Author: Mr. MFI

Categories
Expenses Travel

Travel Rewards Basics: Saving Money on Travel

person with toy airplane on world map
Photo by Andrea Piacquadio on Pexels.com

BLUF: Travels rewards are an effective way to greatly reduce the cost of traveling by minimizing or eliminating your airline and hotel costs. It lets you keep experiencing the world while not blowing your budget!

Who doesn’t love to travel? See different fascinating places, experience different cultures, visit different famous places and oh my, the food. The problem, is the cost of all that fun. Being that this is an FI focused blog, controlling expenses is important as that helps us reach our goal faster. I’m willing to spend the money on vacations, but I’m all for paying less for the same experiences. What’s not to like about that?

What are Travel Rewards?

Travel rewards, also referred to sometimes as either travel hacking or credit card hacking. The concept goes by a variety of different names but they generally mean the same thing. We’re trying to use credit cards to reduce or eliminate travel expenses. These usually revolves around the two largest expenses in a trip which are transportation (airline fares) and lodging (hotel costs).

How? You use normal life spending (groceries, gas, restaurants…etc) put on a rewards credit card to accumulate points. Those points can then be used to book airfare, hotels and rental cars outright or can be used to reduce the cost of them.

For example, say that a couple lived in Atlanta and wanted to take a trip to Hawaii. Atlanta is a hub for Delta so you look online. The cheapest option in late May would be $1,461.22 for two people. Most people would just chalk that up to the normal price of travel, pay and move in. Maybe they would charge it to a 2% cash back card and get $30 back for the purchase.

Example of a typical trip from Atlanta to Hawaii using cash.

Wouldn’t it be nice if you didn’t have to pay for that airfare? On the Delta website you can very easily flip from paying in cash to miles. Picking the exact same flights I see that it costs 70,000 miles and $22.40 to book using miles. Okay, now to get 70,000 miles.

Same trip from Atlanta to Hawaii using miles.

Right on Deltas website there’s a section for credit cards tied to SkyMiles which is Delta’s mileage program.

Boom! Right on the page there’s an American Express card that conveniently has a 70,000 mile bonus right now with no annual fee for the first year. The only stipulation is that you spend $2,000 in the first 3 months. Spending $670/mo should be problem for anyone with the life expenses that you can charge to a credit card.

Just like that we flew to Hawaii round trip spending $22.41 for two people instead of $1,461.

Types of Travel Rewards Programs

There are three main groups of travel rewards credit cards out there. Let’s dive into the details of each.

Flexible Points Programs

Flexible points programs give you rewards in points associated with their respective programs. Then, depending on the program you can either book travel directly with the company using their travel portal, transfer points to airline or hotel partners in their rewards point system or redeem the points for cash. The best deals are usually via points transfers but your mileage may vary (pun intended 😃).

One great thing about these programs is that the points usually don’t expire. As long as you maintain an account in good standing with them (at least one card) then they just sit there.

  • Chase Ultimate Rewards (UR) Points – This is one of the most popular programs due to the high value of their points, large number of card options and large number of transfer partners. You can buy travel directly through their website, transfer points to travel partners in their rewards programs or take the points as cash.
  • American Express Membership Rewards (MR) Points – Also very popular and some people prefer it over Chase. It has different transfer partners than Chase. You can buy travel directly through their website, transfer points to travel partners in their rewards programs or take the points as cash.
  • Citibank ThankYou Points – A newer player to the flexible points programs game these aren’t as publicized but they work in a similar way. Just like Chase and American Express they let you book travel directly through a portal with them, transfer them to partners or redeem them for cash.
  • Capital One “Miles” – Capital One calls its system miles but it’s really a flexible points system like the others. In general it’s the least valuable because it has the fewest transfer partners, which is where you get the most value from your miles. It does have one unique feature in that you can use your miles to wipe out any travel expense that you pay for in cash at $0.01 per mile. For example, you could use 50,000 “miles” to wipe out a $500 rental car charge on your Capital One card. This is one way to get reimbursed for other travel expenses that you otherwise might have trouble getting for free.

Note that while these programs are very flexible, they don’t transfer to ALL airlines and hotels out there. For example, Chase UR points don’t transfer directly to Delta at the time of writing this article (see image below). You can use the points to book Delta through their portal. American Express DOES transfer to Delta. It’s best to go into accumulating points in these programs with a next trip in mind so that your spending gets you points that you know you will use.

Chase UR Airline Partners in April 2021

Airline Miles Programs

Each airline has their own mileage programs and they partner with different credit card companies to offer credit cards that accumulate miles in those awards programs. Spending money with those cards accumulates miles and the sign up bonus (SUB) is also paid out in those miles.

For example, here are a couple different Chase cards associated with different airlines. The United card would give you Explorer miles and the British Airways card would give you Avios points. When you open these cards they connect with an existing rewards account with the airline or open a new one if you didn’t already have one.

Your points are automatically transferred over to the airline account (often monthly) so your points are safe even if you cancel the credit card. Each airline has it’s own rules for points expiration though so be sure to look that up so your points don’t accidentally expire on you.

Hotel Points Programs

Hotel rewards cards work in the same way as airline cards. The biggest difference is that the value of each point can vary much more wildly between programs compared with the airlines.

Sub-optimal way to accumulate travel rewards

If I were to describe the perfect customer in the eyes of a credit card
company it would probably go something like this. A customer is lured into signing up for a card with a substantial SUB, but doesn’t hit the minimum spend to get the bonus. They keep the card their whole life and carry an account balance the entire time.

