Wednesday, March 12, 2008

Income vs Wealth

Many people tend to confuse income and wealth. We automatically assume that rich people have high incomes or, more frequently, that people with high incomes are rich. This may be true but, while working as a mortgage loan underwriter in a savings and loan years ago I frequently reviewed loan applications from people with rather high incomes but little or nothing in the way of net assets. Oh, they often had a number of items listed in the asset column of their loan application – expensive cars, boats, etc. however, in the liability column to the right of the asset column were debts that more than equaled the stated value of the assets. While the incomes of many of these people enabled most of them to obtain the mortgage they were applying for to purchase their dream home, they could hardly be considered rich or wealthy.

Income is the money one receives from their work (this is the most common source of income) or from owning a business, property one can rent or from other income producing investments. Wealth, on the other hand, is the ownership of income producing assets. All wealth originates as saved income – a person either saves and invests a part of their income or they inherit assets from someone who saved and invested their income. Most truly wealthy people will use the income produced by their assets but generally will not sell their assets and spend the proceeds on consumption as this will reduce their wealth and the income it can produce.

I mentioned above that a high income does not necessarily mean that a person is wealthy. Ironically, a large number of the self-made millionaires do not have high incomes. Instead they accumulate their wealth over time by regular savings (and prudent investment of that savings) or by starting a business and plowing much of the profit back into the business each year to grow the business. While some people with high incomes do save and invest regularly and build that savings into true wealth, many people with very high incomes – sports figures, movie stars, some entrepreneurs whose businesses take off and makes them a millionaire over night as well as most people who hit it big by winning a lottery frequently end up spending their money as fast as they acquire it and end up broke when they lose the job that is producing the income for them.

Just as in the old fable about the hare and the tortoise, it is usually the person who steadily saves and invests money over time who retires wealthy while the person who begins the race by being first out of the gate with a high paying job, ends up with little or nothing to show for their efforts in the future.

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