As you know by now, I am of the opinion that financial freedom resides within the world of passive cash flow. And since the later is the domain of investing, we must learn to invest. I hate to once again point out the obvious, but as I’ve stated before you will have to find some capital with which to get started, which is very much a function of your ability to lead a frugal lifestyle.
Cash Flow and Financial Freedom
The math is very simple. The formula is: Income – Expense = Cash flow.
“I believe that thrift is essential to well-ordered living.” -John D. Rockefeller
It seems so apparent that unless the number representing expense is substantially smaller then the number representing income, the resulting cash flow suffers. Interestingly, my observation is that most people tend to completely ignore the expense side of the equation. This is to say that when folks notice that the formula is out of balance, they automatically assume that the income is the problem; that it’s too low. However, in my experience the income is usually not the problem.
How to Achieve Financial Freedom – Live Below Your Means
The game of financial freedom is not merely a function of revenue. It is a question of how to keep more of what you do earn. We could discuss investing and tax strategies until we are blue in the face, and yet you will continue to find it impossible to move the needle in the right direction so long as you spend more than you should relative to your income.
The 7 Behaviors of the Wealthy
This point is so important that I don’t want you to take my word for it. In their book titled The Millionaire next Door, the authors Tom Stanley and William Danko summarized the findings of the extensive research they conducted concerning with how and why people become wealthy. They discovered 7 behavioral patterns that are the common denominators among individuals who become wealthy. Here they are:
- They live well below their means
- They allocate their time and money efficiently, in ways conducive to building wealth.
- They believe that financial independence is more important than displaying high social status.
- Their parents did not provide economic outpatient care.
- Their adult children are economically self-sufficient.
- They are proficient in targeting market opportunities.
- They chose the right occupation.
Notice that two out of the seven items on their list, namely items 1 and 3, address the aspect of living a frugal life. In other words, 28.5 percent (2 out of 7) of your success relative to accumulating wealth is directly tied to your ability to live below your means according to the author’s research! Just to illustrate this point, allow me to introduce you to Al and April.
How to Live Below Your Means – Al and April
Al and April
Al is a sixty-two year old engineer who holds 25, or so, patents on behalf of his employer. He is publicized in trade publications throughout the industrialized world and is considered to be one of the brightest minds in the world in his area of expertise.
Al, his wife April, and their two kids are immigrants from the Eastern Europe, who like so many before them came to America looking for a better life. Al has been with the same company for 20 years, where he started as an entry level technician earning a salary of $30,000. Fast forward twenty years, Al is now the head engineer and makes around $95,000.00 per year. It certainly seems that the company has rewarded Al for his commitment and expertise, which is a good thing since April has not been able to work due to illness for many years, and without Al’s income they are toast. They worry, but even so, I suspect that Al and April are better-of than a lot of their peers.
There are three main reasons for their relatively stable financial circumstance. First – Al is absolutely the best at what he does and his expertise happens to be in a very marketable field. Even though his company is a rather large multi-national, Al is totally crucial to their production output. This means that Al has about as good of a job security as any employee can. The company would have to go belly up for Al to loose his job.
Disciplined Spending Habits
Second – Al and April have always been extraordinarily disciplined about their spending habits. Al and April maintain a life style which could be described as well below their means. They use a small portion of their income to live on and save the rest. This means that they do not enjoy the type of refined life style that others with their level of income might enjoy.
No Consumer Debt
Al and April have $0 consumer debt. Instead of luxury vehicles, Al and his wife drive reasonably priced automobiles, which they drive for at least 10 years prior to trading-in. As the matter of fact, when shopping for a new automobile they only have three criteria – first, comfort; second – reliability; and third – they must be able to pay for the vehicle with cash. When purchasing electronics, Al waits for the sale, and never finances anything. Of course, this also means that Al and April do not own the latest models of anything, but they are comfortable with cash in the bank instead. As a rule, Al and April do not buy anything that they can’t pay cash for, their home being the only exception.
