finances fall apart, you can still keep a salary coming in.

With the self-employed however, there’s usually no dividing line—or at best a blurry one—between your finances and your income (which is your business). The same debt that can disrupt your personal finances can also cripple your business.

Does this mean that everyone who’s self-employed should shut down their business and get on the payroll of a large employer? Not at all—but it does mean that if you’re self-employed, you have to see debt in a very different way than a salaried person might.

Managing cash flow is a critical component of self-employment

Managing cash flow is the name of the game if you’re in business for yourself. 50% of cash flow management is income, 50% is outgo. If you’re self-employed, outgo must be controlled because income is usually unpredictable. Even if income is rising, it could dip at anytime and if you’re paying off yesterdays expenses—a.k.a., debt—your ability to withstand the fall will be compromised.

Again, salaried workers have an advantage when it comes to debt. Debt typically requires payback over an extended period of time through regular payments. This type of arrangement is well suited for someone who is compensated on a weekly, monthly or bi-monthly paycheck, one in which both the frequency and amount of income is constant and totally predictable. There is a convenient match between debt payments and paychecks—something that’s usually harder to maintain if you’re self-employed.

When it comes to cash flow, the self-employed are better to be at least a little bit pessimistic. Assume that income can fall at any time and, as a result, to keep fixed expenses—like debt—as low as possible in anticipation.

Why you need to “travel light” if you’re self-employed

In what Western Culture has become, it would do us all well to adopt a strategy of traveling light in life. The real estate/mortgage meltdown since 2007 exposed the weakness of the have-it-all lifestyle that was so popular up to that point.

Since personal finance and your business/income are so intertwined, you need to view both as a single entity with a cohesive strategy for managing them successfully. One will most definitely affect the other.

A house with a big mortgage will be a major liability; it will have to be serviced even if your income falls. If you’re planning to start your own business, trading down to a less expensive living arrangement can be viewed as a strategic move, one that will improve your chance of business success considerably.

Owning your car(s) free and clear is another strategic play. In fact if you run your business from home—as many self-employed do—you probably have no need for a late model car with its attendant monthly payment. As Forrest Gump’s Momma said, “there’s only so much fortune a man really needs and the rest is just for showing off.” And showing off is a business killer!

Any of these efforts to reduce or eliminate debt will free up your cash flow, either to survive tough times, or to expand your business.

The object is to survive hard times—not to succumb to them

Most businesses go through periods of hard times—even if you avoid debt, a decline in income is always a problem. What you do during those times will determine whether your business survives or becomes an economic casualty.

There’s always a temptation for the self-employed to use credit cards and home equity lines to supplement cash flow during lean periods. This should be avoided at all costs. Any money you borrow to cover the short term will result in a reduction of future cash flow, potentially extending the crisis period for many years—maybe even into the next crisis, when you’ll borrow even more.

If you’re self-employed you have to realize that credit will not solve an income problem! If income is down, take a part time job, rent out a room in your house, rely on savings, sell possessions or cut expenses, but don’t borrow. You don’t ever want to turn a short term problem into a long term one and that’s precisely what borrowing does.

How you manage your finances during the good times will determine how you fare in the hard times—think of it as pre-positioning. How do you do this?

  1. Recognize that large debts can cause you to spend more time worrying about paying your bills than you do maintaining and growing your business.
  2. Always live beneath your means—but never more than when income is high.
  3. Resist expanding your lifestyle with every fiber of your being! Put another way, don’t take on debts and other obligations during good times that you won’t be able to afford during lean times.
  4. Extra money should be banked during good times, for withdrawal during the bad ones. You want to use savings—and not credit—to even out the bumps in your cash flow.
  5. Your ultimate goal is to become self-financing. The size of your debts is in inverse proportion to ability of your business to survive.

When you’re self-employed, you don’t have the luxury of putting your monetary affairs into separate boxes the way a salaried person might. All things financial are in the same mix and what you do in one area has a strong influence on what happens everywhere else.

Are you looking for a low risk business you can start for yourself—or for an additional income stream to cover you during hard times in your business? Check out my post The Freelance Blog Writer Side Hustle. It’s a business that’s easy to enter and can blend very well with what ever business or job you have now. It costs nothing to start and you can take it as far as you like.

Have you ever found yourself using debt to cover income shortfalls in your business? How did it work out?

( Photo from Flickr by Keller Postal Express )


4 Responses to Debt is Different for the Self-Employed

  1. The hard thing about being in debt when you’re self employed is deciding “should I invest in my business or should I put more money toward my debt”, at least that’s what I’m going through right now.

  2. Kevin M says:

    Hi Briana–That’s a TOUGH qestion. I suppose it has a lot to do with the amount of debt. If it’s large enough to be threatening, it’s probably best to concentrate on paying the debt, that way you can clear the deck to move forward in your business. But if the debt isn’t large enough to keep you awake at night, and the business investment looks like a high percentage shot to increase your income, you probably want to go that route instead.

    I do think that ultimately a successful small business needs to be debt free. Big business uses debt to leverage growth all the time, and that’s where us small fries often get our ideas to do the same. But big business can sell public securities and get preferential bank financing, and it’s being arranged by high level executives who aren’t putting up personal collateral. We can’t do any of that, which changes only everything! The small businesses that survive tough times are the ones that are running lean.

  3. Chris Ensey says:

    Hi, Kevin — Yes, there are lots of things to consider when self-employed versus not. If you’re self-employed, medical insurance cab become almost a completely different issue than if your employer provides this.

    Generally, that’s something that’s already rolled into your weekly paycheck from an employer, so your check often represents all of your available income. Sure, you can get insurance yourself or possibly through your spouse — but this is just one example.

    But, there are definitely some freedoms gained by being self-employed, as well.

    As always, thanks for your insightful articles!

  4. Kevin M says:

    Hi Chris, very true about the freedoms gained by being self-employed. But as the saying goes “freedom isn’t free”, so there are also paybacks. Debt and health insurance are two of them. But there are ways to deal with both. In the case of debt, it’s to be much more conservative about it.

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