I find it intriguing that many financial experts are torn on the earn more, spend less debate.
When I first began learning about personal finance, almost every blog I read focused on living below your means (i.e. frugality). The first personal finance book I read, The Millionaire Next Door, wrote about millionaires with a frugal mindset. Most of the millionaires were self-made due to their frugal habits. The majority did not drive fancy cars, have fancy clothing or live the “millionaire lifestyle” we associate with these wealthy individuals. Instead, they focused on cutting their expenses and living well below their means to increase wealth.
On the other hand, I have read many blogs that say you can’t get rich by being frugal. They emphasize the earning side of the equation rather than the saving side. Rather than cutting back on the typical expenses such as cable and caffeine, they focus on negotiating a better salary or starting a side hustle.
So which approach is better?
Let’s look at the differences between the two methods.
Penny pinching is the art of frugality. Those that are penny pinchers focus on living below their means. They want to reduce their expenses and manage their money to attain their long-term financial goals.
The great part about this method is that anyone can be frugal. I am in the process of searching for an apartment to live in and my number one criteria is the price of rent. This is something that I can control. If I find an apartment that is $50 cheaper a month, it saves me $600 a year. However, that statement is wrong. In the context of earning more versus spending less, you need to take into account taxes. See, when you make money you have to pay taxes on your income. Here is a simple example:
Taxes: Federal 20%, FICA 7.65% (US only), State 2.35% = 30% Total Taxes
Savings are in after tax dollars so we need to convert them to pre-tax dollars for comparability. To do this, simply divide 600 by (1 – total taxes). In this case, it amounts to 600/.7 = $867 pre-tax dollars. This means that $600 in rent savings is equivalent to earning $867. Spending less makes more sense in this equation because you need to work harder or longer for $867 as opposed to saving $600.
Another important point to be made is that income does not determine wealth. Think about the number of people who win the lottery. Many go from average to rich in a matter of seconds. They spend their new found wealth on buying that large house, shiny sports car and all the luxurious items we associate with the rich and famous. However, due to their spending habits, 70% of them end up broke. This is why income does not determine wealth. Whether you make $50,000 or $500,000, you still need to live below your means.
Like everything, there are some downsides. You will find yourself saying “no” more often than you want. When your friends are spending their paycheck at the bar, you may be home watching Netflix. Additionally, there is a limit on how much you can save. You can only cut your expenses so much until you are stuck with the bare necessities. Finally, you may feel like your life is very dull. Often times you may question, “How can I afford it, without breaking my budget?” Where does that vacation fit into my budget? If you only make $3,500 a month and your goal is to save $1,000, it may be very hard to enjoy much outside of the basics of life.
Often times they laugh at people who recommend the classic advice of cutting back on caffeine. If you are able to negotiate a salary increase, the small savings gained from cutting back on caffeine seems a waste of time.
I mean, hey, who would not want to increase their income by $1,000 a month? If we took the tax example from above, this would be equivalent to cutting back $700 on expenses per month. The idea here is that there are opportunities available to increase your income to allow you to live the life you want. Often times increasing your income via a side hustle or negotiating a higher salary is the best way to earn more. For instance, I started this blog as a side hustle. While it is not a get rich quick scheme, it allows me to diversify my revenue streams so if I lost my job tomorrow I would still have some, very little, income coming in.
Just like being a penny pincher, there are arguments against this method. The first one is that not everybody can earn more. Unlike cutting cost, something everybody can do, earning more requires some skill, motivation, and luck. Luckily, there are thousands of ways to make more today. Whether you are an Uber driver or a tutor, we all have some skill. Another argument is that even if you increase your income, you still need to manage your money. Without frugality, you will live the paycheck to paycheck lifestyle regardless of how high your income is.
Which method is best for you?
In the ideal world, you would increase your income and cut back on cost. When you increase your income lifestyle inflation may occur. With a $5,000 raise, you may think you can take a $5,000 vacation a year. This is where frugality comes into play. Learning how to balance your income growth as well as limiting your spending will create wealth.
This is why I personally believe it is more important to be frugal rather than earn more. Without proper spending habits, your income means nothing. However, with that said, increasing your income allows you to exponentially increase your wealth and achieve goals quicker. If building wealth is your goal, penny pinching and increasing your income should be used simultaneously!
What mindset do you have? How do you negotiate a higher salary or start a side hustle? How do you manage your spending?