It was a few years ago that I followed a conversation between two guys, one of them planning to buy a house for USD 1 Mio.
That guy told that the down payment would be USD 250’000 and that he has saved that amount during the last 10 years. He said that his nest egg surpassed at least his “spending budget” of one year. As the conversation went on, the future home owner said that – considering his high salary – his bank better offered him an attractive interest rate for the mortgage. After all, he added with a wink in his eye, he was now a millionaire.
That conversation shows a general misconception many people have on wealth and income. Wealth is what you accumulate over time, not what you earn. The key factor in the process of wealth building is the saving rate. A high salary does not automatically translate into substantial wealth.
Now take our future home owner. His gross salary must by somewhat above USD 300’000 per year and yet his wealth increased by a relatively small amount of about USD 25’000 per year. A massive portion of his pay has been eaten away by his spendings. Very highly paid jobs tend to accentuate the effect of lifestyle inflation which means that increasing income leads to (disproportionally) growing spending.
The purchase price of a house in the amount of USD 1 Mio. does not mean the home owner is a millionaire. The current net worth (assets less liabilities) of our highly paid executive is USD 250’000. Considering his savings rate of about 10 %, the accumulation of USD 1 Mio. would take him decades. Many people earning far less managed to accumulated that amount in a relatively short time period just by consistently keeping a high savings rate.
Now let’s assume our highly paid executive had followed a more down to earth lifestyle and had spent say USD 125’000 per year instead of USD 250’000 which would correspond to a savings rate of around 50 %. His accumulated wealth after ten years would by far exceed the amount of USD 1.25 Mio (just make the math if the assets compounded at 4 % annually) allowing him to buy that house without any financing by a bank and additionally have a buffer of hundreds of thousands of dollars. Higher wealth helps to establish passive income sources as more funds can be invested. Over time the compound effect gains steam and the wealth building process accelerates significantly. A higher savings rate due to a down to earth lifestyle also makes much less dependent on a (high paying) job and gives more flexibility in life.
The key take away: no matter what’s your income, focus on your savings rate as it is the key factor to substantially improve your financial wellbeing and to build wealth over time.
Great post. People assume that their income will exist at that level forever and just keep increasing their lifestyle… only to find out that at some point it stops and they should have saved more.
Like Big Boi says in the song ATLiens – it’s not what you make but how much you spend
Hi Ross
Yes, that’s so true. Just amazing what a massive portion of one’s income is litterally eaten away unless focus is set on the savings rate. It boils down to that measure when it comes to wealth accumulation and gaining financial flexibility and yet most people focus on earning and consuming.
Thanks for stopping by, appreciate your commentary.
Cheers
So true-it’s not what you earn, it’s what you keep! People making a very low income can actually be richer than a powerful executive. Saving and investing over a long period of time puts compound interest to work for you, while debt puts it to work against you.
Hi Liz
Yes, it just requires a different mindset. Keeping consumption (relatively) low in order to save and invest on a regular basis for the long run is extremely rewarding. It gives us options and flexibility in life.
Appreciate you stopping by and commenting.
Earning more money gives you the ability to save more money. But that’s just the ability. You have to follow through with the saving part.
One of the biggest and best pieces of advice for young adults is to continue living like a broke college student as long as you can, so you can save that extra money (or pay down loans). Keep living like most do that are 5-10 years younger than you and you’ll be that much ahead of your peers in the net worth column!
Hi Kimberly
That really is great advice and I couldn’t agree more. Systematically keeping expenses under control (or even better reducing them) is key to translate income into substantial wealth over time.
Thanks for stopping by, appreciate your commentary.
Cheers
The bigger your spending, the bigger your golden handcuffs. He can’t ever walk away from that high paying job because his lifestyle costs way too much to maintain.
Hi Angela
That’s so true, jeah, the “golden handcuffs” are such a great metaphor; while a high salary and job benefits are great, lifestyle inflation is creeping up, more often than not, spendings grow at an ever faster pace than the salary and people get more and more bound to their employer (resp. to a high paying Job). Meanwhile the rat race is moving, faster and faster. Many people have “golden handcuffs”, they pay a high price for being stuck, having a lot of stress and feeling unfulfilled. Breaking these constraints really requires a mindset shift (applying a more down to earth lifestyle, improving the household’s finances …)
Appreciate your commentary and thanks for stopping by.
Have a Great Year 2018 and all the best.
Cheers