I know my readers are smarter than that and would never do those things. However, many customers do get a SUB and then just keep a credit card forever. They enjoyed that bonus and built loyalty over the year they have it and often keep the card. That’s exactly what the credit card companies are hoping you do.

What’s the problem with that? It will take you forever to accumulate travel rewards after the SUB. In the previous Delta example we spent $2,000 in 3 months and flew to Hawaii for free. After that though, you accumulate 2x miles on dining and 2x miles on groceries. If I spend $800/month on groceries and $200/month on dining that’s $12,000 or 24,000 miles a year. It would take me 3 years to earn enough miles to go back to Hawaii! 3 months vs. 3 years. That’s the power of the SUB!

Supercharged travel rewards

What’s the optimal way to accumulate travel rewards then? Maximize the SUB of course. Open a credit card, spend enough to hit the SUB and then move on to another card. How effective is this? Very. In the last 18 months my Mrs. MFI and I have 308,000 UR points, 115,000 United miles and 61,000 American Airline miles. This is all using personal spending in a household of two people that spends less than $60k a year.

…But it will destroy my credit!

One of the most common misconceptions is that travel rewards (also sometimes card credit card churning) will destroy your credit score. Surely opening and closing that many accounts must hurt your score? Nope. This might be obvious to you if you read my article on how credit scores work and how to increase yours.

Yes, you take a small temporary hit when accounts are opened but the number of open accounts is a low contributor to your credit score. Payment history and credit utilization are high contributors to your credit score and both are improved with more cards open. Obviously this assumes on time payments and not carrying a balance. Opening 4 personal credit cards in the last 18 months still has my scores in the 800s.

My credit scores are doing just fine…

People that should and should NOT try travel rewards:

Just like casino’s being built on the money from the losing gamblers, credit card companies profit from the people that aren’t responsible with their credit. The people that use travel rewards successfully are losing credit card companies money but those people are the minority of credit users. If you are going to truly use travel rewards to save money then you MUST be a responsible credit card user.

People that should try travel rewards:

  • Have good credit scores of at least 700. All the best rewards cards require excellent credit.
  • Pay off their credit cards in full each month (they never pay interest charges).
  • Know how to control their spending and can hit the minimum.

Travel Rewards Essential Tips:

  • Plan our your trips far in advance. It takes time to open cards, hit the spend limits and get awarded mileage. Also, the best deals get booked up early so you can’t usually get good points deals last minute unless demand is low.
  • Target cards and points to a trip, not just randomly based on the best SUB. It’s alluring to stockpile points but what good is that if you have trouble using them? Best to pick a trip then focus on how to get airfare and hotels on that trip for free.
  • Never sign up for a card until you have a plan to hit the SUB spending requirement using your normal life expenses. If you’re spending money that you otherwise wouldn’t to hit a SUB, are you really saving money? This sometimes means opening cards around major purchases or expensive yearly costs like insurance premiums and taxes.
  • Don’t sign up for a new card within a month of the last card. This can be a red flag and could get you denied.
  • Play the game with two players. If you have a spouse, have both people sign up for cards. This allows you to do cool things like sign up for a card and then refer your partner getting you each a bonus.
  • Keep all cards open for at least a year and never cancel right after hitting the SUB. This can trigger that you’re abusing the system and set off red flags. When you’ve had a card for a year the annual fee will hit again. At this point you can close the card and they will credit back the annual fee.

Action Steps:

  1. Figure out the next trip that you want to take that requires flying.
  2. See what it would cost you to take that trip paying for it with cash. Then see how many miles it would take you to book the same trip.
  3. Look at the airline credit cards available and see if there’s a card that can get you the points that you need. This might be only one card or could require two different cards. Besides airlines there are lots of sites like Nerdwallet and The Points Guy with up to date info on the cards with the best rewards.
  4. Sign up, hit the minimum spend, get the SUB and book those flights for free!

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Categories
Taxes

401k vs Brokerage Account: Which Wins when Income Taxes Rise?

aerospace engineering exploration launch
Photo by Pixabay on Pexels.com

BLUF: Income taxes will most likely rise in the future but 401k pre-tax investing net of taxes in this scenario still lasts longer than a brokerage account. Withdrawal needs in retirement would need to be high and taxation at or exceeding historical highs in the future for a brokerage account to catch up to a 401k.

Why I wrote this article

Pre-tax investing has always sounds like a great idea to me. I get to avoid paying paying Uncle Sam taxes from a high tax bracket now, let the money grow tax free and then pay income taxes from lower brackets in the future (because you will be drawing less from those accounts).

Then I listened to a podcast. I listened to an Afford Anything podcast with this guy Ed Slott who published a new book “The New Retirement Savings Timebomb.” Sounds big and scary, right? Well, Ed sure sold it that way. His premise is that tax rates are historically low now and are sure to go up in the future. Additionally, the (marginal) tax rates in the past have been as high as 90%. The horror! As such his advice was that young people should be putting 100% of their money into a Roth, NOT be doing any pre-tax investing.

That made my ears perk up. Anytime I hear personal finance advice that flies contrary to what I had thought I like to investigate it. This all sounded eerily like a scare tactic to sell his book but because I honestly never did the math of which accounts perform better with taxes factored in, I couldn’t be sure. In this post we’ll follow the hypothetical lives of two married couples to see how the Traditional 401k vs. Brokerage / Roth 401k could play out over a lifetime. Note that this entire post will use a married filing jointly example but the principles still apply to those in other filing situations.

