Where do you start on the road to financial independence?
At the very core of increasing your wealth, and thereby freedom, is to earn more than you spend and invest the difference. This is the most basic idea in personal finance but many people don’t go into the details to really understand how to apply it to their lives.
There are three parts to this principle. The first part is earning. How much money are you bringing in each month? Increasing your earnings is one lane on the road to financial independence. So how do you increase your earnings?
The most obvious way is to get a raise at your regular job. According to the Bureau of Labor Statistics, wages went up an average of 2.5% from 2016 to 2017. That barely keeps up with the 2.1% inflation experienced during the same period! You need to increase your earnings by more than that to retire in comfort. But asking for a raise can be a difficult conversation. Before you walk up to your boss, know your market worth, look back on what you’ve accomplished for your company, and formulate your argument for why you should be paid more. Forbes has a great article on exactly how to ask for a raise so you’re more likely to get it.
Sometimes getting a raise isn’t an option. If your current job isn’t providing enough income, switching jobs could give you the pay boost you’re looking for. If you have transferable skills, moving to a different industry can result in a naturally higher salary. You could also narrow your search for positions that have posted salaries higher than your own. Glassdoor.com is a great resource to find out what employees are actually getting paid. Once you’re offered a new job, you can negotiate even higher wages. Salary increases of 10–20% are fairly common from switching jobs.
Many people start side jobs to supplement their regular income. These could include a part-time job outside your normal work hours, joining in on the sharing economy through companies like Uber and Airbnb, or working on a small business in your free time. There are lots of options for earning extra money. If you’re not sure about what you want to do, Google “side jobs” and you’ll get plenty of articles with lots of ideas.
Now, I said building wealth is about earning more than you spend. But we can rephrase this to be spending less than you earn. This is the second, and probably more important, part of building wealth. It doesn’t take a genius to understand that if you spend more than you make, you’ll go bankrupt. Even Mike Tyson, who earned over $400 million during his career, declared for bankruptcy!
Most people could easily tell you how much they get paid each week. But if you ask someone how much they spend each week, they’d likely have more trouble. You need to understand how much you’re spending and what you’re spending your money on in order to systematically decrease your expenses.
The easiest way track your spending is to make all your purchases electronically using a credit or debit card. This provides an electronic record that you can export and sort through. Most cards allow you to export your purchases and many will automatically categorize purchases for you. I like to use Mint.com since I have multiple accounts and it puts all my transactions into a single location. Once your purchases are exported, you can sort through them and figure out which areas you’re spending the most money on so you can create a plan to lower your costs in those areas.
For most people, the three biggest areas of spending are rent/mortgage, transportation, and food.
The general rule of thumb for housing costs (rent/mortgage) is to spend about 30% of your pre-tax income. This includes any bills associated with your housing situation as well, such as water and electric. My wife and I have made the conscious decision to spend less on our housing so that we can save that money, invest it, or spend it on other things. We spend less than 15% of our household income on housing which saves us tens of thousands of dollars a year compared to spending 30% of our income! To reduce your living expenses, start by looking for cheaper places to rent or taking on roommates to offset costs. If you own your home, consider renting out an extra bedroom or downsizing to reduce the cost of your mortgage. Changing your living situation can dramatically decrease your expenses.
For transportation, our costs include the two cars we own, gas, insurance, maintenance, and tolls/parking fees. Owning your own vehicle is quite expensive but, depending on where you live, could be necessary for modern day to day living. If you do own a vehicle, your biggest monthly costs will be payments, insurance, and gas.
Prioritize paying down your loan on car payments in order to decrease your debt. If you’re looking to purchase a replacement vehicle, consider buying a used vehicle that’s two to three model years old. This could save you thousands on your car payments.
If you haven’t shopped around for car insurance recently, make sure to see what other rates you qualify for. As one company likes to say, “15 minutes could save you 15% or more on car insurance!”
For gas, make sure to remove any unnecessary clutter in your vehicle to reduce your vehicle weight and increase your miles per gallon (MPG). Getting regular oil changes and performing maintenance tasks such as changing your oil and air filters will also increase your MPGs, while also helping you avoid costly repairs down the road.
The last major expense is food. Food expenses generally consist of food bought at the grocery store and eaten at home or food purchased at restaurants and bars. My average home cooked meal costs from $2-$5 per person and is packed with fresh vegetables and protein. Compare this to a meal out which costs anywhere from $10-$25. The best way to reduce your food costs, regardless of your situation, is to start eating at home. If you’re not a whiz in the kitchen, I recommend reading The Science of Good Cooking. This book not only provides 400 recipes for you to try but also explains why those recipes work so you can apply those principles to making new recipes. I still regularly consult it when I’m cooking something new.
After you’ve examined rent/mortgage, transportation, and food, look at your other expenses to find ways to lower your costs and continue to build your wealth.
Lastly, once you are spending less than you earn, you need to invest the difference. It’s great to have extra cash in the bank but just having cash isn’t enough to build wealth. Investing allows you to make your money work for you. When you invest, you earn more money simply by having it. If you can manage to get a 5% return every year, a $10,000 investment turns into over $43,000 over 30 years. The stock market returns an annualized average of 9%. At that rate, your money would more than double every decade! Investing your money early allows you to take advantage of compounding returns.
But just like earning more and reducing expenses, investing isn’t a one-and-done type of thing. You need to continually add to your investments. If we take our $10,000 investment from above and continued to add $500 every month, in 30 years our investments would be worth over $450,000. If we could match the stock market return of 9%, we’d have over $1 million. Regularly investing the difference between your earnings and spending will create wealth that you can use in the future.
By earning less than you spend and investing the difference, you’ll wake up one day and find that you have financial independence.