I was enjoying a rather brazen post at Personal Finance Advice on the topic of the utter simplicity of the basics of personal finance (it’s just spend less than you earn and invest the difference) when this comment, left by “StevenL,” really got me thinking:
I think this makes sense to a degree, but in theory what is the point of being rich if your plan is to live well below your means? To save a lot of money, to have it in the bank to continue living cheaply?
In one sentence, StevenL spells out the problem that many have with converting to a fiscally responsible mindset. If you’re earning $80,000 a year, shouldn’t you be living an $80,000 lifestyle? The actual truth of the matter is that well-managed personal finance means that by living below your means now, you can live beyond your wildest dreams in the future. Perhaps an example will clearly illustrate this principle.
Let’s take a look at Alan and Bob. Both are 25 years old, both are making $50,000 a year, and both will be receiving 4% raises each year. Alan believes that he should live a lifestyle appropriate to his income, while Bob believes that he should live a lifestyle appropriate to 10% below his income and invest the rest. So, at age 25, Alan spends $50,000 and Bob spends only $45,000 and invests $5,000 in a 10% mutual fund.
At age 30, Alan has been living a much nicer life than Alan, with the extra luxuries that his extra spending can afford. He’s bringing in $60,832.65 a year and spending every dime of it. Bob, on the other hand, has been socking away the cash at a rate of 10% a year, and those investments are earning him 10% each year. Bob’s total income is $63,593.36, but he’s still investing 10%, so he actually only spends $57,234.02. Alan drives his Lexus by Bob’s house every day, shaking his head and laughing at Bob’s cheap car. But things are about to change.
At age 40, Alan has noticed that Bob’s lifestyle is catching up with him. Alan brings in $90,047.18 that year and spends every penny. Bob, on the other hand, is still socking away 10% each year. He now has $116,733.77 in investments and is bringing in a total of $100,713.42 this year, combining his investment returns and salary. After socking away 10% of it, Bob spends $90,642.08, which is $594.90 more than Alan. They’re both driving Lexuses now!
At age 55, Alan is still driving his shiny Lexus. He made $162,169.88 this year and spent every dime. Bob, on the other hand, has $335,301 in investments and brought in a total income of $193,762.35. Even after socking away 10% of that, Bob spends $174,386.12, or $12,216.24 more than Alan.
Not only does Bob end up spending more than Alan and living a more luxurious lifestyle, he has a lot of money invested, while Alan has nothing for the future.
StevenL, the reason to save your money and live cheaply now is so that you can live a better, more independent life in the future. You’re choosing to be Alan when in the not-so-near future, Bob will be running laps around you in both security and quality of life.