One of the mantras that we hear a lot in the world of personal finances is “budget, budget, budget.” But is this type of mentality really the best way to build wealth? More and more, some in the personal finance realm are starting to switch to a net worth mentality in order to better define progress on the road to financial independence.
I see a budget as more of a management resource. When you focus on a monthly — or even a yearly — budget, you simply managing your resources. You keep track of your income, and you make adjustments in order to keep your expenses from over-running your income. In this scheme, small amounts — like $10 or $20 — don’t really make that big of a difference. After all, if there is room for it in the budget, spending it on a lunch out or a couple of lattes doesn’t really matter. It isn’t going to mess things up for your budget.
However, I do see value in the budget mentality as a valuable tool to help you learn financial self-discipline. It is also great for getting started in managing your own personal finances. You get used to understanding how cash flow works, and you learn how to prioritize. But I think that once you have the budget down, and you have established a solid foundation, it is time to expand your horizons to a net worth mentality.
The net worth mentality, on the other hand, forces you to consider things from a long-term standpoint. The net worth mentality goes beyond simply managing your resources month in and month out. Instead, you focus on a plan for building long-term wealth. Sure, with a budget you can set aside money for savings. But with a net worth mentality, you look at ways to grow small amounts of money into larger contributions to your financial independence. The Simple Dollar offers this illustration:
You might not think a change that saves you $10 a month is a big deal from just the view of a monthly budget, but that $10 saved every month over ten years creates quite a different picture – used properly with an 8% annual return compounded monthly, that $10 a month becomes $1,802.12.
I think that nicely captures the difference between a budget mentality and a net worth mentality. If you have a net worth of $100,000, that’s almost 2 percent of your net worth. Consider what would happen if you could make several $10 changes a month, or if you could make some larger changes.