There are three categories of finance.
- Bucket 1: Your income
- Bucket 2: Your spending
- Bucket 3: What’s left over
Everything that has ever been written on a financial topic fits into one of those categories. It either deals with how to make money, how to spend money, or what to do with the leftovers.
A lot of people may feel that Bucket #1 is the most important bucket if you want to be rich. It takes a large income to have large net worth right? Well… no, actually. Bucket #3 is the most important if you want to build wealth. Having a large income doesn’t guarantee wealth. No matter how much money you earn, you can spend it all.
Let’s say person A earns $150,000 and spends $150,000. They are no more wealthy than someone who earns $50,000 and spends $50,000. At the end of the year neither one have anything in Bucket #3. But let’s say person B earns $50,000 and only spends $45,000. Person B has $5,000 in Bucket #3, the leftovers bucket.
Person B can use that $5,000 to build wealth. They could invest in stocks that pay dividends. They could start a profitable business. They could buy a rental property that provides income. They could do any number of things to provide additional income.
At first Bucket #3 would only provide a small amount of income. That can be used to help grow your savings. Eventually, over a lifetime, Bucket #3 would provide a large amount of income. When your investments provide you enough income to live on then you are truly wealthy. You can see how keeping your expenses lower would make this easier. Not only would you have more money leftover to invest, you would also require less income on which to live. Meaning that you could reach the goal of wealth that much sooner. The goal is to have this cycle running on its own, without you having to work.
Let’s use rental income as our example:
Person B saves their $5,000 per year until they have enough to put down on a rental house. True, this may take as long as 10 years. But how much will Person A have in savings after 10 years? If they keep up their current spending levels, nothing! After 10 years of saving Person B puts $50,000 down on an investment property that provides them $500 a month income. (an example of this could be: $1,500 in rent – $800 mortgage -$200 additional costs = $500 profit)
Now they can add that $6,000 per year to the $5,000 they were already saving, allowing them to save $11,000 per year. They save up for 5 more years and buy another rental property. Now they are able to save $17,000 per year. (The original $5,000 + $6,000 from the first property + $6,000 from the second property.) If they continue this pattern they could own five houses within 22 years of first starting to save.
It would look something like this:
Year 10 = Buy first house. Increases savings to $11,000 annually
Year 15 = Buy second house. Increases savings to $17,000 annually
Year 18 = Buy third house. Increases savings to $23,000 annually
Year 20 = Buy fourth house. Increases savings to $29,000 annually
Year 22 = Buy fifth house. Increases savings to $35,000 annually
Let’s say they started saving when they were 25. So they are now 47 years old. Instead of buying any more houses they decide to start paying off the mortgages on the houses they have. They now have $35,000 a year to put towards this goal. If they owe an average of $140,000 per house they could have all the houses paid off by the time they are 67 years old, not even counting additional payments they would make in the meantime.
Let’s assume once the houses are paid off they earn an average of $1,000 per month from each house, giving them an annual income of $60,000. That’s pretty decent! Just from investing $5,000 of their income per year over the course of a working lifetime.
What does Person A have after a lifetime of work? Remember person A? After a lifetime of making (and spending) $150,000 per year they have nothing. When the income stops, so does their lifestyle.