Let’s talk taxes

This discussion requires a solid foundation in how the US tax system works so lets make sure that everyone is on the same page there. I know, talking taxes sounds about as exciting as going to the dentist. I’ll keep it brief!

How a progressive tax system works

In the United States we have a progressive tax system. The income that you earn starts out being taxed at a low rate and the taxation increases as you make more money. Each chunk of income that is taxed at a different rate is referred to as a tax bracket. $0 to $19,900 is a bracket of income that is taxed at the 10% rate in 2021 for married couples filing their taxes jointly. The next dollars you earn from $19,901 to $81,050 are taxed at 12% and so on.

These tax brackets are indexed to inflation from a law passed in 1984 meaning that the dollar amounts typically go up every year.

2021 Tax Rates and Brackets

How taxes are calculated

The most common mistake people make is thinking that the highest tax bracket that their money “touches” is the rate that ALL their money is taxed at. For example, if a couple makes $200,000 they think that their taxation is $200,000 * 24% = $48,000 which is wrong. This leads people to try and do silly things just to stay out of the next highest tax bracket when it doesn’t make much of a difference.

The table below shows how your taxes are actually calculated. If a couple makes $200,000 a year, the first thing that comes off the top is their $25,100 standard deduction. This is free income that is untaxed leaving the couple with $174,900 that is subject to taxation. Each bracket of income is then taxed at each tax rate and added up to a total tax. As you can see only the income above $172,750 is taxed at 24%. $2,150*24% = $516.

Tax calculation example for a 2021 married couple filing jointly

Take all those individual tax bracket amounts and sum them up and you get the total taxes that you owe. In this case $30,017 on an income of $200,000.

Marginal Tax Rate vs. Effective Tax Rate

The highest tax bracket that your money touches is called your marginal tax rate. In the previous example for a couple making $200k, that’s 24%. Since that is the marginal tax rate is thrown around sometimes people freak out and mentally use that number to calculate what they think they’re going to own.

In reality, what you actually owe in the end and what you should care about is your effective tax rate. This is the percentage of tax that you actually paid on the taxable income that you earned.

For example, this couple ended up owing $30,017 on an income of $200,000. $30,017/$200,000 = 15% effective tax rate. Sounds a lot better than 24%, doesn’t it? The problem is that marginal tax rates to figure out by glancing at a table while you need to calculate your effective tax rate taking a number of things about your tax situation into account. For that reason the marginal tax rate number will often be used in discussion. Now that you know what it means don’t let that trip you up!

Effective tax rate calculation

Taxes in the future

We do need to recognize that income taxes around 2020 are quite low. If no laws change, on January 1st, 2026 taxes brackets will reset from the Tax Cuts and Jobs Act (TCJA) of 2017 expiring with the following changes:

  • 12% tax rate goes back up to 15%
  • 22% tax rate goes back up to 25%
  • 24% tax rate goes back up to 28%[2]

Outside of that there is speculation that taxation increase will be required to pay for the massive money printing to recover from the pandemic. Going back to Ed Slotts’ comments when he said taxes have been as high as 90+%. He’s not wrong, but the comment is misleading and scary for the average person. In 1944 at the tail end of WW2, taxes for the highest (marginal) tax bracket were 94%![3] What he doesn’t mention is that it was for income exceeding $3 million in 2021 dollars. Allow me to get out my tiny violin for you if you’re crushing the game like that. The lowest bracket was 23% (still high) on up to ~$30k in 2021 dollars.[3]

Investment Account Taxation

To make sure that we’re on the same page with how taxation works with retirement and brokerage accounts lets review the topic.

Pre-Tax Accounts: 401k Investment Taxation

Using a 401k investment account means the money comes out of your paycheck tax free and reduces your taxable income. When you reach 59.5 years of age and withdraw the money it’s taxed as ordinary income just like a W2 paycheck today. Until you withdraw that money it’s allowed to grow tax free inside the 401k account. The near term benefit is that you save that money AND it reduces your tax bill.

The argument Ed Slott makes is that income taxes now are pretty low and they’ll be much higher in the future. You should pay those taxes today and put the money into a Roth 401k post-tax.

Post-Tax Accounts: Brokerage account & Roth 401k Investment Taxation

In this example I’m using a brokerage account because it’s accessible to many and allows you to contribute at least as much as the traditional 401k so we can compare apples to apples.

Brokerage Account:

A brokerage account is not a retirement account. Anyone can open one and the money simply goes in after all normal payroll taxes have been removed. You can then buy stocks, bonds and other alternative assets with those funds. If you sell assets within a year of buying them they’re called short term capital gains and are taxed as ordinary income. If you hold them for longer than a year then they’re taxed at a special, lower rate.

The 0% tax bracket is large enough that many couples in retirement can sell long term gains and pay no taxes. Unqualified dividends and bond interest is taxed differently but using your standard deduction that can be wiped away. The example below shows how a couple could withdraw $100,000 from a brokerage account in a year and pay $0 in tax.

Roth 401k:

Contributions to a Roth 401k have ordinary income taxes taken out of it first and then the money goes in after tax. The advantage is that when you withdraw the money there’s no tax to pay!

Case Study: 401k Fanatics vs. The Brokerage Buyers (or Roth 401k)

To see how a lifetime of saving, investing, withdrawals and taxation happens in an apples to apples comparison I give you the following scenario.

