The basic math behind financial independence is actually not that difficult to understand. The more you save, the quicker you get there regardless of what the stock market does. In other words, controlling what you can control in the form of your savings rate will also be the most impactful that you can do. While not difficult to understand, following this advice year in and year out is incredibly difficult!
Below is a chart that shows how long until you reach financial independence given your savings rate. As with any financial model, I’ve made assumptions in order to isolate the impact of just the savings rate. In this case, I assumed a 5% real return (about 7% nominal return) during the investment period with a 4% withdrawal rate. These assumptions are probably considered the standard math that most financial professionals would use.
If you follow the mainstream media’s advice and only save 10%, you’ll be financially independent in a mere 50 years. Now, to be fair, this is not exactly a fair comparison. This compares only an individual’s savings relative to their full monthly expenses. Most of us have other sources of savings that work in our favor. For example, US citizens have Social Security and many employees also receive a match into their 401k from their employer. These both have the benefit of increasing an individual’s savings rate without actually requiring an individual to save very much. A 5% savings rate can turn into a 15% savings rate at least between these two benefits. Nonetheless, I and many reading this are more interested in becoming financially independent far earlier than our late 60s.
Many in the FIRE community will have undoubtedly seen a chart like this in the past. They may be slightly different based on assumptions, but the graphs all ultimately look the same. Saving 20% will give you financial independence in about 36 years, even after ignoring something like Social Security (in reality, due to Social Security, you could retire earlier than that). Someone working from age 23 right out of college could retire in their 50s with a 20% savings rate– definitely an “early retirement” by society’s definition, but not exactly what we’re going for. A 30% savings rate knocks nine years off of that number. A 50% savings rate allows you to stop working after 16 years with a high confidence that you’ll never have to work another day in your life if you don’t want to. Start saving this amount early enough and you can be one of those retirees in their 30s!
Unfortunately, life happens and most of us are not able to maintain a 40% or 50% savings rate consistently. Having kids, buying a home, losing a job, or just making the occasional stupid financial decision as we all do will push you back a few years. This is not to demoralize you, but instead it’s to shift your mindset. Let’s not think about 21 years down the road, but instead control what we can control in the here and now. Let’s take the first derivative of the above chart and look at the impact that changing (hopefully increasing) your savings rate has on reaching financial independence.
The Power of 1%
Looking at the marginal benefit of an additional 1% in savings helps provide perspective when you think about where you spend money. Using the same assumptions as above, let’s take a look at how much less time it would take to become financially independent by increasing your savings rate.
This chart is incredibly skewed because the benefit from even going from a 4% savings rate to a 5% savings rate is huge (almost 6 years less until financial independence!). Let that be motivation to those who are saving little or none – every marginal increase in savings rate is widely impactful. For the rest of us, let’s cut off the left tail and take a closer look.
The way to read this chart is to look at each point – the vertical axis represents the number of fewer months you would need to reach financial independence for each 1% increase in savings rate on the horizontal axis. For example, going from 20% to a 21% savings rate (the point in the upper left of the graph) would reduce your financial independence timeframe by 12 full months. One whole year of your life for a 1% increase in savings! There’s clearly a diminishing marginal utility here – if you’re already saving 70% or more of your income, an additional 1% doesn’t do a whole lot but you’re already kicking ass and taking names as it is! The chart is naturally a bit choppy because you have to be at or above your expenses to be considered financially independent and we’re using full months.
Additionally, this chart is additive from left to right. Going from a 20% savings rate to a 22% savings rate takes your financial independence timeframe from 36 years, 2 months to 34 years, 2 months – two full years of your life for a 2% increase in savings rate! Even going from a 40% savings rate to a 42% savings rate reduces your time by 13 months (7 months going from 40% to 41% and 6 months going from 41% to 42%). A single percentage point is incredibly powerful.
Use this chart when you look at your expenses. Let’s say your monthly budget is $5,000. Each 1% increment is only $50. If you’re already saving 30% of your income, is that high end cable package worth an extra eight months of your life? It might be, but at least when you have this kind of data, you can make a fully informed decision.
As many of you know from my recent post, I’m not a fan of the “Latte Factor” and playing small ball. Instead of focusing on the small stuff, let’s focus on the big things like earning more money or reducing housing expenses. To take this analysis one step further, let’s not bother looking at going from a 20% savings rate to a 21% savings rate, let’s look at going from a 20% savings rate to a 25% or 30% savings rate. Now we can see the major benefits of greater income and lower expenses.
Going from a 20% savings rate to a 25% savings rate knocks of 56 months (almost 5 years!) until you become financially independent. Even going from a 50% savings rate to a 55% savings rate decreases that time by over two years. Instead of finding $50 savings, focus on ways to save $250 or $500 from your $5,000 montly budget. Better yet, find ways of increasing your income by $500 or $1,000 per month. These are the things that become really impactful.
How does this work in practice? If you can get a $70,000 per year job instead of $60,000 per year, you’ve increased your after-tax income by at least $500 per month. There you go, you’ve just knocked off 3-4 years. Buying a $300,000 home instead of a $400,000 home saves you $400 in mortgage payments and several hundred more in lower property tax and insurance bills. Another 3-4 years. Buying a $15,000 car instead of a $30,000 car will save $300 per month or more. Two more years. Add all of these up, and instead of taking 25-30 years until financial independence, you’re below 20 years. Being financially independent in your 30s and 40s would lead to a truly amazing life!
Knowing the marginal cost of the actions you take is the most surefire way to live a deliberate life. Use this information as part of your decision making process. Many times, even knowing that adding an expense will make your financial independence goal further away allows you to say no. The other times when you make the opposite decision and add an expense, at least you’ve made the conscious decision.
For example, we own a lake home that we enjoy regularly and that many of our friends and family often come up to in both the summer and the winter. I estimate that purchasing this property and the associated costs attached to it moved our financial independence date back at least three years (probably longer). And you know what? It’s totally worth it. Our kids have a place where they will swim and run around in the woods throughout their childhood and we get to see family and friends more than we likely would because they all enjoy coming up as well. For us, the tradeoff was worth it. For others, it wouldn’t be.
On the other hand, there are many tradeoffs that we do not consider worth it. I drive a pretty low to mid-range car to go to and from work. It didn’t cost much, we don’t have a car loan, insurance is cheap, and it often averages over 40 miles per gallon. Could we buy a new Mercedes or something fancier? Of course; we’ve very fortunate to have a high enough income and ample savings to do so. We’d also never even consider it, because fancy cars do not provide us a level of enjoyment that would correspond to the cost. There are many people where owning a car like that would provide a huge level of enjoyment, and so long as they’re making the decision actively and can afford to do so, then they should feel free to. In response, they may cut back on housing or vacations – they’re making an active choice.
That’s the purpose of all of this. That’s the benefit of working to become financially independent. It’s not living like a hermit and depriving yourself of heat in the winter. It’s making conscious decisions about what you value and where you want to spend your money. Blindly spending money without thinking is stupid, and it’s stupid beyond just the financial aspects. The time and energy required to dig yourself out could have been better spent doing something else. Instead, recognize that you’re constantly making tradeoffs and deliberately take the time to make those decisions well.
Keep building my friends.