Paul Stanley, the author of The Millionaire Next Door: The Surprising Secrets of America’s Wealthy and The Millionaire Mind talks about why one should focus on personal net worth over income when building wealth. Why is this? Because in the long run, you need wealth, not a high income to survive financially.
In this country, many times we mistake someone that has a high income for being wealthy. This isn’t always true. Just because a person has a high salary, it doesn’t mean they are living like a king. If you really want to be wealthy, forget about focusing on having a high income and focus instead on your personal net worth.
On average, a millionaire’s income is 7% of their personal net worth. The median income is 8% of their net worth. (For a quick lesson on average versus median, read this post.) But what exactly is this telling us?
It means that the typical millionaire has a ton of money! In all seriousness, it shows that the typical millionaire is safe should they lose their job. After all, the income they bring in from their job only accounts for 7% of what they are worth. Should they lose their job, they can still get by financially intact because most of their income comes from other sources (think rental real estate, investments, side hustles, etc.).
This is also the reason why the wealthy pay less in taxes than most others. Income from your job is taxed at ordinary income levels while investment income is taxed at investment income levels. The rate for ordinary income is much higher than investment income tax.
So I ask you, what is your income to personal net worth ratio? Do you know?
Calculating Your Personal Net Worth
Remember that net worth is your assets minus your liabilities. (I have a free net worth template for you to download here.) Your income is your salary plus any dividends and interest you receive, as well as any other forms of income you earn.
To calculate your ratio, simply take your income number and divide by your personal net worth. The lower the number, the better off you are financially. Currently, my wife’s and my ratio is 50%. Not ideal by any means. When I analyze our numbers, what are weighing us down are my house and my wife’s house. If we were to magically breakeven on my house (currently underwater), we would be at 35%, which is better.
You Need To Increase Your Personal Net Worth
This is a relatively easy calculation to perform and it will give you a good idea of where you stand. While earning money is important, it is equally important to save as much of it as you can. Saving and investing your money creates your net worth. The higher your personal net worth, the better your ratio will be.
Take a look at this example as proof. You have two doctors, John and Mark. Both earn $100,000 per year. John’s net worth is $600,000 while Mark’s is $50,000. John is a saver and Mark is a spender. What are their ratios?
John’s ratio is 17%, which is very good. Mark’s on the other hand is 500%. Remember, the lower the number the better. While you may see Mark earning a high salary and “living the life” with his big house and multiple cars, he really is barely keeping his head above water. In fact, Mark is really Stanley below:
Using the personal net worth ratio holds true for lower income people. Take Joe and Kevin for example. They both earn $30,000 per year. Joe has a personal net worth of $600,000 while Kevin has a personal net worth of $50,000. Their ratio’s are 5% and 60% respectively.
This shows us that Joe is a master saver and is truly wealthy. Kevin on the other hand saves some money, but could save more.
The point of this post is to show you that you shouldn’t focus on income alone. Yes, you should do everything in your power to earn the highest salary possible, but that high salary is worthless to you if you aren’t saving any of it.
While calculating your personal net worth is a great first step in looking at your financial life, it’s not a complete picture. By running this ratio, you can see exactly how well you are doing and how well you can handle an emergency should it ever come up.
You may be asking how you should go about increasing your net worth. Remember that your net worth is simply your assets minus your liabilities. The more you save the higher your net worth will be. Therefore, the first step in increasing your net worth is to budget. I know, the dreaded b-word. Luckily, there are some awesome tools that make budgeting easy and in some cases, dare I say, fun. OK, that was a stretch, maybe enjoyable is a better word.
First is Power Wallet. It’s 100% free and is just plain awesome. I use it myself. Before I found it, I was tracking my net worth through excel spreadsheets. If you find Power Wallet isn’t for you, then I suggest You Need A Budget. This costs some money, but makes you look at your money differently. Definitely one to check out as well.
Once you have the budget in order, it’s time to start investing. Automated is the way to go here, as it takes away your biggest threat to success – your emotions – out of the equation. For investing, I use Betterment. It’s simple and gets the job done. I also encourage you to read my post on becoming a stock market millionaire. It outlines everything you need to know to be successful in the stock market.
Now that you are budgeting and investing your money, your net worth should begin to increase. As you live within your means and pay off your debts, you will begin to see your ratio change so that you aren’t relying on your income as much.
I encourage you to sit down annually and determine your ratio and record it. Work to better your ratio each year. It will get you in the habit of trying to save more, which will make your financial future that much brighter.
If you don’t want to manually track your net worth, there is a free solution that will track your net worth for you, along with your spending, saving and investments. It’s called Personal Capital. I’ve been using it for a few months now and am amazed at the graphs and how it encourages me to save more to improve my finances.