Mr. Money Mustache can tend to get a little high-level at times, talking about all these feelings and philosophies that underlie the proper path to wealth.
But you can’t just smile your way to the top – there are real numbers at work in the background, whether you understand them or not. These can gang up and torture you (as in the case of a person with a crushing 60-hour workweek who maintains a paltry 10% savings rate), or they can boost you right out of a mandatory work sentence in unprecedented time.
This is especially relevant in the wake of the annual spending article, which always brings up a lot of questions about how Mustachians accumulate wealth so quickly. So let’s start with the big picture, which is how to become wealthy:
Financial Independence in 3 Easy Steps:
- Figure out how much money you are taking home and subtract the amount you are spending.
- Be sure to keep all that surplus money at work, by paying down high interest debt first and then investing the rest.
- Once the total value of all your investments reaches 25-30 times your annual spending, paid work is now entirely at your discretion. For life.
So with this post, let’s explain these three fundamentals of rapid wealth accumulation the MMM way, so the schooling will be there for all future students.
We’ll begin with the end in mind. Net Worth is a bit of a degrading term, as it incorrectly implies a person is only worth the amount of money he or she has accumulated. But you can use this for motivation, since as a Mustachian your figure will tend to be unusually high.
The overall formula is easy:
The Value of everything you own (-subtract-) The total of all your loans
The details are equally easy, although sometimes debated. So I’ll tell you the way I happen to think about it:
- You do include the value of any properties you own, including your primary house
- All 401(k)s, IRAs, savings plans, and other hidden assets are included
- All mortgages, loans, credit card balances and other nonsense get subtracted
- Don’t bother with depreciating consumer stuff like your cars, furniture, or Apple products, unless you are willing to sell them right now.
Let’s start with a deliberately twisted example:
Joe Consumer (age 33) is a Washington DC Lawyer pulling down $250,000 per year.
He has a condo he paid $517,000 for with a current market value of $580,000 and a mortgage of $460,000. He also has a BMW 535i sedan that cost him $61,300 including tax a few years ago, payment is $539 per month and remaining balance is $43,000.
401(k) balance is $50,000, IRA is $27,300 and he has $90,000 left on his Harvard student loans, which he plans to get serious about soon and pay off over the next 10 years. Credit card balance is just a bit high at $8,000 right now, what with the holiday season hangover. What is his net worth?
Whoo! Look at that collection of financial spaghetti. Oddly enough, when people write to me with financial problems this is usually how they are described: a big list of confusing and unsorted details. They just heap them on a plate and hope it will straighten itself out some day. When you’re confused about your own money, it is likely that you are wasting a lot of it.
Joe’s Net Worth
Ownership of the Condo: $580,000 – $460,000 = $120,000
Retirement accounts (401(k) + IRA): $50,000+27,300 = $77,300
Student loans, car loan, and credit cards: $-90,000 + $-43,000 + $-8,000 = $-141,000
Total Net Worth: $120k + $77.3k – $141k = $56,300
If you ask the average Josephine, Joe is a successful rich guy, doing very well for a 33-year-old. Expensive house, flashy car, massive income and even some money in the bank. If he just keeps on the current path and saves a bit more during those “peak earning years” in a couple decades once he makes partner, he’ll have a nice fat retirement fund by age 65.
My diagnosis would be quite different: “Holy Shit, Joe! What the hell have you been blowing all your money on?! You should have had a higher net worth than that many years ago, given your career!!”
Very Rough Guideline: Take the total money you’ve earned after taxes in your lifetime (suppose that for Joe it happens to be $1,243,100). If you don’t have at least 40% of it still around to show for it today, you are spending way too much.
Bonus: Suppose his nearly-new BMW can still be sold on Craigslist for $33,000. Although he has already lost $28,300 in depreciation on this horrible money pit, he could end the bleeding immediately by selling the car and taking the $33k plus $10k of his own money to pay off the $43,000 note. This would increase his net worth by $33k and set him on a much more prosperous path for the future.
This was Joe’s problem above. The key is to understand where your money is going, and for most of us that means tracking your spending. I calculate it like this:
Everything that flows out of your wallet, bank account, credit cards, or automatic payroll deductions for things like insurance.
I include property taxes and sales tax, but do not count income tax or other payroll taxes.
I include all loan interest and fees, but do not count the principal portion of loan payments.
Why? Because I’m very interested in financial independence: that point when your passive non-work income is enough to pay for a hypothetical retired life of your choosing. Right now, Joe might be earning $250k and paying over $60,000 in income taxes. In retirement, he will probably be in a lower tax bracket. Plus income might come from dividends, long-term capital gains, or rent checks from investment properties he owns. He might even live in an area with a different tax rate.
You need to deeply understanding your spending needs and wants in order to know if you can afford to retire. Instead of taking random guesses at the factors above, I prefer to think of everything in terms of after-tax dollars. Take-home income instead of gross income.
