Wealth

The Formula for Building Wealth

All building wealth really comes down to is: spend less than you earn, and invest the rest. The more you decrease expenses and the more you increase earnings, the faster your wealth will grow.

And the great news? Those investments you make will increase your earnings even more. Assuming your expenses stay the same, you’ll then have even more income to invest the following year, which in turn will make you even more income the next year. Do this for enough years and the effect snowballs (due to the incredible power of compound interest), until eventually your investments alone are making you even more money than your expenses. Congratulations! You’ve reached financial independence (FI), you can quit your job (if you want to) and live off your investment income alone!

On the other hand, spending more than you earn can also get you into a vicious cycle. If you spend more than you earn, you need to either spend your savings or investments (if you have any), decreasing your income, or go into debt (increasing your expenses) to repay loans. Assuming you don’t change anything the next year, you will lose even more money, and go further into debt. Unfortunately, this effect also snowballs, increasing expenses more and more each year and getting you further and further into debt.

The image at the top of this page is a visual of this simple formula for building wealth. The goal is to stay on the right side!

What Does This Look Like?

Click to expand and see a few hypothetical scenarios, in addition to a tool you can use to see your financial future.

Take a look at the 4 scenarios below to see what effect income and expenses have on wealth building over time. Earnings are your expected (after tax) income from your job. Spending is everything that flows out of your wallet, bank account, or credit cards EXCEPT money that goes towards savings or investments (i.e. stocks, bonds, etc.). New money invested each year assumes you take any income leftover after subtracting your spending, and invest it at 7%. FI Goal (based on the 4% rule) is when your investments become enough to pay off your living expenses for the rest of your life.

How to Calculate Spending

DO include money spent on car purchases, repairs, collectibles, etc. as these are NOT investments (see above). Don’t include income taxes, but do include any other taxes (i.e. property, sales tax). DO include debt payments (car payments, student loans, mortgage payments, outstanding credit card debt, etc.) You can exclude debt payments from spending in future years once they are paid off.

The easiest way to figure out your annual spending is to take a look at your annual bank and credit card summaries. Most likely, all of your credit card purchases will count as spending, while some withdrawals from your bank statement may have gone towards savings/investing or paying your credit card balance (spending which is already included on your annual credit card summary). You could also try using free software like mint to help you with this.

Scenario 1: Living Paycheck to Paycheck

Earnings: $60k
Spending: $60k
$ You Invest Each Year: $0
FI Goal: $1,500,000

In this scenario, you avoid debt (for now), but you also never save any money. In addition, if you slip up (lose your job, unexpected expenses, etc.) you’ll go into debt. Once you do, unless you increase your income or decrease your spending, you’ll keep falling further and further into debt. And FI, or even traditional retirement, are out of reach. You’ll be working for the rest of your life.

Scenario 2: Cutting $20k in Expenses to Save and Invest 33% of Your Income

Earnings: $60k
Spending: $40k
$ You Invest Each Year: $20k
FI Goal: $1,000,000

In this scenario, you steadily build up your nest egg. If you slip up, you’ve got some money saved up you can count on. In addition, you’ve lowered the bar to reach for FI/retirement since you’ve learned to live off less while still leading a rich life. If you keep this up, your investment income is likely to cover expenses in 17 years, and you’ll be a millionaire and reach FI in 23 years.

Scenario 3: Increasing Income by $20k to Save and Invest 25% of Your Income

Earnings: $80k
Spending: $60k
$ You Invest Each Year: $20k
FI Goal: $1,500,000

You’re still building up your nest egg and you’ve got some money saved up you can count on. Even though you’re still saving and investing the same amount as in scenario 2, the bar for FI/retirement has been raised since you now need to have more investments/generate more investment income to sustain your higher spending lifestyle. If you keep this up, your investment income is likely to cover expenses in 21 years, you’ll also reach millionaire status in 23 years, and reach FI in 28 years.

Scenario 4: Decreasing Expenses by $20k and Increasing Income by $20k to Save and Invest 50% of Your Income

Earnings: $80k
Spending: $40k
$ You Invest Each Year: $40k
FI Goal: $1,000,000

You’re building up your nest egg at a pretty quickly and you’ve got plenty of money saved up you can count on. Since you’ve found ways to maintain a similar lifestyle for less money, the bar for FI/retirement has been lowered even as you approach it faster. If you keep this up, your investment income is likely to cover expenses in just 11 years and you’ll be a millionaire and reach FI only 15 years from now.

These images show your progress for each scenario. You can access the Google Sheet and play around with your own scenarios here (once you open it, go to File > Make a Copy so you can have your own to edit.

See Your Financial Future

The second tab of the Google Sheet also includes a more customizable model where you can plug in information specific to your life (i.e. age, current debt, current investments, expected earnings and expenses, etc.) to get a nice visual forecast of what your net income and net worth will look like each year. At the very least, play around to see what happens when you only “live slightly beyond your means” (spend more than you earn). See how quickly you can fall into the debt trap – and what it will take to get out of it. Stay to the right (see flowchart above)!

Pay Yourself First – Make it Automatic!

“Okay, okay, I get it. But all these spreadsheets and figuring out expenses are giving me a headache…” What if you could make building wealth automatic, so you don’t even have to think about it? You can! It’s called “paying yourself first.”

Ever wonder why the government automatically takes taxes right out of your paycheck before you even see it, instead of sending you a bill? How much less do you think they would collect if they relied on folks to take action to pay them every year instead of getting their money automatically? You can take advantage of this same strategy, but to your benefit! Most workplaces allow you to automatically deduct a % from each paycheck to go into a 401k investment account! We’ll talk more about investments and the different accounts in later posts, but the best things about this approach are:

You set it once (unless you want to update the % at a later time), and it happens automatically every month
Employers will often match some of what you put in = FREE MONEY!
It’s taken right out of your paycheck, so you never even get a chance to spend it
It’s taken out of your paycheck even before the government takes their cut – so you don’t pay taxes on this money either!

If you don’t have access to a 401k (or already reached the contribution limit), you can still make automatic contributions to your own investment account. Almost any investment account will let you set up automatic deposits (set them up so they happen shortly after pay day) that will automatically take money out of your bank account each month and invest it for you. It should take less than an hour to set up – and you’ll be set for life.

Questions? Thoughts? Let me know in the comments and happy wealth building!