Overview

To make this fair they both have the same exact gross income and very high expenses (they aren’t good savers) every year. The 401k Fanatics max out their pre-tax 401k at $39k/yr and then are left with $0. The Brokerage Buyers followed Ed Slotts advice and paid the taxes first and contributed everything to a post-tax account. Because of that they are taxed more heavily on their income and have a smaller amount of post tax dollars to put into their brokerage account per year – $30,378.

401k Fanatics:

Below is what a typical year looks like for the 401k Fanatics.

Brokerage Buyers:

Below is what a typical year looks like for the Brokerage Buyers. With no pre-tax contributions they pay more in taxes up front and therefore have less money to invest in their brokerage account each year ($30,378) compared with the $39k/yr of the 401k Fanatics.

Assumptions:

  • Tax brackets – both couples incomes are taxed at 2021 tax levels through the accumulation phase. In the withdrawal phase we’ll vary the tax rates to see what happens.
  • Investments – both couples invest in the same low cost VTSAX index funds monthly. $3,250/mo for the 401k fanatics ($39,000/12) and $2,531.50/mo for the Brokerage Buyers ($30,378/12).
  • Investment returns – both couples get 7% average annual returns compounded monthly.
  • Brokerage account taxes – since income needs of the Brokerage Buyer couple are within the 2021 capital gains 0% bracket it is assumed that they pay no taxes upon withdrawal. For this reason the brokerage account is interchangeable with a Roth 401k for tax reasons in this example. They all pay $0 in tax when withdrawing. Any dividend or bond income is expected to be small enough to fall within the standard deduction.
  • Inflation – we’re going to use 2021 dollars all the way though the example. Expenses will rise with inflation but it is assumed to impact both couples the same.

15 Years of Saving and Investing Later…

How have our good little saving and investing couples done? Quite well! They started later in life at 45 years old and are now 60 after saving for 15 years. The 401k Fanatics are millionaires in the two comma club while the Brokerage Buyers have accumulated a healthy $807k in their brokerage account.

Retirement time! Who wins?

After 15 years of investing the couples have retired. They’ve paid off their house and cars and now only need $80k/yr to support their lifestyle. Let’s see what happens when the 401k Fanatics have to pay ordinary income tax on those withdrawals while the Brokerage Buyers get to laugh in the face of the tax man all the way to the bank!

Income taxes rise to 2026 levels

What happens if congress does nothing, the tax rates reset higher and that continues into the future? See below for the 2026 tax rate impact on our 401k Fanatics.

Hey now, what happened? The 401k Fanatics were able to make that money last almost 7 years longer than the Brokerage Buyers despite them paying 0% tax. Why? Well with the progressive tax brackets the 401k Fanatics are still only paying a 9.62% effective tax rate. Projected far into the future the Brokerage Buyers will still never catch them.

Income taxes rise to scary “2036” levels

Okay, maybe you believe that taxes will get much higher. After all, the fed has been printing money faster than Leonardo DiCaprio in Catch me if you can. I’m calling them “2036” tax brackets. What then?

The lowest rate becomes 15%, then 20% and increasing up to 70%! Yikes! That would be pretty bad.

Surely that must have tipped the scaled in favor of the Brokerage Buyers paying 0% tax? Well, nope. The 401k Fanatics effective tax rate went up to 13.5% and still get 4 more years of money than the Brokerage Buyers. Even projected far into the future they would never catch them.

The obvious next question that I had to answer was how bad would future tax rates have to get for these two couples to run out of money at the same time? Well pretty horrifically bad – I believe the worst in history even topping 1944 WW2 levels when the first bracket, $0 – $30k (inflation adjusted) was 23%![3] I had to come up with a 22.11% effective tax rate to make then break even.

What does that look like for tax brackets? I played with some numbers to come up with one potential. I thought that the “Doomsday” naming was appropriate.

Conclusions:

The big takeaway from this for me is that you really need to focus on effective tax rates when thinking about taxes in the future. Pre-tax money will always grow faster initially by comparison because you can simply save more of it. If you have really poor 401k investment options with high expense ratios that would certainly narrow the gap over but it’s situation dependent on how close the outcome would be.

The other observation is that the more you need to consume, the more of a tax penalty you pay and the more you need to worry about tax rates. I can’t imagine a world where the rich and poor pay a flat tax so the lower incomes will likely be taxed less. The less you can live on, the less you’ll be taxed.

Early Retirement Considerations:

Winning is great, but you don’t win if you can’t retire early because you can’t access the money. If you have an early retirement plan you do need to balance 401k investing with post-tax investing because having more money in a 401k doesn’t matter if you can’t access it when you need it.

Most people saving 50+% of their income can max out a 401k and contribute a substantial amount to a Roth and a brokerage account. That said, everyone’s situation is different and you need to plan out your investments to have the money you need, in the right buckets, at the right time.

Action Steps:

  1. Make sure you are investing in a 401k to get your employer match. That’s a 100% ROI!
  2. If you’re just starting out consider trying to maximize those pre-tax buckets.
  3. After that consider Roth IRA contributions.
  4. Build that brokerage account. Have you considered putting some of your emergency fund in there?
  5. If you plan to retire early, take a look at the different buckets of money. How much do you need to get to 60 years old to access retirement accounts? A detailed post coming on this topic.

