I recently ran into a lawyer friend of mine I hadn’t seen in years and had a chance to catch up.
During our conversation, the subject of finances came up, and he started complaining about living paycheck-to-paycheck. I responded with shock. Wait! What? You’re a partner in a law firm making $400,000 a year! How can you be living paycheck-to-paycheck? Then he rattled off his expenses and then it all made sense.
- A mortgage in an exclusive gated community
- Payments on a Mercedes sedan and BMW SUV
- Tuition for two kids at exclusive private school
- Vacations at the lake, beach, and mountains
- Country Club Membership
So why not cut out some vacations? “I can’t do that. It’s my only time with the kids.” How about golfing public courses instead of the country club? “I don’t like crowds.”
You would think a guy making $400,000 a year doesn’t have to think about money but think again.
One thing became abundantly clear as I talked to my friend – he was unwilling to curb his expenses. And that’s why my friend is merely rich and not wealthy. There’s a difference. If my friend stops working, his money will go away. The wealthy don’t worry about money like my lawyer friend. He makes a good income, but if he stopped working, he’d be in trouble.
But how do the wealthy weather financial storms? Because they’re not slaves to their jobs. They have other sources of income.
It all comes down to priorities between rich and wealthy.
The rich are income-focused, and the wealthy are net worth focused, which explains their approach to income and expenses. For the rich, it’s a classic case of the tail wagging the dog – the tail being their expenses and the dog is their jobs. The rich justify their extreme spending habits with their incomes.
The problem is the rich rely on active income to cover their expenses, and active income can stop at any time – when a surgeon loses the use of his hands, or a lawyer loses his license.
During the last Financial Crisis, when active income slowed down or went away altogether, the rich – many of them millionaires – suffered. You’re thinking to yourself, well, these people were millionaires, where did it go wrong?
For many of the rich before the Financial Crisis hit, they bought into the hype, thinking being a millionaire made them immune from disaster. Right? Wrong.
The problem with the millionaire label is when a personal residence is included in net worth calculations; this can be deceiving because real estate with a mortgage is a liability, not an asset. Unless real estate produces income, it’s a liability.
That’s why when the Financial Crisis hit, and real estate values were wiped out, so were the number of these so-called millionaires. The wealthy, on the other hand, rode out the storm because they didn’t rely on active income but other sources of income as I will delve into below.
Because the rich rely on active income to cover their high spending habits, it’s not surprising that many live paycheck-to-paycheck. We’ve all been told that to get ahead; we can either earn more or spend less. With those with active incomes like doctors, lawyers, and CEOs, income is usually already maxed out while expenses keep rising.
The wealthy are different because they’re not focused on income. They’re focused on net worth. The wealthy approach is to both increase income and spend less.
Unlike the rich who ignore expenses, for the wealthy, focusing on expenses is just as vital to getting ahead. They’re responsible with their spending – cutting back on unimportant and unnecessary expenses.
That’s not to say the wealthy are frugal to the point of suffering. They still love comfortable lives, but why drive a $120,000 car when a $60,000 car gets them comfortably to the same destination? Is it still a nice car, right?
Being frugal only will not make you wealthy because it will take more than just cutting expenses. The wealthy don’t put those $60,000 savings in my car example under the mattress. They put it to good use, which brings me to the whole point of this discussion.
The difference between the rich and the wealthy is passive income. Passive income comes from having your money work for you 24 hours a day, even while you’re sleeping — the rich work for their money. With the wealthy, the money works for them.
Some examples of passive income include real estate, business interests, and dividend stocks. Passive income-generating real estate is a favorite of the wealthy because when a crisis hits, while dividends may go away, passive real estate income endures. People don’t stop needing shelter, and businesses don’t stop needing an office and retail space.
Whereas the rich allocate almost all their income towards expenses, the wealthy allocate a large portion of their income towards assets – passive income-producing assets. With a focus on net worth, the wealthy are constantly focused on increasing that surplus basket that will allow them to acquire more passive income-producing assets.
That’s why reducing expenses is essential to their wealth-building strategy in addition to increasing income.
Passive income providing regular distributions is the key building wealthy. The wealthy reinvest their regular distributions into other income-producing assets or to reduce further liabilities. Either way, more capital is freed up to throw back into the wealth machine.
The problem for the rich is their earned income is limited to the number of hours in a day. And with expenses continually increasing, the rich find it hard to free themselves of this vicious cycle.
The only way to get out of the cycle is to follow the example of the wealthy who reduce their expenses as a vital part of their investment strategy and not just to have more money to put under the mattress.
The wealthy also have a goal to increase income but the type of income they’re after isn’t limited to the hours in the day.
Passive income doesn’t sleep. It’s generated 24-7 and if invested in the right assets, continues to pay even during downturns.
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