Live Your Net Worth, Not Your Paycheck

Most people live their paycheck.  If they make $40,000 per year, they spend $40,000 per year.  If they make $150,000 per year, they spend $150,000 per year.  Actually, it is worse than that, since most people are also making payments each month on things they’ve bought before, so they are actually living on their future paychecks as well.  

All of this seems like a perfectly fine situation until the car breaks down.  Or until you get laid off.  Or you get a medical condition and need to take an extended period of time off for a surgery.  Then suddenly cash flow becomes an extreme issue since you really don’t own the things you have.   They are just being rented each month through payments.  The car you “own” is being repossessed.  The home you “own” is being foreclosed upon.  Everything you have is tied up in your income, and any little hiccup in that income is disaster.

What is instead of living your paycheck, you lived based on your net worth?  What if you started out spending no more than 25% of your net worth per year – giving yourself the ability to live for about four years at your current lifestyle should your income stop.  Then, as your net worth grew to the point where you were approaching financial independence, what if you figured out how much income you could reasonably generate from your net worth – 5% would be a reasonable estimate – and limited your spending to that?  Doing so would allow you to continue to live at your current level indefinitely even if your salary stopped.  How would your life be different?  Here’s a hint – it would be a lot more secure.

For example, let’s say that you have the following net worth at age 35, having been working on paying off your home, putting money away for retirement, and putting some money into investments:

Home equity: $100,000

Retirement accounts: $60,000

Car Equity:  $10,000

Savings: $9,000

Investments: $50,000

Total Net Worth: $220,000

Your spending limit would then be = 0.25*$220,000 = $55,000 per year, with the rest being used to fund retirement and build assets.

Let’s now say that your salary is $80,000 per year and grows by 3% per year for the next 20 years.  Let’s say you followed this idea and you limited your yearly spending to $55,000 per year, regardless of your income, until your net worth was four times your income.  At that point you then limited your spending to your income after that and let your assets compound.   Let’s also assume your assets grew by 6% per year, being a mix of mainly stocks and home equity.  Your net worth and spending would then grow as follows over the next 20 years: 

Year Salary Net Worth Spending
0 $80,000 $220,000 $55,000
1 $82,400 $258,200 $64,550
2 $84,872 $291,542 $72,886
3 $87,418 $321,021 $80,255
4 $90,041 $347,445 $86,861
5 $92,742 $371,471 $92,742
6 $95,524 $393,760 $95,524
7 $98,390 $417,385 $98,390
8 $101,342 $442,428 $101,342
9 $104,382 $468,974 $104,382
10 $107,513 $497,112 $107,513
11 $110,739 $526,939 $110,739
12 $114,061 $558,555 $114,061
13 $117,483 $592,069 $117,483
14 $121,007 $627,593 $121,007
15 $124,637 $665,249 $124,637
16 $128,377 $705,163 $128,377
17 $132,228 $747,473 $132,228
18 $136,195 $792,322 $136,195
19 $140,280 $839,861 $140,280
20 $144,489 $890,253 $144,489

Note the effect here is to limit your lifestyle while you build security.  When you are just starting out in a job and you have no savings, you’re continuing to live like a student until you start to build up some savings, home equity, and investments for security.  Once you’ve built up your security blanket to help insulate you from life’s little events, you increase your spending and start living more of the good life.  

Doing this also lets you command a much higher income since while you are working, your assets will be generating income in addition to your salary.  In the above example by the time you were 40 you would be making $93,000 from your salary, but you’re also making $22,000 per year from your investment portfolio and increases in the value of your home.  This means you have a cash flow of $115,000 while your coworkers who’ve spent every dime only have a $93,000 income. They also probably have debt, probably sucking away $10,000-$15,000 of that $93,000 per year, so they have $77,000 in spending power while you have $115,000.    That’s an extra $38,000 per year to out towards college tuition, paying off the home, or just adding luxuries.  Keep this up and you’ll have the spending power of $1 M per year by the time you’re ready to retire while they’re living on maybe $200,000.

So by limiting your spending, between the ages of 35 and 40 you have grown your net worth by more than 70% while most people would simply be treading water.  You’ve seen your available spending increase by $40,000 as well, matching that of your peers even before they pay their credit card interest payments and car loan interest payments, but unlike them, your income has the solid foundation of your net worth behind it.  If you lose your job, you can tap your investments and savings and maintain your lifestyle, at least for a long period of time.

OK, so obviously there is an issue with this strategy and a little tweaking is required.  When you first start working you probably have a zero net worth or maybe even a negative net worth.  Obviously if your only possession is a $3,000 paid-for car, you can’t live on $750 per year.  You could, however, set a minimal amount of spending needed for absolute necessities – shelter, food, utilities, transportation, and clothing – and then limit your spending to that level (or close to it) until your net worth justifies moving beyond it.  This would guide you in controlling your luxuries until you are on firm financial ground.

