Want to Retire Early? Stop Buying Liabilities

The following is a guest Post from Otto Riches. Otto is the founder of offthesalary.com, a blog that is dedicated to strengthening your financial literacy so you can retire early. He loves talking about money, investments and the frugal life.

Off The Salary

I will tell you a little secret. You don’t need a huge income, all you need to do is focus on where your money is going.

The general mass of people seem to associate rich people with high income, but that’s only one part of the puzzle. The more important difference between a rich person and somebody who is struggling to makes ends meet is in what they buy.

To help you understand let me draw you some pretty pictures.

Income Spending

Super simple stuff, but it applies to everyone. Everybody makes at least a bit of income and everybody has to spend in order to live. So that brings us to the next point:

Profit-Income-Spending

Again, very simple concept, profit is simply the difference between Income and spending.

Finally, before I tell you how early retirement works, I want to show you this:

Assets - Liabilities

I’m sure you have heard of them, what are they? Just remember:

Assets – Make Money

Like investments.

Liabilities – Take Money

Like mortgage interest, car loans, property tax on big houses, etc.

Alright got it? Let’s move on. In order to understand how to get rich and retire early let’s simplify society into three financial classes.

Class 1: Poor Class

When you think of poor people you probably visualize somebody hanging around your local fast food joint asking for money, or somebody living in the slums and working a minimum wage job. That’s how society seems to view poor people. The funny thing is to be poor, you don’t have to live in the slums or panhandle money. There is only one thing that defines a poor person:

A Negative Profit

That is, to be poor you have to spend more than what you earn. So sure, maybe somebody living in the slums is poor but the crazy thing is that somebody living in a mansion and eating at fancy restaurants every night might also be poor. It’s just hard to tell because people tend to judge by appearances. Nobody looks at a person’s cash flow. In reality though that is what defines your financial class.

If you have a negative profit you are not going to retire … Ever! Negative profit is something to steer clear of and it’s actually rather simple to avoid with a bit of financial literacy.

Let’s move onto something a bit more interesting:

Class 2: The Middle Class

This is where most people in developed nations like to hang out… For their whole lives.

To get to the middle class, you get yourself a nice fancy degree and go work hard for a nice big corporation and get your steady salary with pretty decent benefits. Then you go and get yourself a big house and lease a new car, and of course don’t forget to go on fancy vacations every year! Wow the middle class sure sounds nice hey? Only one problem … . The middle class has:

Zero Profits

Or maybe they have a very small amount of profit just to stash away on a rainy day in their low interest savings account. Middle class tends to spend almost everything they earn, they likes to buy liabilities! The worst part about the middle class is that the more money they make, the more they spend. Big mortgages, car loans, hot tubs, fancy vacations, oh my! If you are in the middle class don’t plan on retiring early… if you’re lucky you might be able to get away with retiring in your old age and only because the government will help you out. Early retirement is out of the question for those stuck in the middle class. So how the heck does one retire early?

Enter:

Class 3: The Rich

And no, not these fancy people smoking expensive cigars and taking their pet tiger out for a walk in their 100 acre backyard. The only thing that distinguishes a rich person from somebody stuck in middle class is one thing:

Positive Profits!

Like a pretty solid positive income. How do you get positive profits? You take your income, then you buy assets, then whatever is left over you can spend on your living expenses. Rich people track their cash flow like hawks! They know exactly what is coming in and what is going out. Then they minimize their expenses by living frugally and actually tend to spend less than the middle class! They buy assets which in turn make them more money, and the profits keep growing and growing!

Great, now we know the difference between the three classes, but how do you retire early?

Well that is pretty simple, you see income comes from three places:

Total Income

Active income is what you get for working a job, you get it in the form of a salary. You are basically directly trading your time and energy for money.

Passive Income comes from investing time. So you work really hard for no money and hope that you can get money in the future without working. Things like writing a book, or recording a song, or starting a blog about finance… you know stuff like that.

Portfolio Income is what your assets generate for you, like dividend income from your awesome investments and stock appreciation. Portfolio Income comes from investing money.

For people stuck in the poor and middle class the only income they get is an active income. This is why they work for a long, long time! The rich however, are much more interested in the other two. So how do you retire early?

1) Find out how much you are spending.

2) Cut unnecessary spending and live frugally, this will increase your profits and assets which will give you more income.

3) Keep working your active job until your passive and portfolio incomes can cover your spending and have some left over to keep growing your assets. That is have a passive profit.

Early retirement happens when:

Passive and Portfolio income > Spending

How big does your passive profit have to be? Well that totally depends on you. If you want to be comfortable, make sure it’s big enough to cover any assets price swings and unexpected expenses.

That’s it folks, now you know how the rich get rich and how to retire early!

Hope you enjoyed the read.

Blogger-in-Chief here at RetirementSavvy and author of Sin City Greed, Cream City Hustle and RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit.

21 Comments

  1. Great stuff, and the pictures make it that much better. Good post and a mantra that is common sense but few actually devise a plan to achieve it. My portfolio and passive income is growing every year. Here’s to a great end to 2015 with profits.

