Your net worth directly affects your salary. If it’s negative, your salary goes down. Positive, and it goes up.
While this isn’t literally true, I think it’s helpful to think in these terms to help keep your motivation up as you work on the goal of reaching financial independence.
The Math of Net Worth
Part 1: Headwinds
Have you ever tried sailing into a headwind? You may need a gang of rowers to get anywhere. It’s no different for your earnings when you have debt.
Mark works your standard job — $40 an hour, 40 hours a week, 52 weeks a year
|Take Home (Post-Tax)||59K|
|Yearly Cost of Debt @6%||6K|
|Net Worth Adjusted Take-Home||53K|
You’ll notice that Mark owes 100K in student loan debt at 6%. * This costs him 6K a year, which is subtracted from his take-home pay.
Mark is really taking home 53K instead of 59K.
Put another way, his negative net worth resulted in a 10% reduction in real earnings. And it will continue to do so every single year until he fixes the situation. Would you voluntarily take a 10% pay cut?
Part 2: Tailwinds
This is the opposite scenario. You’re sailing with the wind at your back, and your boat is cruising at a velocity you could never achieve by your singular rowing efforts. Awesome!
Linda makes the same as Mark — $40 an hour, works 40 hours a week, for 52 weeks a year.
|Take Home (Post-Tax)||59K|
|Average Annual Investment Return @ 6%||30K|
|Net Worth Adjusted Take-Home||89K|
You’ll see in the chart that the big difference between Linda and Mark is that she has no debt. Her grandmother left her 500K which she’s invested in the stock market market, 100% in Vanguard’s VTSAX. For this exercise, let’s say this fund returns an inflation-adjusted 6%. **
The earnings of the invested 500K comes out to 30K/yr. So in a sense, Linda is now taking home 89K/yr instead of 59K. ***
This is nearly a 50% increase in yearly earnings and a whopping 60% more than the debt-burdened Mark. That wind is gusting pretty strong behind Linda.
Part 3: Net worth’s effect on Net Worth (And the Rich Get Richer)
|Mark’s Yearly Salary||83K||Linda’s Yearly Salary||83K|
|Mark’s Take Home (Post-Tax)||59K||Linda’s Take Home (Post-Tax)||59K|
|Mark’s Debt||100K||Linda’s Investments||500K|
|Mark’s Yearly Cost of Debt @6%||6K||Linda’s Average Annual Investment Return @ 6%||30K|
|Mark’s Net Worth Adjusted Take-Home||53K||Linda’s Net Worth Adjusted Take-Home||89K|
In order to see how much Mark and Linda’s net worth changes over the following year, we need to know their rate of spending. Let’s say they each spend 40K/yr to cover living expenses.
This leaves Mark with 13K a year left to pay off his student loans, and Linda 49K to add to her investments.
|Linda’s Net Worth||500K||Mark’s Net Worth||-100K|
|Linda’s Net Worth Adjustment||49K||Mark’s Net Worth Adjustment||13K|
|Linda’s New Net Worth||549K||Mark’s New Net Worth||-87K|
You can see the enormous difference in annual net worth adjustments between Mark and Linda. Mark’s net worth will go up somewhere between 13 and 16K for the next few years, while Linda’s will be climbing over 50K during the same annual intervals.
One year of work for Linda has the same change to her net worth (49K) as about three and a half years of work for Mark. Every year she works, she earns and saves enough to buy her more than a full year off at her current cost of living (40K). Mark’s only buying a third of a year off for working the same amount of time.
It’s crystal clear that it’s better to be in Linda’s boat. But hey, we knew that the minute we learned she inherited 500K. The real question is what can Mark do about his situation? Because the fact is there are a lot more Marks in the world than Lindas. There aren’t many huge sums of money just waiting to drop out of the sky and land on our heads — this sort of thing just doesn’t happen for most folks. (It sure didn’t happen to me.)
Still, that shouldn’t get Mark down. He has plenty of time to turn into a financial superhero, given hard work, consistency, and learning the skill of financial independence i.e. Learning to FI. Mark can turn that headwind into a tailwind in just a few short years if he can reduce his cost of living and throw all savings into his student loans. He could start with the Early Retirement Extreme 21-Day makeover to cut costs. Or check out the forums on either EEE or Mr. Money Mustache. There are lots of people who will read about his situation and then offer suggestions on how to make his dreams of becoming financially free come true.
Here’s what Mark has to do. Cut his living expenses to 22K a year. Max out his 401(K) plan and then fund his IRA, which allows him to save pre-tax money. The “Time Until Financial Independence” calculator at mustachecalc.com shows that even from a starting point of negative 100K, using drastic cost cutting while leveraging his tax-advantaged accounts he could retire in perhaps as few as 13 years, with a stash of over 600K. Even if he was only able to drop expenses to 30K a year, his time to FI is about 20 years. This may seem like a long time, but this means if Mark is 30, he could be done at 50, which is well before the traditional retirement age of 65. He’d be giving himself fifteen years of his life back, and these are years in which he’ll likely be healthy and able to enjoy the time.
Even if Mark never retires early, embarking on this journey still makes sense. Because after a while, he’ll have a stash of money saved up, which will give him options in life. Cash = choices. He can respond to unexpected expenses. He might want to go on a few expensive vacations, which he can then easily afford. Put another way, present-Mark is working to give future-Mark freedom.
That’s some powerful motivation to get started, immediately.
Geeky Analogy Alert
I think of Linda sort of like Peter Parker, AKA Spider Man. Peter didn’t have to put in any effort to become a super-hero. A radioactive arachnid fell out of nowhere and bit him, and that was that. Similarly, Linda didn’t do anything to earn her 500K inheritance. It just happened. Lucky her.
Us regular non-lucky folk are going to have to be more like Kick-Ass.
For those of you who don’t know, he’s a dorky teenager with absolutely no powers who decided he was going to become a superhero anyway. How does he do it? Discipline, fortitude, tenacity. He learns from his mistakes and picks up new skills: martial arts, nunchucks. He absorbs beating after beating but rather than giving up, he learns from his failures, finds a mentor, and keeps training.
Before he know it, he’s got the wind at his back, slicing through hordes of enemies with the greatest of ease.
All he had to do was gut out those first initial trials. He made a plan on how to achieve his goal, executed it, and stuck with it over time. This is really the only close-to-guaranteed way to achieve financial independence for people who weren’t born with the advantage of pre-existing wealth.
Create your own tailwind, so your future doesn’t rely on blind chance.
And kick ass along the way.
*1) In this example, Mark earns over the 70K Modified Adjusted Gross Income (MAGI) limit for deducting student loan interest on his tax refund. He must pay the entirety of the student loan interest with post-tax earnings.
*2) The ‘earnings’ on investments is not a linear progression — it will vary year to year. Some years it might drop 20%, others it might go up 30%. Still, over time, it’ll average out to 6-7%, adjusted for inflation. The more years you work, the more likely your overall earnings on investments will be very close to the per-year average.
*3) Linda could even avoid taxes on on the investment earnings if she keeps her annual spending very low and follows strategies documented by the Mad Fientist.