The Income & Expense Wealth Gap

This past Memorial Day weekend, while other people enjoyed nice weather and BBQ, I was in a hotel conference room at a seminar. I spent the entire weekend working with a financial calculator and studying finance and investing from Gary Johnston. To some people, that sounds horrible, but this class is only offered two times per year, both over a 3-day holiday weekend, so if you want to learn it, you decide which of those two weekends to give up and be there.

We covered a lot of different areas of finance and wealth building. It was a fantastic learning experience. I would encourage everyone to take Financial Freedom Principles from Gary. Some of you reading this right now might say that you would never spend a holiday weekend doing this, and you would rather spend it relaxing and doing a backyard BBQ. If that is the case, you are already off on the wrong foot and might think what follows is equally unpalatable.

Building wealth and financial freedom require that we sometimes do things we don’t like or want to do. If it were easy, everyone would do it, but since most people don’t, there is an even greater opportunity for those that will.

As I have discussed in previous articles, most Americans have little to no net worth. Many have enormous debt and live far beyond their income. The idea of saving is non-existent for this group. The U.S. savings rate has been dismal for decades.

Savings is how you build capital, and capital is what you use to invest, buy cash-flowing assets, and invest in businesses. Without capital, wealth building will never happen. Everyone should create a capital accumulation plan.

There are three possible scenarios everyone, lives under:

1. Income = Expenses = No Savings: In this scenario, your income meets your expenses, but you have nothing is left after paying expenses. You are probably expanding your lifestyle as you make more money, and you might be one of the faux rich. This group is one of the “living paycheck to paycheck” crowd. Sadly, your story doesn’t have a happy ending.
2. Income < Expenses = Debt & No Savings: Your income doesn’t meet your present expenses. You are either not paying your debts and suffering the negative consequences of those actions or accumulating more debt to keep your lifestyle propped up. This is also a “living paycheck to paycheck” group with a downward death spiral going on. This scenario has a time limitation on it. You will reach the end of a very dismal road at some point.
3. Income > Expenses = Savings: Your income is greater than your expenses, and you have extra funds each month to save and invest. This is a rare minority of people.

The best scenario is number three, and the worst is number two, but number one will also end in misery. The goal is to be one the rare, few, and proud members in category three and continue to widen the gap between income and expenses.

As I pointed out in my capital accumulation plan, you must develop capital to invest; there is no other way to build wealth. You will need to maintain a gap between income and expenses and continually strive to widen that gap as time goes on, not shrink it.

There are two ways to accomplish this goal. Focus on income and/or focus on expenses. The faux rich will focus exclusively on income and overlook the part about focusing on income and expenses. Each increase in their income comes with a corresponding increase in expenses. Their wealth gap never increases, or worse, it gets smaller over time to the degree a gap exists at all.

The poor will focus on cutting expenses because it is difficult for them to obtain credit but will miss the part about also focusing on raising income. By the way, there is a huge difference between being poor and being broke. Being poor is a mindset and is mentally and emotionally crippling, often lasting a lifetime. Being broke is a temporary financial situation. I have been broke many times, but I have never been poor.

The wealthy do two things differently. They focus on income and expenses and drive the gap between the two larger and larger over time. In addition, they spend a lot of time planning and working toward the future. The faux rich and poor do neither.

Focus on Both Income and Expenses

The most successful formula is to focus on BOTH income and expenses. To drive the gap, focus on growing income from either your salary, business, or investments and simultaneously work on reducing expenses. If you work on both, you will continually widen the gap between your income and expenses, creating a larger pool of capital to build wealth. This works very well when you are younger. As you get older and your income, savings, and investments grow you can allow your lifestyle to grow, but ALWAYS maintain and grow the gap. Think about when you were in college and how you lived. If you were like the typical college student you lived on Ramen Noodles and had 3 or more room mates to keep costs down. I wouldn’t live like that today, but why not live like that after college for a while to build up capital?

Focus on Income

Focusing on income is the most fun of the two ways, but remember, you need to do both. However, let’s start with the fun one first. There are many ways to grow your income.