  2. I think this illustrates how important it is to increase your income. Many college grads have a high amount of student loans and relatively low wages starting out. If you can increase your income to the point where you are siphoning it off into assets (like dividend-paying stocks), you can slowly build up your passive income.

  3. The equation and idea is so simple, it is amazing that more people don’t understand it. There is just too much outside pressure in our culture that makes something so simple seem so difficult to people. Or at least something that they aren’t willing to do.

    • So very true, my friend. Thanks for stopping by and adding to the conversation.

  4. I have “middle class” in my DNA. So when unexpected job loss came, there was panic with being in “the poor class” where we definitely had a negative profit. With hard work, my husband’s business started to succeed, and we were back in the middle again – ready to embrace zero. Only in the last 3 years have we clued into the concept of eliminating debt and investing. For two people used to the middle, we feel a bit out of our element as we adopt these new habits – which will lead to the positive profit of (I’m really uncomfortable saying it!) “the rich class.”

    • ” … we clued into the concept of eliminating debt and investing.” That light bulb comes on at different times for each of us. When it does, most of us realize two things. First, it is possible to lift ourselves and our family to a higher finance plane and second, doing so dramatically increases our options, giving us more choices, which is a key part of a satisfying life. It isn’t about a given dollar amount, it’s about having choices. Thanks for stopping by and adding to the conversation, my friend.

      • I agree its about having choices. I’m 46 and just want to set myself up to be able to retire early if I want or need to. You never know what can happen so I think its important to plan ahead just in case. Im not against still working, but I dont want to have to stay in a bad job or be in a bad financial situation if I were to lose my job.

  5. These concepts are talked about in “The Millionaire Next Door” and the original “Rich Dad, Poor Dad”. Both I think are must reads.

    I think it is difficult for people in the US to not spend money. The culture is about consumption and possessions. Everyone wants that latest phone, a luxury car, a bigger house, etc. I am willing to bet that most people are not happy, they always are striving for more and/or have so much debt that the stress level is intolerable.

    I really like this article about not buying liabilities. Too many people think of a house as an investment but it really a liability. Sure everyone needs a place to live but buy what you need and stay there. A cheaper house means, less expense for insurance, property taxes, etc. Also with a smaller house you are less likely to buy more things when it is full.

    So what is it? Why are some people able to become wealthy and many others not, despite their income? Why are some people really engaged in personal finance and others it means nothing more than paying the bills?

    Okay, this is enough of my ramblings for today. Thanks for the great article and discussion.

    Gringo Andy
    The Accidental Retiree

    • “I really like this article about not buying liabilities.” Related to this is the fact that too many people confuse consumer goods and assets. A low-cost index fund in a well diversified portfolio is an asset, a nice new refrigerator – even one with all the bells and whistles – is not.

      Thanks for stopping by and adding to the conversation, my friend.

    • Hey Andy,
      Glad you liked my posts:) Thanks for the input!

      -Otto

    • I also really enjoyed this post, so I read it a few times. 🙂 I agree with Andy that housing can be a liability. IMHO, we put ourselves in situations in our personal lives by way of spending way too much that results in the need to always have a source of active income. Recently, I was discussing with a co-worker why qualified employees don’t take more risks by applying for leadership positions. I think that we run to the middle (me included) when our liabilities are numerous so that we don’t risk losing active income to cover debts. Great post.

      • “I think that we run to the middle (me included) when our liabilities are numerous so that we don’t risk losing active income to cover debts.” Agreed. Even when debt levels aren’t high, most people are completely beholden to their source of active (aka labor or earned) income and most of their decisions are based on any potential impacts – negative or positive – to that source. That is why I often say being financially free is really about having choices; to work or not, to travel or not, to assist family members, etc. The way to increase your choices/options with respect to living your desired lifestyle is to lessen, and eventually eliminate, reliance on active income while increasing passive (aka residual) and portfolio income.

  6. Love the visuals! Not matter what you earn, as long as you can spend less and save the difference you can be successful. Add some additional streams of passive income and they can fast-track financial freedom.

    • Hey Brian!
      Thanks for the comment glad you liked the post.

  7. That was so simple. Yikes! Wish I’d been into this whole thing 20 years ago. I will definitely be bookmarking this post. Thanks! 🙂

    • In many ways it is simple. However, my experience has been that there are at least three factors that prevent many from attaining financial freedom: insufficient wages, ignorance of basic personal finance concepts and practices, and discipline.

      With respect to wages, unfortunately, we – here in the States anyway – have been in an environment where wages for the vast majority have been essentially flat for the last 30+ years as the income gap continues to widen. It is hard to save/invest if you can barely maintain the basics. Even if more people had more money, the reality is that a obscene percentage of the population remains financially illiterate. Simply put, too many have no idea what to do with the money they do have. And finally, there is a segment of the population that possesses an adequate income, but because of their lack of discipline (and ignorance for many) end up living paycheck to paycheck … just living for the moment.

    • Hello Kay!
      Glad you liked the post 🙂

      And totally agree with you James, having a higher wage early on would help but ultimately it comes down to having solid financial knowledge.

  8. Hey James,
    Thanks for putting this up! Also if anybody has any questions I am happy to answer them here 🙂

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