Purchase the Right Primary Residence
When in 2004 Al and April decided to buy a new house, they made this decision not because they wanted to upgrade their lifestyle, but because the house they were living in needed substantial repairs due to its’ age, and they decided that it made more sense to build a brand new abode in lieu of sinking $30,000 or $40,000 of cash to upgrade the old one. Al and April settled on a comfortable but in no way lavish three-bedroom, 1,600 square foot ranch floor plan. They paid $180,000 to have the house built for them, financing what was left after their $80,000 down payment with a fifteen year mortgage at 4.25%.
Additional Mortgage Payments
How were Al and April able to come up with $80,000 for down-payment you ask? Well, this, once again, is a function of their frugal approach to finances. Throughout the nineteen nineties, Al was making additional payments toward the principal of their previous house every month. The amount varied according to their cash flow situation, but because of this they were able to pay-down the principal at considerably faster pace. On top of this, the real estate market was booming, driving the price of his house higher and higher. Al and April, unlike many of their peers, resisted the temptation to use their house as a piggy bank and did not refinance their home when the market was good to finance a boat, vacations, furniture, cars, and all the rest. This is why when Al and April sold their house they were able to realize a lot of money at the closing. They put it all toward the purchase of their new home. And, naturally, they are now treating the new mortgage same way, which is how Al and April will retire in a home which they own outright within three or four years.
Rational Thinking and Temptations
Finally, the third important reason behind Al and April’s stable financial circumstance is that they have what a lot of people seem to lack – common sense and ability to think rationally and resist the temptation to follow the crowds. Al feels that just because everyone else buys a bigger home, does not necessarily mean that he should; just because everyone else drives luxury cars, does not mean that he should; and just because the pundits on TV tell everyone to stay the course and keep their money in the market in the middle of a financial melt-down, does not mean that he should. This is why Al’s 401 K suffered losses of substantially smaller magnitude then a lot of other folks in 2008. Al, having learned from his experience dating back to the bursting of the tech. bubble in 2001, was able to move majority of his holdings into cash prior to experiencing huge losses. Al heard the so called professional advisors recommending that he “stay the course,” but his common sense told him otherwise. Unfortunately for them, the majority of Al’s peers listened to the experts…
These are the main reasons why Al and April are in a much safer financial position in 2010, heading into retirement, than the majority of baby boomers. Take a look at their financial statement:
|INCOME & LOSS STATEMENT||Al and April|
|Earned Income||Gross Income|
|Earned Income 1 Gross ($90,000/yr.)|
|Earned Income Total|
|Earned Income 2 Gross ($0)|
|Passive Income (R/E Income)|
|Passive Income (business, real estate, annuity, etc.)|
|Rental Income 1|
|Rental Income 2|
|Rental Income 3|
|Rental Income 4|
|Credit Card 1 (interest only @ 8%)|
|Personal Expenses Total|
|Credit Card 2 (interest only @ 9%)|
|Business Expenses Total|
|Car Payment 1 ($25,000 @ 5%, 60 mo.)|
|Car Payment 2 ($25,000 @ 5%, 60 mo.)|
|1st Mortgage (PITI at 4.25%, 360)|
|Repairs and Maintenance|
|College tuition for child|
|Legal & Accounting|
|Earned Cash Flow|
|Passive Cash Flow|
|NET CASH FLOW|
|Credit Card 1|
|Credit Card 2|
|1st Mortgage Balance|
|Liquid Cash Fund|
|Car Loan 1 Balance|
|Car 1 Value|
|Car Loan 2 Balance|
|Car 2 Value|
|Retirement Account 1|
|Retirement Account 2|
Notice, the frugality is apparent in almost every discretionary item: cell phone/TV, entertainment, mortgage, and vacations. You may wonder – how can anyone live with no vacations? Well, perhaps vacations would mean less to you as well if you had escaped from an Eastern European communist country where your very existence was threatened, let alone your livelihood. Perhaps, if you had been reborn in a free society that is the United States of America and had been given an ability to provide a better life for your children, than you as well would trade-in vacations and put that money toward your kid’s college tuition.
Live Below Your Means to be Financially Free
If you do not subscribe to anything else you read in my blog, please take this to heart – you must learn to live beneath your means!