Increase Earnings

The primary way people address this method is by getting a better job. That is logical but comes with a variety of shortcomings. First, getting a better job that comes with a higher salary will also come with a tax increase. The higher your income goes, the more taxes you pay; as I have discussed before, W2 income is expensive income, and it is the highest taxed income there is, and increasing the amount you get will only exacerbate this issue.

The second issue with increasing your salary through job-hopping is that unless you are also building your skills and experience, you will be limited in how high your income will increase. In economics, we are taught that labor falls into two basic categories:

Skilled

Skilled labor involves trades (plumber, carpenter, electrician, etc.) or professionals such as doctors, lawyers, business, IT, teachers, etc. You either need to complete trade school or college and sometimes both. Over time you will learn new skills to make you better at your job, and the experience you gain is valuable as you widen the depth and breadth of your knowledge and capabilities.

Unskilled

Unskilled labor is often manual or basic clerical work that might require a little job training but doesn’t require specialized training, college, or trade school. If you are in this type of job, I am sorry to say that you can be easily replaced by someone else and many times will be at some point in your working life. Your experience may make you a little more efficient, but it is unlikely much protection against a downsizing or likely to increase your income from job-hopping. Unfortunately, this is a dead-end road for people in these positions.

While I am not a fan of being in a job in any capacity and much prefer entrepreneurship over a job, if you are in a job, strive to be in the former and not the latter category. However, regardless of what job you hold, you will have an upside limit on your earnings and pay substantially more taxes than people who choose a different path. Gary taught in the seminar that a job is OK if you plow your earnings into buying cash-flowing assets that eventually free you from the job. I agree in principle but I have used entrepreneurship and freelancing to create that income stream that allowed me to buy cash flowing assets.

Increase Earnings: Entrepreneurship

I have talked about this extensively, and it is a cornerstone of my philosophy. I believe everyone should have a small business, I prefer freelancing and do it full time, I understand not everyone will want to do that for various reasons. However, everyone should still have a small business, either part-time or full-time. You will increase your earnings and have some positive control over your taxes by starting a business. It is your business, so you control how much time you spend running it. You also control how to structure it for maximum tax advantages. Finally, it provides additional income that you can use to widen the gap. At a minimum, decide today to have a side hustle.

Increase Earnings: Increase Your Skills

I believe that lifelong learning is a competitive advantage. It is one of the taglines of my blog. If you want to earn more, you need to be more. To be more, you will need to learn new skills. Skill-building should be a constant and never-ending process for every single wealth builder. You are never finished. As I started this article, I spent the weekend in a finance seminar. I do stuff like this a lot, along with all the other things I outlined in my lifelong learning article. Finally, with your own business you can set up a self-directed 401(k) plan that YOU control. This plan can have both deferred and Roth buckets that give you incredible tax advantaged investing options.

Increase Earnings: Build Cash Flowing Assets

This method falls neatly into my investing in alternative assets category. You can increase your earnings by building capital to purchase assets that produce more income. Rental property and interest income from notes are prominent in this category. Other wealth builders call this mailbox money, passive income, and money while you sleep. My real estate investing primer will get you started on the right foot. Buying or creating notes will generate interest income. I have a friend that finds raw land, negotiates to buy it, typically with owner financing, and sells it to someone else on a note. The note generates income for him. Multiply this activity several times a year and you will create a nice stream of mailbox money. My friend is hoping to eventually replace his software engineering job for passive note income. He will eventually do it.

I have another friend that buys run down houses that need a lot of work, but are still houses you can live in. She turns around and does what is called an “equity for repair” deal. In this deal she finds a contractor that needs a place to live and sells him the house for a below market price (because it needs work), but a lot more than she paid for it. Part of the deal is that he must repair this house and fix it up over time, but he is literally building equity with his labor. Remember he owns the house. She sells it to him on a contract for deed for more than she paid plus interest. She doesn’t have to go fix things like a rental property, but still has a valuable cash flowing asset as the contractor makes house payments to her each month. As your assets increase, so will your income. Using that income to widen the gap further and building more capital will increase your cash-flowing assets.

