A Simple Example of Why Spending Less than You Earn Works

It's simple math really, spend less than you earn and you have a surplus and are growing your net worth. Spend more than you make and you're going backwards no matter what else you do. This is the reason that my best piece of financial advice is to spend less than you earn. It's also the first step to becoming rich (or growing your net worth if you prefer.)

Today we have an excerpt from Trent Hamm's free ebook Everything You Ever Really Needed to Know About Personal Finance On Just One Page that deals with this subject. It's a simple example that gets the point across very quickly:

In the end, this is the fundamental rule of personal finance: spend less than you earn. It's the one point that comes up time and time again in almost every personal finance book you read or talk that you hear.

It's easy to see it when you look at each side of the coin. Let's say you earn $30,000 a year and you spend $31,000 a year. That extra $1,000 has to be borrowed, often from sources like credit cards. The following year, in order to maintain your lifestyle, you still spend $1,000 a year more than you make, plus you spend $300 more than that just making the minimum payments on your debt, leaving you a total of $2,200 in the hole (the $1,000 extra you spent the first year plus the $1,000 extra you spent the second year plus the $300 extra you spent repaying that debt minus the $100 you actually managed to pay off). The debt builds - after the third year, you’re $3,600 in debt. It keeps growing and growing and growing until that debt is eating up all of your income, leaving you in misery.

On the other hand, let's say you only spend $29,000 a year - only $2,000 less in spending. That extra $1,000 goes into your savings account and earns 3%. The next year, you drop another $1,000 in the account and now you have $2,030 in there. The next year, another $1,000, bringing you to $3,060.90. That money builds up and soon you have a house down payment or the seed money to start the small business of your dreams - or even something as simple as the ability to easily pay for a car repair without your heart skipping a beat.

The difference between these two stories is only $2,000 a year. There are two avenues to achieving this goal: spending less and earning more. By working on either (or both) of these areas, you can increase the gap between those two numbers - and that gap is your ticket to freedom. The harder you work on either spending less or earning more, the bigger that gap will become and the quicker that train to your dreams will arrive at the station.

As I've documented again and again and again (and even more than that), these same principles apply even if you're making a boatload of money. If you spend more than you earn, you're going backwards financially -- period!

Comments

[Rob Bennett]

I agree with the general idea being expressed here.

But I don't think it is quite that simple.

Not all spending is pure consumption. Much spending is directed at life enhancements that have the potential to increase earning power in the future. If you spend on education, this is obvious. But spending on restaurant meals can help you make contacts that lead to job offers or business opportunities down the line. Dressing well can help you get a promotion. Taking a vacation can recharge your batteries.

I agree that in principle it is best to spend less than you earn. But some young people are not earning enough to spend less than they earn and also invest in their own futures through smart spending decisions. I believe that there are circumstances in which it makes good sense to spend all that you earn or even to go into debt.

Most of us spend too much. But not all of us do. Some of us actually spend too little.

Rob

[Trask]

Well said Rob. A recent high school graduate, unless heir of millionaires, will likely have to SPEND MORE THAN HE/SHE EARNS to get ahead. Why is this ALWAYS left out of the advice? And if spending MORE THAN YOU EARN for college is good then why not nice clothes for job interviews and contacts? Once again, if one can justify spending more than they earn (TEMPORARILY) for education then why not lunches? Or vacations? Or whatever a person thinks they need to get ahead (e.g. starting a business)?

And, in the example given in the post, inflation is completely ignored. What if you earn $30,000 a year and spend $29,000 but inflation rises 5%? This person is AUTOMATICALLY worse off than they were a year ago even though they spent less than they earned. If inflation is 5% in that given year a person's LOST $1,500 in purchasing power so in reality, in order to maintain the same lifestyle that person needs to spend $27,500 to "keep the same lifestyle" and if inflation continues at 5% it will repeat the following year. Why is this information always left out with these simpletons?

My advice, GO OUT THERE AND GET AS MUCH AS YOU CAN using whatever means you need to do so. If you need to spend more than you earn to do it then so be it, life is not a guarantee and neither is wealth!

[Melissa@frugalandthriving]

Ta for the great post. While I agree that there are occassions where spending more than you earn may be beneficial (like leveraging to buy an income producing asset such as a rental property) it can't ever be a long term strategy, it's just not sustainable - unless of course you shirk your responsibility and never pay back your debts! Cashflow is an underlying principle of finance, and the well soon dries up if you keep spending more than you earn.

[Adrian B.]

As much as "spend less than you earn" is touted as a major rule for wealth building, it STILL gets criticized. I don't understand this.

Looking at the above examples, I don't see how spending more than a person makes helps the individual in anyway.

What, a person can't make contacts doing relatively free activities like hanging out in the library or jogging in a community park? You can't go on a cheap vacation locally? How come an individual can't pick up a part time job (temporarily) and cashflow some of these potentially money-making activities? How come he can't rent or buy used to "dress well"?

As for Rob's examples. Sure, most young people don't have large incomes, but they usually don't have large expenses either (relatively speaking, of course). With their youth, a young person can't pick up more than one job to "invest in their own futures through smart spending decisions"?

I just don't see how spending more than you earn is ever a good thing. The article shows mathematically why it doesn't make sense. This website constantly shows the value of how "spending less than you earn" leads to wealth. Why can't we just accept the validity of this rule and move on?

[Craig @ Money Help For Christians]

Spending less than you earn involves creativity. For a price there is always a convenient ready made solution. The simple and convenient solution involves going out and buy what you 'need'. A creative solution means analyzing if you really need the item. It involves asking if there is a substitute. It requires you to ask if 'it' can be done any cheaper.

I suspect if one were committed to living on less than they earned it would be possible in all circumstances. It might be inconvenient. It might be time consuming. But I suspect it is possible.

Some people need to focus their time on the "spending less" part of the equation. Others need to spend their energy dealing with the "than you make" portion. But, it does seem like if one of those portions are askew then you will spend much of your life catching up instead of getting ahead.

[Melissa]

I didn't get into debt AT ALL until I got married and have a spouse who has always spent more then he earned. Now I'm in $9000 credit card debt and while it makes me feel a little better that the average couple also is about that bad, every time I talk to my family I am shamed.

I emailed him the Trent Hamm link last week so I hope we get on the right track.

[ParisGirl111]

This is so true. I have read it in Dave Ramsey, Suze Orman, and Mary Hunt's books. Really...being financially free is not rocket science. It just requires discipline and doing. Dave Ramsey says its 80% doing and 20% head knowledge. I believe that's true!