For example, let’s assume you’re starting out, making $50,000 per year, and have a net worth of $0.  Let’s also assume your salary increases by 3% per year and you get an 8% annual return on your assets (you’re investing almost entirely in stocks at this point because you’re young and bulletproof).   You choose to setup a spending plan as follows:

1.  You estimate that you can get by with $30,000 per year, which includes the bare necessities, plus maybe $80 per month in “frills,” plus a $1000 vacation each year, so you start out at this level, putting the rest away into assets.  

2.  Once your net worth exceeds $30,000, you start increasing your spending to 25% of your net worth.  

3.  You then limit your spending to 85% of your salary until you are age 50 (putting the rest away for retirement).

4.  When you reach age 50, you just start spending your whole salary, letting your assets grow on their own.

5.  When your net worth exceeds 20 times your salary, you start using some of the income from your stocks and bonds as well, until you retire after working for 45 years.

Your budget and net worth would look like the following:

Year Salary Net Worth Spending
0 $50,000 0 $30,000
1 $51,500.00 $20,000.00 $30,000.00
2 $53,045.00 $43,100.00 $30,000.00
3 $54,636.35 $69,593.00 $30,000.00
4 $56,275.44 $99,796.79 $30,000.00
5 $57,963.70 $134,055.97 $33,513.99
6 $59,702.61 $169,230.16 $42,307.54
7 $61,493.69 $200,163.65 $50,040.91
8 $63,338.50 $227,629.52 $53,837.73
9 $65,238.66 $255,340.66 $55,452.86
10 $67,195.82 $285,553.71 $57,116.45
11 $69,211.69 $318,477.38 $58,829.94
12 $71,288.04 $354,337.33 $60,594.84
13 $73,426.69 $393,377.52 $62,412.68
14 $75,629.49 $435,861.72 $64,285.06
15 $77,898.37 $482,075.08 $66,213.62
16 $80,235.32 $532,325.85 $68,200.02
17 $82,642.38 $586,947.21 $70,246.02
18 $85,121.65 $646,299.35 $72,353.41
19 $87,675.30 $710,771.54 $74,524.01
20 $90,305.56 $780,784.56 $76,759.73
21 $93,014.73 $856,793.16 $79,062.52
22 $95,805.17 $939,288.82 $81,434.39
23 $98,679.33 $1,028,802.70 $83,877.43
24 $101,639.71 $1,125,908.82 $86,393.75
25 $104,688.90 $1,231,227.48 $88,985.56
26 $107,829.56 $1,345,429.01 $91,655.13
27 $111,064.45 $1,469,237.77 $94,404.78
28 $114,396.38 $1,603,436.45 $97,236.93
29 $117,828.28 $1,748,870.83 $100,154.03
30 $121,363.12 $1,906,454.74 $121,363.12
31 $125,004.02 $2,058,971.12 $125,004.02
32 $128,754.14 $2,223,688.80 $128,754.14
33 $132,616.76 $2,401,583.91 $132,616.76
34 $136,595.26 $2,593,710.62 $136,595.26
35 $140,693.12 $2,801,207.47 $140,693.12
36 $144,913.92 $3,025,304.07 $151,265.20
37 $149,261.33 $3,260,977.11 $163,048.86
38 $153,739.17 $3,508,067.75 $175,403.39
39 $158,351.35 $3,767,048.96 $188,352.45
40 $163,101.89 $4,038,411.78 $201,920.59
41 $167,994.95 $4,322,666.02 $216,133.30
42 $173,034.79 $4,620,340.95 $231,017.05
43 $178,225.84 $4,931,985.97 $246,599.30
44 $183,572.61 $5,258,171.39 $262,908.57
45 $189,079.79 $5,599,489.15 $279,974.46

So you would live on bare necessities for the first five years, at the end of which you’d have $134,000 in assets.  You could then take maybe $50,000 and make a good down-payment on a home.  You would then start to raise your spending, growing to 85% of your salary by about year 8.  From that point on you’d have 85% of your salary to spend as you please, putting 15% away into savings and for retirement.  

By the time you reached 30 years on the job, you’d have a net worth of more than 10 times your salary, so you could stop saving for retirement entirely (while your coworkers are cutting back on their spending to fund their retirements).  By the time you were on the job for 36 years (about age 56), you would start supplementing your salary with income from your portfolio, adding more than $80,000 to your budget each year by the time you retire.  At the end you’d have a net worth of about $5.6 M and be able to retire with dignity.   This is after living large for the last 15 years

Saving and putting away money early is the key to a secure financial life.  Limiting your spending to increase your net worth makes all the difference.  Put your money towards acquiring assets and security while you are young, and you’ll have a much more secure future later.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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