A common problem in America today is the growing wealth disparity between the rich and poor. We see it written and talked about all the time, in fact. And it is often pointed out that the odds are stacked against the poor and middle class, while the wealthy have many advantages.
It’s true that it is harder to build wealth than to maintain it. Those with wealth have many advantages that those without do not. However, the constant focus on wealth disparity and the difficulties faced by the poor and middle class can cause people to become hopeless and feel stuck. The mentality becomes a convenient excuse to not take necessary actions to change one’s circumstances. Thus, this often becomes a self-fulfilling prophesy.
There is a better approach for those looking to build wealth and improve their station in life. Instead of focusing on the negatives, study the factors that allow the rich to get richer and learn how they work together. Only then can we begin to put those concepts into action and accelerate our own wealth-building process.
Read More: 5 Things I Did In My 20s That Made Me Rich In My 40s
Interest
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” — Albert Einstein
Americans are burdened with many types of debt, including student loans, medical bills, mortgages, car payments, and credit cards. While things like medical emergencies can and do happen, far more often people consciously — and even eagerly — choose to make the mistake of going into debt. Only about 10% of car buyers use cash, for example, versus 90% who finance. Over 85% of homes are purchased with 30-year mortgages, too.
It is easy to calculate the direct costs of financing by adding interest to the cash price of a purchase. More damaging than the direct costs to use debt, though, are the unconscious effects. Even “good debt,” such as that used for education or purchasing a home, can quickly become “bad” when you overspend.
The average American home size has doubled since the 1950’s, even as families get smaller. College costs continue to grow far faster than the general inflation rate annually, and the debt of graduates grows with it, approaching $40,000 on average. At the same time wages are stagnant or shrinking. Does anyone doubt these phenomena are a result of easy credit?
Related: Making a 30-Year Mortgage as Smart as a 15-Year
On the flip side, the wealthy use the effects of interest to make life easier. They benefit from interest on savings and investments working for them.
When the wealthy use debt, it is often to carefully use “other people’s money,” leveraging lucrative opportunities into even bigger and better opportunities. Even in today’s low interest rate environment, the spread between having interest working for you rather than against you is a massive advantage when building wealth.
Related: How Will the Fed’s Rate Hike Impact You?
Insurance/Risk Management
There are worse things in life than death. Have you ever spent an evening with an insurance salesman? — Woody Allen
Every time you buy insurance, you spend money for a product you hope to never use. The irony is that the people that most need insurance are the least able to afford it, while those that can most afford it often do not need it.
It is important to understand that every time you purchase insurance, you are making a decision with negative expectancy. No company — at least not one that is planning to still be in business when you need them — will sell an insurance policy unless they are likely to make money in the process. Therefore, every insurance purchase you make is likely a losing bet for you, and a carefully calculated winning bet for the insurance company.
You never want to buy insurance unless you need it. However, when living paycheck to paycheck, you often need insurance to prevent financial ruin. Short-term disability, long-term disability, and life insurance can all be important to manage financial risks. Even very expensive types of insurance, like warranties on products that you can not afford to be without, may make sense.
Learn More: How Much Life Insurance Do You Need?
Adding insult to injury, you often have to buy insurance to protect lenders to allow you to live a lifestyle you cannot afford.
What do I mean by that? When you take out a mortgage, you are required to buy homeowner’s insurance. This protects the bank that actually owns your home. If you do not take out a conventional mortgage, you may have to buy private mortgage insurance (PMI) to protect the lender against the increased likelihood that you will default on your mortgage.
As your wealth grows, you can start self-insuring smaller things. The more wealth you build, the more you can self-insure and the less insurance you need to purchase. This accelerates the wealth building process.
Taxes
“People who complain about taxes can be divided into two classes: men and women.” –Unknown
Taxes are one of the biggest challenges to the wealth building process. Our tax system is very complicated, causing many to throw up their hands in disgust and resort to complaining.
