Why Higher Income Doesn’t Always Equal Higher Net Worth
- April 9, 2018
- by Emily
When people talk about being wealthy or “rich,” they rarely pause to define wealth—this is true when you’re talking to a neighbor but also often true when you’re reading about wealth in the newspaper. So it’s no wonder that many people are confused about the relationship between net worth and income… and which is most important to being “rich.”
It would be disingenuous to say that there is no relationship between net worth and income, but they are different parts of an individual’s financial picture. Calculating net worth is an income-blind exercise… on the flip side, calculating your total income does not take into account the resale value of your assets in any way (some assets generate income, but that income stream is different from the asset’s market value).
Is there a Correlation Between Net Worth and Income?
Yes, but it’s not as strong as most people assume it would be. People with higher incomes do have, generally speaking, larger net worths, but the correlation is relatively weak. It’s also not clear if higher incomes cause net worth to be higher, or if it’s the other way around—that people with a high net worth are more likely to become high earners.
The reason that high income doesn’t always translate into high net worth is simple: Most people spend a significant portion of their income.
Another way of looking at this is: What people spend is relative to what they make.
You can only build net worth if you save money and pay down debt. If all of your income is going towards car leases, clothing, food, rent and entertainment, it doesn’t really matter, in terms of building net worth, whether you earn $10,000 per year of $100,000 per year. If you spend it all, your net worth will not grow.
At Wealth Meta we think it makes more sense to look at purchases in terms of utility, in order to maximize what you get and pay the least. This also includes looking at maintenance costs associated with more expensive purchases. Generally speaking the bigger the house, the bigger the tax and maintenance bills.
So Income Doesn’t Matter?
A former mentor of mine taught me:
It’s not what you earn, it’s what you keep.
If you make $100,000 per year, you could opt to save or invest $20,000 annually. If you make $10,000 per year, it’s pretty obvious that you can’t put $20,000 away for retirement every year. So yes income does matter, but only if you are inclined to make your money work for you.
Consider a software developer who makes $112,000 per year and saves $2,000. They are saving about 1.7% of their income. Compare that to a freelance photographer who makes $38,000 but saves $3,000. The photographer is saving about 7.9% of their income and manages to do more with less. Some people are able to achieve upwards of a 50% savings rate. The higher the savings rate sooner things like financial independence and early retirement become a reality.
Saving is easier to do if you have a high income, but it’s possible at most income levels. In fact, for a family that makes the average income of $55k, if they save 15% of their income ($8250/year), at a 7% return they will end up with $1M after 30 years, and over $2M in 40 years.
Home ownership plays a role in building net worth, to which income is a key ingredient. It is much easier for people with higher incomes to become homeowners because A) their income helps them qualify for a loan, and B) they are able to save for a down payment. Mortgages are a kind of forced savings in that each month a little bit of the loan balance is paid down. In addition homes tend to rise in value in the long run. So the ability (or lack thereof) to buy a home is important in the acquisition of wealth over time. Whether or not home equity is included in net worth is another conversation, but it should be counted in "total net worth" which is everything a person owns minus debts.
Age, Student Loans, and Debt Are a Big Factor
The other reason that net worth and income are not strongly correlated has to do with age and education. Many young people in high-earning professions also have enormous student debt burdens. Consider our comparison of becoming a Plumber vs a Doctor where the doctor is $390k in debt after 8 years of school!
Eventually, statistics say, these people will build a net worth that will surpass their lower-earning, higher-net-worth peers—but it will take years of student loan payments to do so. So just because a newly minted corporate attorney or brain surgeon looks rich in terms of a fancy car and a big house, on paper their net worth might be small or even negative for the time being.
Building Your Net Worth
The bottom line, when it comes to building net worth, is to not to spend all of your income. Gurus call this "paying yourself first". Building net worth is a result of paying off your debt, saving money and, investing the money you save so it starts to work for you. An essential element to doing this is to establish a budget and stick to it.
We know getting started at growing your net worth it not easy. Our related post on automating your retirement contributions explains how to take out the stress of investing each month.
Tracking Your Net Worth
In order to build your net worth you need to actively manage it. That means you know what it is, check it regularly, and keep it aligned with your desired asset allocation. More than likely for a person who has been saving for a few years, net worth ends up being spread across multiple financial institutions in a variety of assets. To solve this problem (for ourselves and our readers) we created a tool called the Net Worth Dashboard. It supports publicly traded tickers symbols (stocks, ETFs, mutual funds), but also offline assets like private investment funds, cash accounts, or even your rare book collection. Give it a shot and let us know what you think!