Mind The Gap (Ratio)
Mind The Gap
The phrase was first coined in 1968 as an automated auditory warning to train passengers on the London Underground making them aware of the horizontal and sometimes vertical space between the train door and the station platform. The gap was something to be cautious of and navigate carefully. In financial circles, there is another type of gap to discuss. One that we want as big as possible if we are going to power our road to financial independence.
These thoughts sprung from a comment on my blog the other day by Shawn at thesmartfi. He wrote:
I am learning the path to FI is not the same for everyone. The bottom line is the bigger the gap between earning and spending equals a faster path to FI. My path may be slower than some because of a smaller gap.
His point made me realize that for most of my journey, I have generally concentrated on the earning side. My 175K/year annual budget hardly qualifies me as a low spender. What eventually supercharged my progress towards FIRE was adding in a few sprinkles of frugality to my already high level of income.
For once, I was working both sides of the equation.
This has always been the part of the equation that I am most comfortable with. I was groomed by my parents to be a high earner. I had both the opportunity and financial support to go to medical school. I watched as a child as my parents owned businesses, ran side hustles, and became real estate investors.
Under my parents tutelage I learned how to multiply my W2 income from X to 5X. I developed a side hustle selling art work. I bought and rented condos to create cash flow. I developed a knack for lazy side hustles which produced extra income with little or no learning curve.
I have always felt at home with this side of the gap equation.
What I never realized before, is that the expense side of the gap equation is just as important as the income. Although we are familiar with the idea of budgeting, our family has always thrived more in a non-budget environment. My parents were the ultimate stealth wealth practitioners, but I never really noticed. We still lived in a big house and went on great vacations. It was only as I got older, that I realized that they spent only a small fraction of their yearly income.
I have started to improve this side of the gap. When I fired my financial advisor, I saved roughly eighteen thousand dollars a year. Then I cancelled my life insurance policy.
If my wife decides to leave her job, we will no longer need child care which could save another $25K a year.
The gap ratio
So if you want to reach FI, your income doesn’t matter. Your expenses don’t matter. What truly matters is the difference between the two.
Income (after tax)-Expenses= The Gap
The point is to increase income or decrease expenses or both. In my estimation. You would like your expenses to be either less than or equal to The Gap. This would be the same as saving 50% after tax income or a gap ratio of 1.
The gap ratio thus becomes:
The Gap/Expenses= The Gap Ratio
The math is simple.
If you make $100,000 a year post tax, and you spend $50,000. Then The Gap is : $100,000-$50,000= $50,000. The Gap Ratio is $50,000/$50,000=1. A gap ration of 1 correlates with a 50% savings rate, and starting from year one will take 17 years to retire.
If you make $100,000 and spend $25,000 then $100,000-$25,000= $75000. $75,000/$25,000=3. A gap ratio of 3 correlates with a 75% savings rate and will take about 7 years to retire.
I like using the gap ratio because it is simple to calculate, and your goal should be somewhere around 1 (saving 50%). The higher the number, the faster you will be retiring. The lower, the longer you will toil with your W2 wage.
Based on our yearly income, our household Gap ratio comes out something like this:
Gross Income: after tax: $420,000. Expenses $175,000. $420,000-$175,000= $245,000
$245,000/$175,000=1.4. Savings rate is about 60%. Starting from zero, it would take us 13 years to retire.
What’s your Gap Ratio?