Formula for Wealth

I recently read Brandon Turner's article in Entrepreneur:

http://www.entrepreneur.com/article/246429

In it he states that "You don't understand how money works." This is a topic that has interested me for a long time. I have even worked on a speech, (that I may never give) in which I really explain what money is, and how it works. 

It may seem weird that I would work on a speech that I may never give, but I find that this is a great tool to for refining my own understanding. It also is a great way to catch myself in mistakes. Sometimes writing something down, or listening to myself say something can make it more obvious that it is a foolish idea. Or as I found out recently, I use the word actually too often.

Brandon's article was good. The books he listed are a great foundation for learning and understanding money. I would add playing Kiyosaki's Cashflow game puts things into perspective really well. 

First we need to define what wealthy is. Brandon's article is titled "4 Reasons Why You'll Never Be a Millionaire, and How You Can Change That". But really it doesn't matter if your net worth is a million or not, what matters is the ratio of passive income to lifestyle expenses.

If you have a million in your mattress at home, you're a millionaire. But if you spend $500K a year, that money will be gone in 2 years.

If you make $5K a month, but live on $4K a month, that is wealth. Bump up the lifestyle to $6K a month, and now you are no longer wealthy. If you want to increase your lifestyle, it is best to first increase that passive income.

Often people will see a solution to their problems, and jump in fully, changing every aspect of their life overnight. Then they get overwhelmed, and quit. People that make more gradual changes, and are willing to take a step back, and accept setbacks are the ones who will be more successful.

The first few steps here really match Dave Ramsey's Total Money Makeover. A great book that I think should be the start of any person's plan. Once a person gets out of debt, I believe a different path is better then the one he lays out, but that doesn't mean he is wrong. There are many paths, and many people will be more comfortable with his.

1. Get on a budget.

This one took me 6 months to really get down, and a year before it was dialed  in. But this forces you to figure out where your money is going, and how much of it is being wasted. Ramsey said being on a budget feels like you got a raise, and I have to admit it did. It also gives you a number to work toward for creating an income.

2. Live below your means.

Dave talks about cutting your lifestyle to the bone. I would say it depends on your goals, your income, and how quickly you want to become wealthy. Your budget gives you the information to use to cut out the less important things in your life, and to decide on what to delay for now.

3. Cut your debt.

Dave has people first create a "baby emergency fund" of $1,000 in the bank, and forget about the money unless a real emergency comes up. Then he talks about listing your debts smallest to largest, and paying only the minimum on all debt, and everything else to the smallest debt. (The Debt Snowball.) 

This is not the most mathematical way to do it, but it is the most psychologically satisfying way, and I agree. Also if your paying off these debts quickly, the interest should not be a big factor. Adding say $500 to a $50 payment makes a big difference. Then your adding that $550 to say a $100 payment. When that ones gone, you will now have $650 to add to the next payment. You can see how this all builds, and quickly too.

Now you do have the choice of finishing the debt payoff, or stopping when you get to a point where you can quickly save up that money into a good pile for investing.

4. Create sources of passive income.

There are different sources of passive income, real estate is one of the most commonly used, and most likely to be successful way to build that passive income.

Do not think of replacement income. Too many people think they need to replace double their current income before they ever take action, and that is a big mistake.

Instead think of this as a reverse debt snowball. An investment snowball. You create a source of income, say $400 a month. (Can be done with real estate.) Maybe it took a couple years of saving to get that deal done, but with an extra $400 a month coming in, the next deal will be that much quicker. Then you get to $800 a month, then $1,200, 1,600, $2,000...

However long it took you to get to those 5 houses, the next 5 won't take even half the time. Especially if you're increasing that rent each year.

5. Increase your lifestyle only after increasing your income.

At some point you will want to quit living with such a tight budget. When that occurs could happen before, or after you have replaced your working income with passive income.

But the key here is when this is finally decided, always increase the passive income before increasing the lifestyle. And always at a lower level then the income. I like the idea of keeping it at about 50%. For every dollar you increase your income, only increase your lifestyle by 50¢.

This keeps you living below your means, and always building up both your emergency fund, and a source of investment income.

6. Freedom!

At some point you will have more then enough. You will need to decide if you want to keep going, or not. If you love your job, keep it. If not, quit. If you have enough to live the life you want for the rest of your life, even if that is much much longer then you expect, you really don't need to keep investing in more and more, unless that is what you want.

At this point you are free to do as you wish. If you want to help others, go for it. If you just want to travel the world, that's fine too. Maybe you just want to own a cabin by the lake, and fish every day. 

The formula in a nutshell:

• Live below your means
• Dump excess personal debt
• Create passive income piece by piece
• Increase lifestyle at a rate slower then the income.