Focus on Expenses

I started by talking about raising your income over time, which is an essential part of widening the gap, but your gap never widens if your expenses increase along with your income. It stays the same in a best-case scenario or worse, shrinks as costs creep higher or your income fluctuates. To truly widen the gap, you must control expenses. You can shrink them from where they are or keep them from expanding over time. Ideally, you do both. You maintain a conservative lifestyle and look for ways to cut expenses. Here are the large areas that most people should focus on.

Housing

This is probably the single most significant expense that most people have. So, looking for savings here is a logical place to begin. There are many debates in the financial community about housing. I will focus on a couple of areas.

Rent vs. Buy

The largest debate among financial writers is the disagreement on buying vs. renting. I am firmly in the camp of buying. Rent increases for most people every single year. If you purchase a house, you can lock in a large part of the cost with a fixed 30-year loan. Your property taxes and repair expenses will increase, but your principal and interest portion of your payment will stay fixed. In addition, you will benefit from your loan’s amortization over time. You will also benefit from any appreciation that occurs over time. The cost of housing will only increase over time. The longer you wait, the higher the expense. We see first-time home buyers now using approximately 38% of their monthly budget to get into a house. This is already bad, but it is likely to get worse over time, not better.

You can also tap into your home equity after owning your home for a while, paying it down, and gaining some appreciation. If you start in a modest home initially and decide to purchase a nicer house in the future, you can roll the equity from your existing house into the new house. You can also house hack by living in the house for a while, fixing it up, and keeping it as a rental when you move to your next home. I have used this strategy and love the result. You could replicate this strategy repeatedly. You buy a house and live in it for a year or two and then move but keep and rent out the old house. Each loan you get will be an owner-occupied loan (best rate and terms) while helping you to build a rental property portfolio.

If you happen to be buying houses that appreciate or you improve them, and they are worth a lot more when you sell. You can take advantage of section 121 of the tax code, which allows you to sell your primary residence and keep most of the capital gains (speak with a CPA) from the house tax free. There are case studies of investors doing just this and some making well over $1,000,000 in a relatively short period of time, all tax free. Neither of the above strategies are available to you as a renter.  

For example, my current house has a monthly payment of principal and interest that is lower than the rents from any of my rental properties. I still pay taxes and insurance on top of this, so it isn’t a perfect comparison, but it illustrates the concept that I can live in a nicer house at a lower portion of my monthly budget because I have always chosen to own rather than rent.

I have a rental property that a new homeowner could have purchased with a 6% mortgage in 2010, and today would be paying approximately $360 for the mortgage, insurance, and taxes. I currently rent that house for $875 and could probably get $925 for it, but I try and keep my rent a little below market rent, so they are easy to fill and keep people long term. This is a decent neighborhood and not some war zone, in case you are wondering. I happen to live in a town where housing is still reasonably affordable compared to other cities.

I know some financial writers claim because your house doesn’t produce cash flow and because it requires you to put money in, it isn’t an asset. I would disagree. First, renting also is an expense. Second, if I utilize Section 121 or house hacking, I can turn my home into either tax free cash or rentals when I move. I think everyone should own their home and not rent. As a real estate investor, I am glad there are plenty of people that disagree with me 🙂

Location – Location – Location

There is an old saying in real estate that all real estate is about location, location, location. I am referring to where you choose to buy your house. If you choose to live on either coast or most large cities, your cost of living will be higher, including the price you pay for a house. If you locate in a smaller city, your cost of living is likely to be lower.

If you live in Seattle, Portland, New York, Miami, Boise, Phoenix, Denver, or several other large cities, you will pay substantially more for a house than in the Midwest. This comes with a tradeoff. A smaller city doesn’t have as large of an economy, and you lose out on some cultural attractions that come with larger cities. I understand that, and ultimately everyone must make that decision, but I find that I can travel to see culture and still benefit from a lower cost of living in the Midwest. I could choose to live in a larger, more expensive city, but because my housing and other expenses would eat up more of my monthly budget, I would still be missing out on things.