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Sources

  1. TaxPolicyCenter.Org. https://www.taxpolicycenter.org/statistics/historical-average-federal-tax-rates-all-households. Accessed 4/17/2021.
  2. FedTaxPlanners.com. How 2026 Sunset Laws will impact your tax cuts. https://fedtaxplanners.com/how-2026-sunset-laws-impact-your-tax-cuts/ Accessed 4/17/2021.
  3. Tax Foundation Tax Rate History. https://files.taxfoundation.org/legacy/docs/fed_individual_rate_history_nominal.pdf. Accessed 4/17/2021.
Categories
General FI Investing

Should You Use Extra Money to Prepay Your Mortgage or Invest?

BLUF: The decision to prepay your mortgage or invest will end up varying based on each individuals mortgage parameters, risk tolerance and goals. 2-4% mortgage rates make stock investing a better historical performer than prepaying your mortgage. However, you need to run the numbers AND consider other intangible benefits to arrive at what’s best for you.

Prepay Mortgage or Invest: A Common Quandary

I see this question posed all over personal finance forums and social media platforms. How the question is phrased depends on the person but usually goes something like this: “My mortgage is less than 4% and the market historically returns 7-8% on average. Isn’t it better to invest instead of pre-paying my mortgage?”

Alternatively, I’ll sometimes see hardcore investors bashing those that are paying off their mortgage early because they’re “making a poor choice” or are “leaving money on the table.” The conversation revolves around borrowed money being cheap and those long term investments outperforming the mortgage on average.

It’s very normal to want to want to make the “best” decision and I realized that I had never seriously considered this question in my situation. I always do the math as a part of my decision making process so this article will show my numbers, my process for evaluating the options and give you my thoughts on other considerations if you are faced with this decision.

Our situation:

Mrs. MFI and I have a cute little 1,500 sq/ft split level house here in NY (image above) that only cost me around $130k to buy near the peak of the housing boom. With a low purchase price, a refinance in the middle after my divorce and some overpayments along the way we only have $45,529 left to pay on my 30 year mortgage at 3.625% Before you hate us for that mortgage only costing $456 a month, consider that our property and school taxes are more than $456/mo. Sigh, thanks NY – the tax state.

Aside from my mortgage we’re debt free! Having crushed my old debts and consumer ways there is a part of me that would love to pay off the mortgage and have no debts. However, we’re also saving hard to reach financial independence and that includes after tax savings in a brokerage account as we’ve used our tax advantaged options. As such, we have about $1,000 a month that could either be used to make additional principle only mortgage payments, invest in our brokerage account or some blend of the two. What should we do?

The Comparison Approach:

If the 30 year mortgage is taken to term with no additional payments it will be paid off in March 2031, just under 10 years from today. With that being the baseline case of do nothing extra and stay the course I came up with a variety of options that I could do between now and 3/1/2031 which is the end of the time period for the study.

Comparison options:

  • Option #1 – Pay the normal mortgage payment ($456). Invest $1,000/mo into a brokerage account until the end of the study (3/1/2031).
  • Option #2 – Pay the normal mortgage payment ($456) plus a $250/mo principle only payment. Invest $750/mo in a brokerage until the mortgage is paid off (4/1/2027). At that point invest the full $1456 ($456+$250+$750) into the brokerage until the end of the study (3/1/2031).
  • Option #3 – Pay the normal mortgage payment ($456) plus a $500/mo principle only payment. Invest $500/mo in a brokerage until the mortgage is paid off (8/1/2025). At that point invest the full $1456 ($456+$500+$500) into the brokerage until the end of the study (3/1/2031).
  • Option #4 – Pay the normal mortgage payment ($456) plus a $1,000/mo principle only payment. Invest $0/mo in a brokerage until the mortgage is paid off (1/1/2024). At that point invest the full $1456 ($456+$1,000) into the brokerage until the end of the study (3/1/2031).
The comparison data in tabular form.

In all of these cases I have the $456 monthly mortgage payment and $1,000 extra to use to either pre-pay the mortgage or invest in stock based index funds in a brokerage account. In cases where the mortgage pays off earlier than 3/1/2031 (the end of the study) I apply the extra money to the investment account.

The great unknown in all of this is the investment return of the stock market over the next 10 years. I took three different average returns over the 10 year period and used that to calculate the brokerage returns. The four values used were -3.8% (worst 10 year period in S&P history since 1928[1]), 0% (a lost decade), 7% (long range historical average), 13% (a continued raging bull market).

Resultant Data:

What information did I want at the end to help with my decision of which option was better? There were a few things:

  • Mortgage Payoff Date – I wanted to see where in time this would fall so I could see if I might be at FI before the mortgage was gone.
  • Mortgage Net Worth Change – This would be important if we were calculating a timeframe where the mortgage wouldn’t be payed off such as 5 years. In my case, all cases pay off the mortgage so it’s $45,529 for each.
  • Brokerage Account Net Worth Change – How much would that brokerage account balance change for each method? The account is already in use so I’m looking at the change in value not the absolute value.

The Process:

How did I do this? I use two main spreadsheets. First I used a loan amortization schedule spreadsheet (widely available for free on the internet) that let me include monthly principle only payment amounts. I made a sheet for each option. That sheet provided me with certain pieces of information that I cared about including number of remaining payments, remaining interest paid for each option and the date of the mortgage payoff. Well, it at least gave me the data to calculate remaining payments and interest paid.

loan amortization schedule spreadsheet

The second spreadsheet I used is a compound interest sheet that included an option for regular deposits. I created one of these sheets for each option and varied the investment timeline. I had to take the mortgage payoff date calculated from the amortization spreadsheet to then input into this sheet the right time for the investment per month to flip to the full $1456.