So if we sort out what is surely a twisted ball of credit card, EFT and ATM transactions, Joe’s monthly spending might look something like this:
Interest portion of his $2500 mortgage payment: ($2000)
Interest on credit card and student loans: $480
Car Payment: $539
Employee contribution for health insurance: $150
Full collision+comprehensive car insurance: $200
Car Registration/licensing fees: $200
Unnecessary checkups at BMW Dealer: $150
Condo fees: $450
Property Taxes: $500
Country Club Membership: $200
Dining out: $1000
Wine and Scotch collection: $400
Clothes, Suits, and Gentlemanly Accessories: $600
Haircuts and Massages: $200
House cleaner: $400
Dry Cleaning: $150
Cell Phone: $150
Cable TV/Internet: $150
Miscellaneous Shopping, Gifts, Etc: $500
Total spending: $8919 per month
So how can a busy person track all of these transactions and categorize them well? You have two choices:
- Manually save all receipts and enter them into a spreadsheet or piece of budgeting software every night, or
- Do all your spending on a credit card and let some financial software like Mint, YNAB, or Personal Capital grab all your transactions and sort them out (this is what I prefer).
In either case, you’ll probably spend at least some cash which you pull out of ATMs. You will see this in your automated spending report as well – I suggest assigning your cash spending to a category called “the decadent throwing around of unnecessary $20 bills.”
This boils down to the amount of your paycheck that you eventually get to spend yourself. So let’s look over Joe’s shoulder as he opens a biweekly paycheck:
Gross Pay: $8620
401(k) plan deduction: $692
Employer 401(k) Match: $300
Automatic deduction he has set up to pay towards student loans: $1000
Professional Fees/Insurance: $200
Federal Tax: $1724
State Tax: $689
Net pay to his bank account: (8620-692-1000-200-1724-689) = $4315
Since there are 2.16 pay periods in the average month (52 / 24) you would scale this up to see that he gets an average of $9349 per month showing up in the bank.
But this is where many people get confused, because this paycheck he takes home is not really his take-home pay. You need to add back in the money that he is actually using – including to pay off loans – or will get to use – including all retirement and savings account deposits.
Gross Pay + Employer 401(k) match – taxes and fees
= $8620 gross pay + $300 employer 401(k) match – $1724 federal tax – $689 state tax -$200 professional fees
= $6407 biweekly or $13,839 per month
If this sounds like a shitload of money, that’s because it is. Anyone making $250k gross pay should be rolling in it and saving the vast majority, therefore able to retire within just a few years. If you get your savings rate right.
Now that we’ve done all the hard work, we get to hit the gas pedal and show off a little, since we can make some bold forecasts.
(Take home pay – spending) / (take home pay) , then multiply by 100 to get a percentage
For Joe, it would look like this:
($13,839 – $8919) / ($13,839) x 100
Hey, Joe is still saving a third of his income, even with the most outrageous spending list that I could invent for a single guy. It’s not completely suicidal, but he is still squandering an opportunity that only a tiny percentage of humans have ever been offered: the opportunity to become financially free while he’s still young.
To steal a few data points from the most popular article in this blog’s history: The Shockingly Simple Math Behind Early Retirement: Joe’s 35% savings rate means he is on track to retire in about 25 years. He is already 33, so this means he is sentencing himself to be locked into that office until age 58.
This may seem “early” by current American standards, but if the reports I get about high-octane Washington DC law careers are accurate, that shit can get old in a hurry. It is far wiser to earn your freedom while you are still fired up about working.
From this point, it can get far worse or far better. Joe could get married, have multiple children, and expand the level of spending (larger house, more vehicles, private schools, etc.) to consume even more of his income.
- If he adds just $3000 to this monthly budget, he drops to a tragic 15% savings rate and is set for a 43 year working career
- On the other hand, if he trims down the excess and goes to a still-insane $5000 monthly spending level, he’ll be saving about 65% of his income, which means he will be set for life less than 10 years from now.
- If he can streamline life to just a slightly less ridiculous level than that, let’s say to my own level of spending, he will be retired well before 40.
So there you have it: The easy way to calculate spending and savings rates, and your net worth.
Although I illustrated it here with an outrageous but very common example of high income and high spending, the principles work just as well, and are even more important if you are living on an average income. In the US, it is quite possible to live well on under $7000 per person per year, and even gradually become wealthy on a below-average income.
But the first step is to understand how all these dollars fit together. How are YOU doing?
Bonus: For those who love to calculate, my friend and fellow early retiree Darrow Kirkpatrick maintains a really thorough roundup of the best retirement calculators on his blog here: http://www.caniretireyet.com/the-best-retirement-calculators/
This is a very interesting discussion as long you realize, as MMM pointed out, that Net Worth is only one measure of value. I would say a MMM attitude of contentment is even more valuable. This reminds me of the classic book: “Millionaire Next Door”. Even the wikipedia article about that book dogs on Americans for sucking at accumulating wealth: http://en.wikipedia.org/wiki/The_Millionaire_Next_Door#America:_the_ultimate_UAW