Why Some “Rich” People Are Broke
It’s not what you make, it’s what you save that Counts
In a recent post, I talked about the number one factor you need to focus on if you are pursuing Financial Independence (FI) and/or Early Retirement (FIRE), and that is your personal savings rate. How much of your take-home pay are you saving and investing? In today’s post, I want to dispel a commonly held belief that all you need to do to hit financial independence, is make more money.
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Don’t get me wrong, the more money you make the easier it is to achieve a higher savings rate. We all have a certain “floor”, if you will, of how much you can save. You can reduce a lot of your expenses by trading your car for a bus pass, house hacking and living off rice and beans, but it’s impossible to bring your cost of living down to zero. There is going to be some basic amount of money you need to spend to live.
Let’s say you are as frugal as they come, perfectly implement all cost-saving hacks and have managed to bring your required monthly spending down to $1,000 per month. If your take-home pay (what you get after all taxes and deductions are taken off your paycheck) is $2,000 per month you have a “ceiling” of a 50% savings rate. Don’t get me wrong, a 50% savings rate is incredible! But unless you make any more money, it is the best you can hope to do. If your take-home pay was $10,000 per month, you would have a 90% savings rate and be on track for financial independence/early retirement in under 3 years.
Clearly, the more your income rises above your spending floor, the easier it is to achieve a high savings rate. So, all high-income earners must be rich right?
Let’s take a look at the correlation between income and net worth in the U.S.
As the above chart shows, income and wealth are most positively correlated between age 34–39. During this age range, we can comfortably say high-income earners are much more likely to be wealthy. However, once we hit the 40+ age range that correlation drops off and continues trending downwards. For the average American under the age of 35 or over the age of 40, a high income does not mean you are wealthy.
It’s not what you make, it’s what you hold onto.
How could it be that for the majority of Americans, a high income is not leading to increased wealth creation? The answer is that their savings rate is not rising with their income. Meaning that as their income increases, so does their spending. In the personal finance community, we refer to this as lifestyle inflation.
How many people do you know that got a raise or a promotion and decided that they need to “upgrade their life”? They may get a nicer car, a bigger house, start paying for organic everything, switch from no-name clothes to higher name brands or they go on fancier vacations. Many people feel that increasing their spending increases their status in the eyes of their friends and family. Some people think that there is no point in making a lot of money if other people don’t know about it. They prescribe to the “flaunt it if you go it” way of living.
Live like a student for as long as possible. Want to know how I paid off $50,000 in student loan debt and reached a six-figure net worth (without a six-figure income) in 5 years? Once I finished my master’s degree, I continued living like a student for years.
Even after I started working at my “career” job, I continued to live with roommates in a disgusting apartment above the health food store. Why? Because the rent was $350 per month.
I continued to drive my dented, 15-year old, purple Chrysler Neon. Why? Because I needed a car for work, otherwise I would have sold it and bought a bus pass.
Date night? Make a meal at home and go to the park.
Vacation? What vacation?
You get the idea.
I was able to drop my expense floor to as low as I could stand, threw every penny I had towards paying down the debt and saving for a house. Over time, as my debt began to melt and my income kept rising, I very slowly began to increase my standard of living.
Today, I am debt free and my wife and I have done very well on two real estate deals which have helped us quickly increase our net worth. In the past few years, our standard of living has grown, but we are still hovering around a 40%–50% savings rate. We are taking all of our savings and throwing it against our mortgage and investing in low-cost index funds, both of which will help us build our net worth over the long term, regardless of our income increases or not.
Want to increase your wealth over the long term? Don’t fall victim to lifestyle inflation; live like a student as long as you can stand and slowly increase your lifestyle while keeping your spending to a reasonable level.
Bonus: A simple trick to avoid lifestyle inflation
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