The Results:

I’m honestly surprised by the results. What surprised me the most was that there really wasn’t a massive financial difference to the brokerage account balance between any of the options due to my small mortgage remaining and my short time horizon studied.

My small mortgage balance and 3.625% APR only results in a $6,372 difference in interest paid between option #1 and option #4. The biggest delta was between option #1 and option #2 dropping by $3,555.

Take the “average” 7% market return situation. There’s a $9,500 difference over a 10 year period between the extremes of option #1 and option #4 or $950 a year. Not exactly an amount of money that would keep me up at night with a fear of missing out (FOMO).

Option #1 puts the most into the brokerage account so it’s most susceptible to market gains (and losses) based on average annual return variation. Pre-paying a mortgage is locking in a guaranteed return on your money at a rate equal to your mortgage interest rate. For that reason option #4 fluctuates the least with returns.

The easy way to think about this is that if the average annual return of the stock market is greater than your mortgage APR then investing more will always result in a financially better outcome over mortgage pre-payment.

The surprising thing that I learned in calculating the numbers and thinking through this is that mortgage interest doesn’t really matter. In my case no matter what I’ll spend $1,456 a month. What matters if I want the best financial outcome is what makes my net worth grow the most over time for that $1,456. That means house value – mortgage remaining + change investing account balance over the investing timeframe. In my case all options decreased my mortgage by the full loan amount remaining of $45,529 so I didn’t show it.

A typical loan amortization calculator will show the interest paid.

Loan amortization calculators can lead you to focus on this as well showing you large interest numbers over the life of a loan. It’s easy to add a $500 extra payments and see that interest drop dramatically. What you don’t see is what your brokerage account value would do over time if you chose to invest that $500 for comparison.

My Decision:

Drum roll…I’m going to pursue option #2. This option keeps my brokerage contributions high while accelerating my mortgage payoff by 4 years. While it’s not important to have this house paid off by FI I am interested in the psychological impact and would like to accelerate that some.

The $4,250 brokerage account difference between option #1 & #2 is trivial to me so it’s a good balance between investing and accelerated paydown. Coincidentally, 80/20 (stock/bond) allocation is our investment plan so option #2 is very similar. Option #2 is $750 (stock) / $250 (mortgage) and mortgage pre-payment is almost bond like with a 3.625% return on my loan.

Things to Consider for Your Decision:

We all have our own unique situations to consider so my decision might not be the right one for you. Here are some things to keep in mind when contemplating this decision for you.

  • If your mortgage APR is less than 7% and you have a 20+ year investing time horizon then investing in the S&P500 has historically always done better, on average, than prepaying your mortgage. The S&P500 returned 7.3% on average over all 20 year periods from 1928 to 2018[1].If the market returns 7% on average and your mortgage APR is 3% then you’ll make 4% more on average, compounding, over your investing life on any money that you invest in the S&P500 index instead of pre-paying your mortgage. Is it possible for the market to underperform your 3% mortgage over 20 years? Absolutely. But on average it won’t and since none of us has a crystal ball that’s the best that we’ve got.
  • Try not to fixate on mortgage interest saved when projecting what prepaying a mortgage will do for you financially. Look at overall net worth and factor in how your money would grow if you invested the money instead of paying down the mortgage.
  • Keep your big picture goals in mind. Eliminating a mortgage payment will drop your monthly expenses so it’s advantageous to have that happen before FI / retirement if you plan on staying in the house. It will influence your FI date so see when you want that mortgage gone and the impact of the reduced expenses on your FI number.
  • There’s a freeing feeling to being mortgage free (or so I’m told). Remember how good it felt when you paid off your car loans or when you were free of credit card debt? It’s hard to put a price on the feeling of not having a debt hanging over your head. Or the pride felt in knowing you own that house outright.
  • Pre-paying your mortgage is choosing a guaranteed return on your money of your mortgage APR assuming your house value is stable. If you are more conservative when it comes to risk tolerance then mortgage pre-payment will likely be a more attractive option.
  • You don’t have to choose the mathematically superior (most rational) choice that nets you the most money in the end. There are many reasonable choices on the spectrum between invest everything and don’t prepay any mortgage and invest nothing while aggressively paying off the mortgage.
  • It’s much harder to get at wealth that’s tied up in your mortgage. You can refinance it out or take out a HELOC but there are costs involved. If it’s sitting in your brokerage account it can serve as an emergency fund and is far more liquid.

Action Steps:

  1. Make sure you understand your mortgage APR. How does that compare with 7%?
  2. Download a mortgage amortization calculator and compare a mortgage prepay option to an investment option. Consider in between options like invest half and prepay half.
  3. Make a decision and implement it into your budget.
  4. Automate the investments and pre-payments to make it easy to stick with your plan.

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Have you done this analysis before? What did you choose and why? Comment below!

Sources:

  1. FourPillarFreedom.com. Here’s How the S&P 500 Has Performed Since 1928. https://fourpillarfreedom.com/heres-how-the-sp-500-has-performed-since-1928/. Accessed 4/11/2021.
  2. FreddieMac.com. 30-Year Fixed-Rate Mortgages Since 1971. http://www.freddiemac.com/pmms/pmms30.html. Accessed 4/11/2021.
Categories
General FI

The 4% Rule: Do You Really Understand It?

