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Welcome Lifehacker readers! In addition to the piece below, here are some other posts you may enjoy at Free Money Finance:
- Millionaire Interviews -- Interviews with people who have net worths over $1 million.
- Reader Profiles -- Interviews with FMF readers about their personal financial status.
- Money 101 -- Basic personal finance tips for those just starting out.
The following is part of a series I'm calling Money 101 and is designed for those who might not be as advanced in their personal finance knowledge and experience.
As we learned the other day, you measure wealth by tracking net worth. Today we're going to focus on how to grow your net worth so you become wealthy.
Is Becoming Wealthy too Complicated?
If you read financial books and magazines, visit financial websites, and watch money-focused TV, you'll come to the simple conclusion that managing money is complicated. The issues associated with handling money are vast, technical, and can not possibly be accomplished by the average person.
At least that's what they'd have you believe.
As such, many Americans think that becoming wealthy requires a level of specific knowledge that they can't attain. They think that building wealth is too complicated and it's beyond their reach. So they don't really make an attempt to build wealth.
Then you throw in limited self-control and the "I deserve it and gotta have it now" mentality, and you get a financial disaster.
How bad is it? According to a survey of 5,000 people highlighted in the book The Difference: How Anyone Can Prosper in Even The Toughest Times by Jean Chatzky, 54% of Americans live paycheck-to-paycheck, barely getting by, and are one financial problem away from money trouble. Another 15% are what the survey calls Further-in-Debtors – people who are going backwards financially every month. So between these two groups – almost 70% of people are either struggling or going backwards financially.
Not That Complicated
And what makes these results so perplexing is the fact that the principles to succeed in managing your money are pretty simple. They are both easy to understand and few in number. You don't have to be Einstein to succeed financially -- anyone with normal intelligence and a bit of self-control can prosper.
You have probably heard of the 80/20 rule, right? Also known as the pareto principle, it states that, for many events, roughly 80% of the effects come from 20% of the causes. In finances that would equate to getting 80% of the results out of 20% of the advice or tips. But in money management, the rule is more like 90/10 or even 95/5. Following a few, key steps is all you need to become wealthy.
How many steps? Can you handle two?
Two Equations that Lead to Wealth
Personal financial success ultimately comes down to two very basic financial equations. There’s no doubt about it – if you master these two equations alone, you will become wealthy and be far ahead of most Americans:
Income – spending = surplus
Surplus x time = wealth
Yep, that’s it. It seems pretty simple, doesn’t it? In fact, these seem to be “common sense.” But remember that these are two equations that 70% of Americans can’t get right.
If you look at these equations, you’ll see that all efforts to improve your finances come down to two things: increasing your income or decreasing your expenses. The more you do of each of these, the better.
Of course, there are a few more details to fill in the gaps. You need to understand the basic definitions of each term above and know the steps to take to ensure your success in each area. I'll be talking about these as well as sharing ideas to make the most of them as time goes on, but for now, here's a quick overview of each one.
You need at least a minimum level of earnings just to survive. Any amount above that qualifies you as a person who can build wealth. And since the minimum in America isn't that high compared to what people earn (average household income is around $50,000, and you can start building wealth well below that level), almost everyone qualifies.
Your career is where most people get the vast majority of their income. As such, we'll spend a lot of time here talking about how to manage and grow your career so you can maximize your earning potential. The bottom line: even a small change for the better can mean hundreds of thousands in extra income over a lifetime.
In addition to your job, there are a whole host of ways you can earn extra money these days. If you're industrious enough, the money you make on the side can be quite substantial.
No matter what you earn -- whether it's $30,000 or $1 million a year -- you must keep your expenses below your income. You MUST spend less than you earn. If you don't, you will go backwards financially.
Consider two people:
- Jenny makes $30,000 a year and spends $25,000 a year.
- Jim makes $1 million a year and spends $1.1 million a year.
Which person is building wealth?
Of course, it's Jenny. She added $5,000 to her net worth while Jim went backwards (by borrowing) $100,000. Yes, Jim has more POTENTIAL to become wealthy (and much wealthier at a much faster pace) than Jenny, but unless he gets his act together, he's going to be in one big financial mess.
Think about this -- what if they each kept this up for 40 years? Jenny would have $200,000 even if there is zero growth in her savings (which there wouldn't be -- she'd actually have much more.) Not bad for someone making her salary.
Jim? He'd probably be forclosed upon or hauled into court after several years of losing $100k.
While having a high income can be a great asset in becoming wealthy, it certainly doesn't guarantee wealth. That's why we see so many Americans living paycheck to paycheck -- they simply spend more than they earn.
Why can't most people get the two equations above to work in their favor? Many would say it's simply because they don't earn enough money. And for a small portion of the population, this is true. But the survey above also identified why so many people are in tough financial shape: they spend too much. They can't control themselves and they simply over-spend. So they live paycheck-to-paycheck or worse, are falling more behind every month.
The key to spending less than you earn is to take steps to save money in areas that work for you. We'll talk about this issue much more as time goes on.
The difference between what you make and what you spend is your surplus. Some people like to call it a "gap." Others call it "savings."
Whatever you call it, this is the fuel that fires your wealth-creating engine. It's the extra that you add to the pile that sets you up to grow your net worth.
Obviously, you want your surplus to be as large as reasonably possible. That doesn't mean you need to work 80-hour weeks and spend like a miser to squeeze every last penny into your surplus, but you do want a healthy (and growing income) and to keep expenses reasonable and under control. If you do these simple things, you'll grow your net worth automatically.
Time does a couple things for you:
- It allows you to add surplus after surplus to your net worth each and every year. Over a long period of time -- 20, 30, or 40 years -- these can really add up.
- It allows your money to grow upon itself. For instance, if you earn 10% on your money (selected just to make the math easier), your $1,000 surplus becomes $1,100 in year 2. The next year it becomes $1,210 and $1,331 the next.
See how it's growing itself? This is called compounding and we'll talk more about it later. But for now you can see how powerful it can be over a long period of time. 40 years down the road and your $1,000 will be multiplied many times over simply by compounding upon itself.
This is why time is so important in growing your net woth.
Now let's say you're already 50 or 60 years old. You may think, "These tips won't work for me. I don't have any time left."
While it's true that you don't have the advantage of 40 years to save, the tips we will cover here most certainly will make you wealthier down the road than you would have been without them. So don't dismiss these tips simply because you're older. Applying them WILL make you better off financially.
If you put all of the above together, here's the conclusion: you build wealth (net worth) when you spend less than you earn and save up your surplus over time. Yes, it's that simple.
No matter where your net worth is currently, you can improve it by taking the following steps (and the more you do of these, the better):
- Grow your income.
- Cut and/or control your spending.
- Start as early as possible and save your surplus over time.
As a wise man once summarized it: "Save as much as you can for as long as you can."