One aspect of building wealth is increasing income. However, as you increase from low income to middle income levels, your tax burden increases substantially.
Very low wage earners pay very little income tax. Very high earners do not have to pay social security taxes on income over $127,200. They also are commonly compensated in ways that allow them to further avoid income taxes.
People in the middle of these two extremes, who are trying to build wealth, face a serious challenge with our income tax system. As a percentage of gross income, a 10th-percentile taxpayer would wind up paying twice as much in payroll taxes as someone in the top 1%.
Limiting taxes is a very powerful wealth building tool. It is important to see the big picture and develop a comprehensive tax plan. However, this is difficult in the early stages of wealth building.
Decreasing your tax burden becomes progressively easier as you shift from wage earner to investor and/or business owner. This concept is explained in great detail in Richard Kiyosaki’s book, Cash Flow Quadrants.
The Power of Leverage
“Great things are done by a series of small things brought together” — Vincent Van Gogh
Each of the factors outlined above are powerful on their own. However, the real magic begins to happen when you stack the benefits to leverage the impact. Let’s close with examples of how to do this in the early and late stages of wealth building.
Early Stage
Someone living paycheck to paycheck is likely being crushed by interest, while having little interest working for them. They would need to insure nearly everything, and pay high premiums because they could not afford high deductibles. They would have little power to do any tax planning, as every dollar would be needed to pay current expenses.
Something as simple as an emergency fund can help them in all three areas. Someone in this situation could consider working extra on the side or even selling off some things until they saved up, say, $5,000. Then, they could use this money to fund a $1,000 high yield savings account for emergencies, as well as open a Roth IRA with the rest.
These relatively modest savings would allow them to start earning some interest. Much more important, having this emergency fund would prevent them from continuing the cycle of needing credit when bad things happen, allowing them to stop working against the effects of interest.
Having money in savings would mean that all but the biggest disasters would be able to be taken care of right away. This would allow a family to reduce insurance products like warranties. They could also pay lower premiums in exchange for higher deductibles. Then, they could put the money they save each month on those premiums into the savings account, earning even more interest and padding their safety net further.
Related: Are High Deductible Health Plans Worth It?
Using a Roth IRA would mean that they could access any after tax contributions without penalty. At the same time, money not needed could grow for life without being taxed. The monthly savings on interest and insurance payments could then be added to keep this money growing.
Advanced Wealth Building
In a previous article, I outlined a strategy commonly employed by early retirees. In it, they use tax rate arbitrage to avoid taxes in high earning years, then pay minimal-to-no tax in retirement. While that article focused on the tax benefits, this situation can highlight how all three factors work together.
The above strategy is dependent on a high savings rate. Accomplishing this type of savings is most easily done by rejecting a lifestyle of debt. Thus, interest is rarely or never working against you. Savings begin to add up quickly, allowing compounding to work in your favor.
The ability to build wealth rapidly means minimal need for insurance. A person who can save 50% of their take-home income can, by definition, save a year’s worth of living expenses in only one year. A person with this level of wealth can self-insure against short-term disability and easily afford to accept the risk of high deductible plans. Within a decade or two, they can eliminate the need for life and long-term disability insurance as their investments can provide enough income to cover normal living expenses.
Once a person is financially independent, they will be able to live indefinitely on the interest from their investments. They will also have a minimal need for insurance products and a very low tax burden.
Summing Up
It is often difficult to start the wealth building process because it feels like everything is working against you. Hopefully, the knowledge in this article can give some insight and encouragement to stop fighting against massive headwinds, learning instead to redirect your sails (however slight at first).
After some initial effort, the process becomes much easier and continues to snowball in your favor. As time goes on, interest, insurance, and taxes can be used and leveraged upon one another to provide a tailwind, making the process progressively easier. Your goal is mo’ money, less problems… and with just a few small steps, you can begin building your own wealth in no time.
Topics: Money and LifeThe post How to Create Wealth and Make Your Life Easier appeared first on The Dough Roller.
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