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BLUF: The 4% rule is a great starting point to establishing a financial target for early retirement in the beginning of your FI journey. However, it’s a rule of thumb, not a rule. It’s important to understand the details behind the 4% “rule” so you can factor in your individual factors such as taxes, fees, inflation and capital preservation. There’s also a much more complex subject of sequence of returns risk to explore.

Note: For copywrite reasons I can’t duplicate the tables of data from the Trinity study in this article. To get the most out of the article I recommend opening up the study to refer to the tables. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable” by Cooley, Hubbard and Walz.

If you’ve spent any amount of time around retirement, early retirement or financial independence forums you’ve no doubt encountered the term 4% rule thrown around repeatedly. In this article we’ll explore the academic study nicknamed the “Trinity Study” that gave birth to the concept, what the concept is and some considerations when applying it to your own financial independence plans. We’ll also introduce and discuss some terms that might be new to you such as a withdrawal rate (WR).

4% Rule and the Trinity study

The 4% rule is a principle that was created from the results of an academic study published in 1998 by three professors of finance at Trinity University. The paper is called “Retirement Savings: Choosing a Withdrawal Rate That is Sustainable” by Phillip L. Cooley, Carl M. Hubbard and Daniel T. Walz.[1] This paper has been referred to as the Trinity study probably because it’s a whole lot easier to say so I’ll refer to the paper using that name going forward.

The Trinity study sought to answer the question: “What’s a reasonable withdrawal rate when living off savings?”[1] A withdrawal rate (WR) is the percentage of your portfolio that you will withdraw in order to live. For example, if your portfolio was $1M when you retired and you withdraw 4% that first year then you take out $1,000,000 * 0.04 = $40,000.

The paper wanted to address a very real world dilemma that we all will hopefully face one day. “The dilemma is that if they withdraw too much, they prematurely exhaust the portfolio, but if they withdraw too little, they unnecessarily lower their standard of living.”[1] The paper does not address early retirement though. It examined payout periods of 15-30 years since those would be much more typical of a standard retirement around age 65. More on that point later.

The Trinity study methods used:

The Trinity study used real annual returns from the S&P500 index for stocks and long term corporate bonds for any bond allocations. The study looked at different payout period lengths of 15, 20, 25 and 30 years using data between 1926 and 1995. Within those payout periods they tried different WR from 3% up to 12% and using 5 different asset allocations from 100% stocks to 100% bonds (100/0, 75/25, 50/50, 25/75, 0/100).

Here is an example of how they generated the data in Table 1 of the study which shows portfolio success rates. This would be a single data point of a 15 year payout period of 100% stocks at a 4% WR starting at 1926. A portfolio starts with a set value ($1,000 in this case) which doesn’t matter because everything is calculated relative to it. A 4% WR means that you assume you always take out 4% of the initial portfolio value ($1,000) or $40/year.

Each year you take the starting value, add in the annual return (or loss), subtract the money withdrawn and you end up with a final portfolio value. For example at the start: $1,000 + $80 (8% return) – $40 (4% withdrawn) = $1,040 at the end of 1926. This repeats for each year in the 15 year window. If you end up with any money at the end, in this case $161, then the portfolio is a success. Even $1 left means success in this study! Then you do this again starting in 1927, 1928 until you run out of data in 1995. That means the 15 year payout period has 56 different payout periods.

Study Results:

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The tables are what people focus on in the study so here’s a summary of what you’re really looking at:

  • Trinity Study Table 1 – Portfolio success rates from 1926-1995. No inflation adjustment on withdrawals.
  • Trinity Study Table 2 – Portfolio success rates from 1946-1995. No inflation adjustment on withdrawals.
  • Trinity Study Table 3 – Portfolio success rates from 1926-1995. CPI inflation adjustment on withdrawals.
  • Trinity Study Table 4 – Terminal portfolio value from 1926-1995. No inflation adjustment on withdrawals.

Table #1 – Portfolio success rates (1926-1995)

The 3% WR as a fixed percentage of the initial portfolio value has a 100% chance of success for all payout periods, all asset mixes. Change that to a 4% WR and for 30 year retirements the chance of success is 100% for all asset allocations except 100% stocks (98% success). Again, success only means having greater than $0 left at the end of the payout period.

Table #2 – Portfolio success rates (1946-1995)

What happens when you take the same data set and ignore the time period of great depression and world war 2? A booming stock market and higher success rates. 100% success was guaranteed for a WR up to and including 7% for 30 years as long as you held at least 50% stocks.

Table #3 – Inflation Adjusted Portfolio success rates (1926-1995)

Take table 1 and sprinkle in inflation equivalent to the consumer price index (CPI) and you get table #3. What that means is that the WR starts at a percentage of the initial portfolio value $40 on $1,000 (4%) but then the amount you withdraw each year increases with inflation. The table below repeats the same scenario as earlier in the article but adds 3% inflation to each yearly withdrawal. The earlier scenario was successful with 16% of initial capital remaining ($161/$1,000) at the end but the inflation adjusted scenario fails in the last year (-$3).

Table 3 in the study shows high success rates for the 4% WR for 50% or more stocks but the higher bond portfolios get much worse at 25 and 30 year payout periods. Essentially all the probabilities get worse as inflation eats into the lower bond gains but at 3-4% WR the result is still excellent.

Inflation added to the withdrawals make a difference.