You should consider where you live as an X Factor that can increase your standard of living (economically speaking) and take a lower portion of your monthly budget. I like the lifestyle I get in the Midwest, and I like the cost I pay for it even more. I can live in a much larger and nicer house with a large yard for a far lower chunk of my monthly budget than I ever could in a larger or coastal city because I have factored location into my housing decision.  

Transportation

This is probably the second largest expense outside of housing for most people. This is another area debated in financial circles. You have two basic choices here as well—own or lease. I am *generally* in the own category most of the time, but I have also leased vehicles.

I have one factor that drives my decision above all others—the monthly cost. I am not “a car guy”; therefore, the type of car, brand, etc., means very little to me. I am practical about transportation; I need it to move me from point A to point B reliably and with a modicum of comfort. I don’t need it to impress anyone, and if my car goes unnoticed by everyone, even better.

To that end, I view a car as a necessary but annoying expense. So, if I can keep the monthly cost as low as possible, I can drive my gap wider. Sometimes I can achieve this utilitarian need by buying a used car, but my preferred way has generally been to purchase or lease a new one and NEVER sell it. If you buy and later sell, you will lose, but if you buy new, maintain it well, and drive it until it literally has no life left and needs to be hauled to the junkyard, you have pulled every dollar of economic value from the vehicle.

Stick to reliable and inexpensive brands, which makes even more sense in my book. Think of a car as a subscription service. The lower the subscription cost, the better off you are. I pay a monthly “subscription” for transportation, and I need that subscription to be as low as possible and stay that way as long as possible.

Used Car

I am all for buying a used car if you can get it at the right price, but that is the problem today. Used car prices are climbing through the stratosphere, and availability is almost non-existent. Even lower-cost brands with high miles, lots of wear, and unknown maintenance habits are going for staggering money. It has been this way for a long time. For example, an 8-year-old used pickup truck with 80K+ miles can easily cost $25-30K! A new one can cost as much as a house in some markets. So used doesn’t always mean low cost. If you can still locate an affordable used car that isn’t on its last leg, this is still an option. I have not done well with used cars, and I have often found them beat up with poor maintenance and need to put a lot of money in immediately.

New Car

A new car purchased directly from the dealer is an option but probably the most expensive option. Even with non-luxury brands, car payments are easily pegging $500 or more per month. This violates my rule of keeping those monthly costs low, so I can drive my income and expense gap wider while still covering my transportation need. So, I am no longer a fan of this option. I have purchased a couple of new vehicles over the years, and I have driven them until there isn’t an ounce of value left in them. I have kept cars for 12-14 years, and I take care of them while I own them, which stretches the life out even more. Unfortunately, today, new car prices are increasing to massive levels that bring high monthly costs and are rough on an income/expense wealth gap plan.

Leasing

This is currently my favorite option. I can lease a new vehicle for a low monthly payment, which meets my criteria for keeping costs down and driving a gap between income and expense, but this is like renting. The 3-year lease leaves you at the end without anything. You are either forced to buy a new/used car or lease again, but you can also buy your lease out.

Buying my lease out recently worked well. I purchased an extended warranty on my most recent leased vehicle. When it came time to renew, we were under the Covid supply chain problem with 8.5% inflation and almost no dealer inventory, and skyrocketing used car prices, if you could even find one. I bought out the lease and came out smelling like a rose. When I started the lease, I didn’t anticipate this scenario; it was the world we lived in when my lease was up.

For a predetermined cost established at the beginning of the lease, I could buy it out at a price way below what a comparable used car would have cost at a much lower monthly payment. This might be luck, but it was good luck in this case. Until I have more data that contradicts this experience, leasing and buying out at the end has worked out the best for me. Leasing has kept monthly payments much lower. When I bought out the vehicle in the end, I was buying it out at a price that was way better than I could have purchased the exact vehicle from a dealer or private party, plus I also knew the maintenance history. This option helped drive my gap wider than other options.

