The 20% Gap: The Best Path to Financial Well-Being
There’s this little thing everyone wants called financial security. Even better, financial freedom. Yet only a small percentage of us ever seem to reach either one.
The reasons are fairly straightforward.
For many, if not most people, earnings minus spending seems to leave little (or nothing) left over. There are bills to pay. And there are a lot of cool things out there to be had. Houses, cars, clothes, gadgets, vacations. Whatever it is that makes your heart sing—you want it in your life. And even if you don’t have the money for it, there are banks ready to loan you the money and take your future earnings in exchange.
But even if you can afford it, even if you have the cash now to live the way you want, there is a limit to how much of that money you should spend. Seems obvious, right? Yet research suggests many people don’t stick to it.
As T. Harv Ecker, author of Secrets of the Millionaire Mind: Mastering the Inner Game of Wealth, brilliantly puts it, you have to remember that earning or having money doesn’t mean you keep it, and being rich doesn’t mean you’re financially free.
In other words, you have to work at keeping money and being financially free—strategically—in order to get there.
Assuming you’re not already financially set for life (so that you never have to work again based on need), one way to work this is to know and stick to the 20% gap.
What is the 20% gap?
If you earn a million dollars a year, and spend $1.5 million a year, you’re a high-income earner. But you’re probably broke and in debt. We see this with celebrities and sports players all the time. By the same token, if you earn $50,000 a year and live on $40,000, saving and investing $10,000 a year, you will be growing your net worth nicely. You have a better chance of becoming a millionaire than the person who earns over a million and spends it trying to maintain a “rich” lifestyle.
Thomas Stanley, author of the classic, The Millionaire Next Door, who studied millionaires for more than 30 years, suggested that it can take higher-income folks such as like doctors and lawyers, longer to achieve millionaire-status than those earning an average income. That’s because the former tend to get trapped in a cycle of keeping up with the lifestyle of their peers.
Not only can this be financially unsustainable, but it causes the kind of stress that can ruin your health, relationships and seep into every area of your life.
It’s a matter of asking yourself what you really—deep down—want. If you value financial freedom, this is where the 20% gap comes in.
You never want to be spending on your lifestyle 100% of what you bring in. There should always be a 20% gap (or cushion) between what you make and what you spend.
If you can maintain a 20% gap between what you make and what you spend and put that 20% toward saving and investing, you begin to grow your nest egg and create that financial security you want.
The concept is simple. And while we all know it’s not so simple to implement, it’s crucial to your financial well-being.
The first thing you need to do is figure out exactly how much income your household brings in each month. Then you need to know how much 80% of that amount is. That amount should cover all of your spending for necessities and non-ncessities.
Once you know how much 80% of your income is and therefore what your maximum spending for sustainable financials should be, you can also break down how much to earmark for necessities vs. non-necessities. A good rule of thumb for dividing that 80% is to put 62.5% or less toward your living expenses and 37.5% going to non-necessities. In other words no more than half of your total income should go to your living expenses. If you’re spending more than 50% on your mortgage/rent and living expenses, your expenses in that area may be unsustainable unless you’re spending less on non-necessities.
The goal here is to spend 20% less than you make. If that’s too difficult to do or adjust (because it will be difficult, but how difficult is the question), unless you’re circumstances are a rare exception, you may not be able to afford your current lifestyle exactly as it is. Consider cutting expenses somewhere or earning more money to get that cushion in there.
If you feel like you can’t do that but want to, you may want to switch gears now, and start making this a real focus in your life. Rather than winging it, start actually working toward becoming financially free. Just a little more intention and strategy can completely change how you think and the actions you take.
Small steps done daily add up.
Take small steps to cut out the things that are not meaningful to you. Get your family on board; do it together. The lessons you teach your kids by doing this will be invaluable for their financial future. You can cut out meaningless spending and budget money not only for saving but for putting toward the things that make your heart sing. It’s not about denial, it’s about re-directing your spending so it has a greater impact in creating the life you want.
In other words, many people focus on living the life they want right now before they can actually afford it. In that case, you’re going to be money-stressed and not reaching your goals.
Instead of focusing on what you want right now, try focusing on the big picture—financial well-being as part of your daily life. That doesn’t mean cutting out the things you love. Include them where you can. But focus on creating that healthy financial foundation, and build from there. (Again, re-directing your spending to consciously create the life you want).
If your true goal is financial freedom, and you’re not there yet, then it’s time to take new action and get different results. Nothing changes without new and different action. Even one new action at a time, done consistently and persistently, will get you where you want to be faster than doing the same thing every day and getting the same results you always have.
Some things you can do:
- Look for the expenditures in your life that don’t actually increase your long-term happiness. It’s different for everyone. For some, those morning lattes may be their joy, while for others they can be cut out in favor of coffee made at home. Do an inner-joy-check on everything you spend on, and cut it out of your life if it doesn’t pass. This may seem insignificant, but cutting costs can often bring you higher returns than investing in the stock market.
- Outside of your basic needs, spend on things that produce income or take you closer to your goals, and re-evaluate the things that are an expense and move you away from your goals.
Granted, it’s not easy to do. But know that you can achieve financial well-being and/or freedom, and that people who’ve had huge obstacles in their way do it every day. It’s a matter of getting even a little bit more strategic about it. Putting some focus into it. It begins with creating a saving and spending plan and sticking to it; tracking your savings growth; reminding yourself every day of your goals and dreams and taking even one action. It does take time, effort and planning, but it’s time and effort well spent. Just think about how good you’ll feel knowing you’re moving forward.
What one new action will you take today? Let us know in the comments below. We’d love to hear your feedback.
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