The 3 Paths to Wealth Creation
The central premise behind the Financial Independence, Retire Early (FIRE) movement is to quickly build enough wealth that you no longer need to work to finance your lifestyle.
The idea of financial freedom is appealing to millions who have embraced the FIRE movement, but the question remains, how does one build wealth? To put it in the simplest terms possible, you must own assets which are expected to increase in value over time.
Specifically, there are three paths to creating wealth and obtaining financial freedom.
1. Living frugally & investing in the stock market
2. Owning real estate
3. Owning a business
Living frugally & Investing Wisely
This path is best represented by those in the FIRE movement. The math behind the FIRE focuses on one variable, your savings rate. In FIRE terms, your savings rate refers to how much of your take-home pay are you investing in assets that you expect to return at least 5% above inflation. Once your passive income from these investments is greater than your projected living expenses, you are said to be Financially Independent and may choose to Retire Early.
The reason the FIRE movement has become so popular is that it is thought of as accessible to nearly everyone. If you are frugal enough, even someone with a modest income can work towards Financial Independence. For this reason alone, I am a huge fan of FIRE. I am for anything that gives people financial hope.
The investment of choice for FIRE seekers is investing in the stock market through low-cost Index ETF’s. This is considered the smartest way for ordinary people to invest in the stock market for two reasons.
1. Since these funds passively track an entire stock market index rather a specific sector or stock, they provide broad diversification.
2. They are lower cost than traditional mutual funds or picking individual stocks.
You can often buy units of an Index ETF’s for under $100 which is appealing to moderate income earners who may only have a few bucks a month to put aside for investment. Odds are if you identify yourself as part of the FIRE movement, you are investing in Index ETF’s.
This is probably the slowest of the three paths to wealth creation, but it is the most passive. Which means it will require the least amount of your time.
Owning Real Estate
Let me get this out of the way, as it has somehow become a controversial issue in the past several years. Homeowners are wealthier than renters.
Austrian Economists Pirmin Fessler and Martin Schürz released a study measuring how wealth is generated in across Europe and in the United States.
The results for the United States are not surprising:
- Renters have the least wealth
- Homeowners have more wealth than renters
- Business owners & landlords have more wealth than everybody else.
So, odds are, over a 30–40-year time horizon you will generate more wealth by owning your home than renting.
Owning the home you live in is a good start, but if you own the homes other people live in you’ll likely build much more wealth.
In the United States, business owners & landlords have 5 times more wealth than the national average.
(when I refer to real estate from here on out, I am referring to rental properties)
Real estate provides three methods of building wealth.
1. Monthly cash flow
2. Asset appreciation
3. Debt repayment
Wealth Builder 1: Monthly Cash Flow
The monthly cash flow is the difference in the rent you receive and the operating expenses of your rental property. A solid real estate investment should be producing positive monthly cash flow from day one. If it is not, you are not investing, you are speculating.
A savvy real estate investor does their homework before they buy a property. They will ask questions like;
- How much annual rent is the property currently generating?
- How does that compare to similar properties in the neighborhood?
- How much annual operating costs are associated with the property?
- What is the vacancy rate in the neighborhood?
A handy rule of thumb to help determine if a property is likely to cash flow is the “1% rule”. Which states that monthly rent from a property must be at least 1% of the purchase price.
If you bought a property for $100,000 it would need to generate $1,000 per month in rent to achieve the 1% rule. While useful, you can’t simply rely on the 1% rule to determine if the property will provide positive cash flow. It’s important if you are thinking of investing in real estate to learn how to value a potential investment.
Part of why real estate has attractive cash flow is that it has numerous tax benefits including:
- Deprecation on the property
- Deduction of mortgage interest
- Deduction of property taxes
- Deduction of insurance and other operating costs
- Deduction of utilities
- Deduction of Homeowners Association Fees
- Deduction of repair expenses
- And in some cases, deduction of travel expenses
All of these can be deducted against your rental income for tax purposes. That means you can put more of that rent directly into your pocket.
Wealth Builder 2: Asset Appreciation
The second-way real estate helps build wealth is through asset appreciation. If the value of the house goes up, you’ve become wealthier. There is no guarantee your property will increase in value but if it does it will help accelerate your wealth.
Wealth Builder #3: Debt repayment
Since most real estate investments are leveraged, meaning you use a loan to buy the property, real estate provides a third way to build wealth, paying down debt. Each month when you collect rent and make your mortgage payment your equity in the property and your wealth increases.
Let’s say you buy a rental property for $300,000 and have a mortgage of $200,000. On day one you have $100,000 in equity. After 20 years you have used the monthly rent to pay off your mortgage, but the value has not changed, it’s still worth $300,000. But since you no longer have a mortgage you own that $300,000 free and clear and created an additional $200,000 in wealth. The best part is, your tenants have paid most or all the mortgage for you.
If someone else (your tenants) is paying your mortgage, you do not even need the property to increase in value to create wealth.
As the saying goes, “you’re either paying your mortgage or somebody else’s”.
Add up the benefits of the monthly cash flow, potential asset appreciation, and debt repayment and you have a nice trifecta of wealth creation provided by real estate investing.
Note, that real estate investing is riskier and more time consuming than investing in index ETF’s.
Owning A Business
The classic examples of economic inequality is the disparity in wealth between capital and labor. Meaning, between business owners and workers.
Owning a profitable business is how the richest people in the world built their wealth. As a business owner you have access to a lot of preferential tax treatment, if you’re incorporated you can choose to pay yourself a salary or pay yourself with dividends when it suits your needs.
The greatest benefit of being a business owner is that you can pay other people to run the day to day operations of your business which allows you to sit back and collect passive income.
While successful business owners tend to build the most wealth of any other group in society, it is by no means a slam dunk. Don’t forget that two-thirds of all businesses fail.
The term “high-risk, high-reward” applies to owning a business. If everything works out, you can build a life changing amount of wealth. If everything goes up in smoke, you could lose everything.
If you want to dip your toes into the waters of entrepreneurship without leaving the safety of your full-time job, start a side hustle. When I say a side hustle, I don’t mean driving for Uber. I mean starting a side business.
A side business like blogging or setting up an online store is something that you can do in your spare time. This allows you to keep the security and benefits of your full-time job while exploring other avenues to increase your income. If you can increase your income while maintaining your current living expenses, you could have plenty of disposable income that you can invest and begin to grow your wealth.
Starting a side business has three primary benefits.
1. It helps you understand if you are cut out to be a business owner
2. It provides unlimited upside to your income and ability to generate wealth
3. If you are successful (and lucky) it could turn into a full time “real business”
So, there you have it, the three paths to creating wealth, frugality, owning real estate and owning a business.
I am interested in what you have to say.
- Are you a renter or a homeowner?
- Do you own a business?
- Do you own rental properties?
- Do you own stocks or ETF’s?
· Is there another major path to wealth creation that I’ve missed?
Let me know in the comments!
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.