Affordable Brands

One more note here. I have always stuck with reliable lower cost brands of vehicles. I love pick-up trucks and they are very practical vehicles, but also pretty high in cost these days. As a result I have pretty much stuck with an SUV that was decent on gas mileage and lower in cost. My wife and daughter are fans of Honda. I won’t make a recommendation here, just a suggestion that you try and choose brands and vehicle types that meet your needs, but don’t break the bank. I have seen some people buy brand new pickup trucks that cost $80,000 with staggering monthly payments. Worse is people that go out and buy luxury vehicles like a BMW or Mercedes. If that is your thing, more power to you, but I prefer to keep my monthly expenses lower and drive ordinary vehicles that blend in.

Cash Purchases

The last option I will mention is saving up enough cash to simply buy a car for all cash when you need it. No bank loan and no interest. This method can be applied to new or used vehicles. Many financial gurus will tell you this is the only way to purchase transportation. I am all for it, but I am also realistic that most people can’t save up enough cash to even invest, much less buy a car, especially at today’s prices, for all cash. If you can pull this off, you should do it. For the last several years, I have found low-interest rates, and great credit has created cheap enough financing for me that I have found more profitable things to do with my capital than plop it down on a car. That might change as interest rates increase and the supply of used vehicles shrinks, thus affecting prices. The next time around, I might be a cash buyer.

Think about this when it comes to purchasing a car with all cash and we happen to be a low interest rate period, which right now is changing drastically in the wrong direction. However, if I can purchase a used car and lock in a loan for 3-4% then all I have to do to improve my situation is put the cash I would have paid to purchase outright and invest it at a return greater than 4%. If you can’t find a safe investment earning better than 4% I am not sure you are looking hard enough.

General Thrift

Rather than spend a lot of space writing about other minute details of cutting your magazine subscriptions and buying generic peanut butter, I will say that practicing general thrift in other areas of your life, from entertainment to clothing, will be ongoing. It is also one that is personal to each person. What I find tolerable in this area might be a bridge too far for you and vice versa.

I will note a few areas that you should watch closely as they seem small but, over time, add up fast. Tracking your spending in these areas for a month or two might yield some interesting observations.

Dining:

Eating out has always been an expensive option compared to making food at home. This is compounded by 41-year high inflation and severe shortages in the supply chain of every type of food item, and restaurants that are forced to raise prices a lot to compensate. Eating out for lunch, breakfast, and expensive dinners can add up quickly. Once I cut this down to only eating out a couple of times per month, my budget and waistline improved.

Coffee:

This is a big one for a lot of people. The daily trip(s) to grab your $6.00 beverage of choice can easily tack on $120-200 per month in expenses. If you calculate what a $200 per month habit costs you, especially when you figure out what that same $200 invested at 12% can yield over 30 years, you might make a different choice. If you are wondering, my financial calculator says $200 per month invested at 12% for 30 years adds up to $698,922.83 over 30 years! That is some expensive coffee!

Entertainment:

We all need a diversion from time to time, but if you still have cable instead of streaming or going to a lot of concerts or movies, you might want to do a little planning and observation in this department. I have found a lot of room in my expenses in this area that was easy to trim down without giving up too much. Again, before your next outing, be it a vacation or concert, drop the anticipated expense of doing it into your handy financial calculator and see what that money would grow up to if invested at 12% for 30 years. For example, say you were planning a vacation that you expected to spend about $3,000 on over a week. If you invested $3,000 at 12% for 30 years, it would grow to $107,848.92. That better be a fabulous vacation to give up that much future potential.

A friend and fellow investor said over many years he was able to go down to where a concert was held and hang around outside for an hour or two before and pick up discounted tickets all the time from people that couldn’t go or had someone, they bought a ticket for bail on them. These people would go down to the concert area hoping to find a someone like my friend to sell one or more tickets to. He said he attended a lot of expensive concerts and sold out shows for a fraction of the cost. If you are creative, I suspect there are a lot of areas in the entertainment category that can be had for a lot less.

Clothing:

This is another area of spending that can quickly become a problem. Name-brand clothing can add up quickly. Toss in regular shopping trips and new clothes each month, and you find you are spending a mint. Again, your decision in this area is a personal choice. All I am suggesting is that you track and observe it for a few months. Once you have an average, figure out what that money could have earned if you had invested it for 30 years at 12%, and once you see that number, figure out if you want to make other choices.

