Imagine you just arrived at a beautiful estate for a holiday party hosted by your friend Yvette, a neurosurgeon at a nearby hospital.
As you park and walk up towards the house, you spot two gorgeous cars, a Mercedes and a Ferrari, parked on the driveway. You remember these are two of Yvette’s several luxury cars. Yvette warmly greets you at the front door. As you walk in, your eye first catches a crystal chandelier hanging above a large and ornate entry hall. The rest of the house is equally lavish, as is the party you attend. You have a great time and as you leave the party that night you think to yourself - wow, Yvette is really living the good life!
The next weekend you go to another party. This party is hosted by your friend Mariana, who works as a teacher. You arrive at a small three bedroom home and see Mariana’s car, a 12 year-old Honda Accord, parked in the driveway. She happily greets you at the front door and as you walk in you see a nice, cozy home without any signs of wealth. You have a really nice time at the party, though at some point during the evening you think to yourself: hmm, I hope Mariana is doing ok financially.
Most of us would assume that Yvette (the surgeon) is doing much better financially than Mariana (the teacher). But even if Yvette earns ten times more than Mariana, we may be completely wrong. As we discussed in our last article, savings rate, not income, is the best predictor of future financial success.
Let’s compare the financial situation of Yvette and Mariana to understand why that’s the case.
After taxes and benefits, Mariana earns $40,000 a year in take-home pay. By comparison, Yvette earns $400,000 a year in take-home pay. That’s a lot of money! Exactly ten times more than Mariana!
Clearly the first round in our personal financial comparison goes to Yvette.
Mariana saves $20,000 a year, while Yvette saves $40,000 a year. Yvette’s savings are equal to Mariana’s entire take home pay!
Clearly Yvette wins this round as well.
This is where things get interesting. Mariana saves 50% of her income. Each year she spends $20,000 and saves $20,000. How does Mariana save so much of her income? She lives a relatively frugal life, with a reasonably priced home and car. She limits discretionary spending to the areas which matter most to her. Most importantly, Mariana tracks and budgets her spending to ensure she has full control over where her money goes.
Yvette saves 10% of her income. Yes, that means that she spends $360,000 of her $400,000 annual take-home pay! How does she spend so much? For starters, the mortgage on her enormous home and her multiple car payments quickly add up. Additionally, as Yvette’s income rose, her tastes refined. She now enjoys fine dining, luxury vacations, and buying equisitie art.
As a result, Mariana wins the savings rate comparison.
But so what? She’s still saving less actual money. Well, stick with me, and learn why Mariana actually comes out ahead.
Let’s assume Mariana and Yvette both started their careers with $0 in assets. Realistically, Yvette would likely start her career with more debt, after medical school. But let’s give her the benefit of the doubt and assume both Mariana and Yvette received full ride scholarships throughout their education.
Using our handy table from last week, we know Mariana will need to work 17 years to achieve financial independence, since she has a 50% savings rate. Assuming she starts her career at 23, she’ll no longer have to work for money starting at age 40! Not too bad!
By comparison, Yvette will need to work 51 years to reach financial independence! If she starts her career at 26 (after eight years of university and medical school) she’ll need to work until she’s 77. Much, much longer than Mariana.
Why the huge difference? After all, Yvette saves more money per month than Mariana.
The answer is the amount each spends. Mariana spends $20,000 a year, meaning she only needs $500,000 to achieve financial independence. Yvette spends $360,000 a year, meaning she needs an enormous $9,000,000 for financial independence. Note: You can find math for these calculations below
You may think Yvette can easily reduce her spending, since she’s currently spending a huge amount. I’m not convinced. Each of us adapts to the lifestyle we’re living and considers it our “normal.” For Yvette, giving up her luxurious house or cars may feel like failure, especially when she compares with her fellow surgeons. I honestly believe Mariana and Yvette would find it equally challenging to reduce their expenses.
So who wins the overall personal finance comparison? I would say that Mariana wins in a landslide. Her higher savings rate means she will quickly reach a day when she can pay for her expenses using investment income, follow her dreams, and spend her life as she chooses.
You can also achieve financial independence. Sooner than you think! For a step by step guide on how to do so, check out the Path to Financial Freedom!
Note: The math for calculating how much you need for financial independence is simple. Take your annual expenses and multiply by 25. Why 25? Because based on research, it’s reasonable to live on 1/25th (4%) of your assets once you achieve financial independence, since the market historically returns over 4% within 10-year time horizons. Thus, the market would continuously replenish your assets. For more research check out Mr. Money Mustache’s awesome article on the 4% rule.