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.
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.
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:
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:
I’m sure you have heard of them, what are they? Just remember:
Assets – Make Money
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:
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?
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:
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:
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.