The Financial Ogre

You might be thinking that some of the expense reductions I have outlined above and what that money could have turned into over time is an unfair argument. Some will say that you need to live your life and you can’t be a financial ogre or scrooge that never spends money on anything or ever goes on a vacation.

I am not suggesting that. I am saying that you should be making informed decisions. Tracking your spending and using a financial calculator to see what that money could become if properly invested may give you pause and convince you to make alternative choices.

You don’t necessarily have to live this way forever. The way I lived in college isn’t how I live today, so obviously, my lifestyle has increased over time, but I have always been cognizant of what I was spending and what alternative uses it could have. I made informed decisions to maintain and widen my income/expense wealth gap over time.

For example, if I have a gap of 10% between income and expenses and increase my income by 20% and expenses by 10%, haven’t I effectively increased my lifestyle and gap? Alternatively, if I take extended time off from my business and my income drops by 20%, and I cut my expenses by 20 or 25%, haven’t I maintained or even increased my gap while simultaneously increasing my quality of life?

Financial Calculator

A financial calculator and the ability to use it is an essential investor tool and critical for building wealth. Think of it this way, would a pilot fly a plane at night in the fog without instruments to guide them? Probably only the dumb or suicidal ones. It is the same with investors and a financial calculator.

I was taught to use a 10bii financial calculator app from In a Day Development that you can purchase for $5.00 bucks to install on your phone. It is relatively easy to learn and can easily calculate the rate of return of various investments over time plus do a lot of other cool things.

Now you may be wondering where the heck I am going with this. Think of every single dollar that you spend as an investment. You can invest it in housing, transportation, dining out, coffee, etc., or you can invest it in assets that produce a rate of return.

I am suggesting that you calculate what you are currently spending for the various categories above on the expense side of your ledger and compare those expenditures to an investment that is a 30-year 12% rate of return, which isn’t hard to achieve as an alternative investor.

Your daily cup of Joe might cost you well over half a million dollars over 30 years. If you knew that, would you make another choice? If not, fine, but you owe it to yourself to at least see what you are giving up by making that choice.

The Financial Freedom Equation

I was recently taught by Gary Johnston the Financial Freedom Equation. It is a simple equation. Here it is:

Cash flowing Assets > Expenses

Your income from cash-flowing investments such as rents and interest exceeds your monthly expenses. As I have detailed above, this equation has two basic components, income and expenses. I have added entrepreneurship to my income-generating side of the equation, but Gary uses rents and interest. Rents are generated by real estate, and notes generate interest. He likes passive income, and I do as well, but I also enjoy the thrill of entrepreneurship.

The main point here is that driving a large gap between income and expenses at the beginning of your journey will allow you to accumulate capital quicker than a small gap. That capital can be invested in cash-flowing assets, which will buy you financial freedom. The larger the gap, the faster you reach financial freedom.

If your income from cash-flowing assets exceeded your monthly expenses, how long could you go without working? If you answered forever, you would be correct. Keeping expenses controlled is part of the financial freedom equation. If your expenses go up, so does the need for more income from all sources. Understanding what you give up by spending today and how long it will take you to achieve financial freedom. A financial calculator and the ability to use it will help a lot.

Conclusion

The main takeaway from this article is that to achieve financial freedom where cash-flowing assets exceed expenses requires planning and commitment. You need to maintain a gap between the two, and the more significant the gap, the faster you can grow your capital and investments.

If your goal is to achieve financial freedom, that should be driving your income and expense choices. Every choice you make today will affect your present and future, and using a financial calculator will help you figure out what those present choices will be worth in the future.

You owe it to yourself to understand what present choices will yield in lost or gained future benefits. Whatever choices you make today will alter your future for better or worse. I am suggesting you be purposeful and deliberate in your choices. Know what they will yield in the future and decide if that knowledge will alter your present decisions. Maybe it will, and maybe it won’t, but again, be deliberate about it.

If your $200 a month cup of coffee habit is what brings you joy and the loss of $600K over 30 years is less important than carry on, but you might decide that coffee at home tastes a lot better when 30 years from now, you have an additional $600K in assets throwing off income every month to you.

Happy wealth building!