The first step to building wealth is positive cash flow.
Cash flow = Income - expenses. If you are bringing in more money than you are spending you will begin to pay down debt and build wealth. The biggest contributor to positive cash flow is income. We do not generally have direct control over our income level so let’s focus on the other side of the equation, expenses.
Cost of living includes everything you consistently spend money on. There are two types of expenses, fixed and variable. Fixed expenses are recurring and about the same every time, like rent/mortgage/insurance/phone/internet/Netflix. Variable expenses are those that fluctuate like food/clothing/shopping/movies/games.
Find a cost of living you are comfortable with and make that your expense ceiling. Convince yourself to never raise your expenses higher than that amount. Anything you earn over that amount should be saved. Never intentionally raise that cost of living. Assume it will raise at a rate equal to inflation and fight to keep it there. Then, as your income rises so will your positive cash flow without you having to make any more changes to your lifestyle. Do not rely on your income increasing since we are living in a time of increasingly stagnant wages that do not even increase at the rate of inflation, especially in industries like education and manufacturing.
Predict the cost of life events such as marriage, having children, death, your car breaking down and factor that into your financial plan. If you are proactive and disciplined you can be prepared for most of what life throws at you. If you are living paycheck to paycheck then you are only one life event away from bankruptcy.
Positive cash flow is the key to achieving your dreams.
As you build cash you will be able to invest, beginning the transition from employee to owner. When you buy stocks you become a partial owner of a corporation. Investing over time will transition you from earning money with your time to earning money with other people’s time. You will become the employer. Your money will start to make money. Eventually this passive income can surpass your expenses and you will no longer have to work. This is referred to as financial freedom. The lower your expenses, the less passive income you will need and the less money you will need to invest.
Financial freedom means having enough wealth invested so that it earns at least the amount of money you spend on your lifestyle. When you reach that point you will never have to work again while continuing to live how you have always lived.
The lower your comfortable standard of living, the more wealth you will be able to build with your current income, and the less you will need to support your lifestyle after you stop working. If you only spend $50,000 a year you will need a lot less savings (~$1.25 million) than if you spent $150,000 (~$3.75million) a year. Start thinking about your life in terms of how much you spend rather than how much you make and you will begin your road to financial freedom.
Never get comfortable with your means.
If you always live below your means you are much less likely to get trapped in an unsustainable standard of living. It is really hard to reverse your comfort level. As your income level goes up you shouldn’t increase spending to match. You should reward yourself for earning a raise but you should make it a one-off non-recurring expense.
Revisit this cost of living every 5 years or so and re-adjust your budget. You shouldn’t feel constricted, but you shouldn’t feel like you can spend money on anything without thinking about it either. As costs naturally go up in some areas, look for where you can cut costs in others. Are you really using that cable subscription? Could you start brewing coffee at home instead of going to the local cafe every day? Do you really need a $40,000 car? Find areas in your life where you are willing to make sacrifices and still be comfortable. The emphasis here should be on comfort. If you are not comfortable with your standard of living, you should focus on raising your income level to accommodate higher expenses while keeping the same expense-to-income ratio. If you over-discipline yourself, you are at a greater risk of overspending.
Being wealthy is very different from showing wealth.
Net worth is a good metric for measuring wealth. Net worth = Assets - Liabilities. Assets are things that have monetary value, liabilities are outstanding debts. It is not a high income that contributes to net worth but an expense-to-income ratio. Someone who makes $500,000 a year and spends $499,999 a year on non-appreciating assets is no more wealthy than someone who earns $50,000 and spends $49,999 each year. If the $50,000 earner spends less than $49,999 a year than they will become more wealthy than the $500,000 earner who spends $499,999.
It can be difficult when your friends are seemingly living lavish lifestyles -- partying, going out to eat all the time, drinking, and buying fancy clothes. Remember that you don’t know what their balance sheet looks like, and they could be living paycheck to paycheck and/or building debt. It can get discouraging when you are working so hard on your own finances when your peers make it look easy. You also don’t know what hardships they have had to go through. Tragedy can be very expensive especially when you are young. If you are in this situation, try talking to your peers about their finances. We are all in this together, and there is no shame in the struggle. We should be able to talk openly about money.
A friend of mine conducted an informal social experiment. She asked all of her coworkers if they had $5,000 in their bank accounts. Not many of them did. $5,000 isn’t a lot of money. If you earned only $5,000 in a year you would be WAY below the poverty line. Minimum wage in the United States will earn you $15,080 a year. This is even WAY below what you need to live comfortably in this country. She did this not to compare, but to understand how finance works — opening a dialogue so they could help each other achieve their goals together. So many people hold their personal finances close to their chests but it is a very complicated emotional beast to master and we shouldn’t have to do it alone.