Table #4 – Terminal Value of a $1,000 Initial Portfolio After All Annual Withdrawals (no inflation) (1926-1995)

Table 4 takes the data from table 1 but instead of reporting the probability of portfolio success in each scenario it reports how much the portfolio will be worth at the end on average, minimum, maximum and median. It assumes you start with a $1,000 portfolio and take it to the end of the payout period for each block of time from 1926 to 1995.

Of all the table #4 data points I think the one in the lower left is the most interesting because it represents the longest time horizon and a “typical” early retiree asset allocation: 30 year payout period, 4% withdrawal rate, 75% stocks 25% bonds:

  • Average outcome: $9,031 (9x) the starting portfolio value
  • Worst outcome: $1,497 (1.5x) the starting portfolio value
  • Median outcome: $8,515 (8.5x) the starting portfolio value
  • Best outcome: $16,893 (16.9x) the starting portfolio value

This table on the surface would make you believe that with a 4% WR your money will always grow beyond your wildest dreams. On average, your portfolio increases by 9x the starting amount over 30 years with a 4% WR. Case closed right? Well, not so fast. That sneaky inflation thing is missing and not considering it is ignoring two areas that matter in the real world.

  1. Inflation makes your expenses increase so withdrawals increase. The study ignores this fact but year after year our costs generally go up. As I show in the table below, you see the 1927 withdrawal becomes $41.2 instead of just $40 when you add inflation. Then it keeps compounding until you’re withdrawing $60.50 by 1940. Your costs, and therefore withdrawal amounts went up 50% in 15 years with 3% annual inflation. Inflation can vary greatly over time but form 1926 to 1995 it was 3.15% on average mostly driven by the later years.
  1. Table 4 doesn’t tell you how inflation impacted the spending power of those terminal portfolio values. A lot can change in your spending power in 30 years.

For example, take the worst case outcome of $1,497 for 30 year, 75% stock example at a 4% WR. That’s 1.5x your money over 30 years. However, adjusted for inflation when that 30 year period likely occurred (1926-1956) and inflation adjusted that is worth $974 in 1926. In other words, your portfolio with non-inflation adjusted withdrawals went nowhere over 30 years. Not a bad outcome necessarily, but your portfolio purchasing power didn’t grow by 50% either

https://www.calculator.net/inflation-calculator.html

If you take the other end of the spectrum and the best outcome of $16,893 (16.9x gains) and adjust for inflation over the likely 30 year period (1965-1995) and the inflation adjust gains are actually 3.5x, not 16.9x. Again, that also doesn’t take into account inflation adjust withdrawals that would be much higher

What is the 4% Rule (of Thumb)?

“Rule of Thumb: The English phrase rule of thumb refers to a principle with broad application that is not intended to be strictly accurate or reliable for every situation.”

https://en.wikipedia.org/wiki/Rule_of_thumb

The Trinity study when published had one key conclusion: “For stock-dominated portfolios, withdrawal rates of 3% and 4% represent exceedingly conservative behavior.”[1] The data and those conclusions gave birth to the concept that a 4% withdrawal rate is a safe withdrawal rate (SWR) implying that you’ll never run out of money.

The danger with calling it a rule is that it implies that it will always work for all people. It is in fact a rule of thumb to guide you and give you a good target at the start of your journey, but you then need to consider your individual situation. Unfortunately humans are messy and do stupid things. If the market crashes and you sell your portfolio to cash none of this works. If you have a high bond allocation the portfolio success rates start plummeting over time.

Using the 4% Rule to Calculate your FI Number

The most common use of the 4% rule is to then use it to figure out what portfolio size you need to support a WR of 4%. That portfolio size needed to support the WR (often 4%) is referred as your financial independence (FI) number because you could theoretically quit your job at that point. The math is simple: 1/0.04 (4%) = 25. If your WR is 4% then your portfolio needs to be 25x your annual expenses to withdraw 4% of it per year. For example, if your annual expenses are $40,000 then multiply by 25 and you need a $1,000,000. If you change your WR to 3% then 1/0.03 = 33.33x and you need a $1,333,000 to support living on $40,000 a year.

4% Rule – Important Points to Remember in interpreting the Trinity study:

  • It doesn’t model extreme early retirement: The Trinity Study was not modeled around early retirees. It was modeled for standard retirement which is why the longest portfolio payout period studied was 30 years. Many incorrectly assume that if the portfolio success rate at 30 years is 100%, then it will also be 100% at 40, 50 or 60 years.
  • Sorry kids, you’re on your own. Good luck!: Portfolio success in the study is defined as having any money left at the end of the period. $1 left was success! That means that if you have aspirations of leaving inheritance behind then you need to factor that into your plan and choose a lower WR than you otherwise would if capital preservation wasn’t important.
  • Inflation, what inflation?: Only table 3 takes into account any kind of inflation. In other words, tables 1,2,4 assume that you withdraw the same amount in year 1 to live on as you do in year 30. Your expenses never go up with inflation and the table 4 terminal values are not adjusted for inflation. The study claims that using the Consumer Price Index (CPI) overstates the impact of general inflation on an individuals spending. In other words, 3% CPI increase doesn’t mean it will cost an individual 3% more to live the same. I’m not sure if anyone has proven this but I hypothesize that the less you consume by being more minimalist, the less that the consumer price index increasing would increase your life expenses. However, inflation is still going to always impact your life and some inflation should be factored in.
  • We don’t need no stinkin’ taxes!: The study leaves out any taxes, expense ratios, transaction costs and management fees. These are very independent factors so I can see why they left them out but they’re very much part of the real retirement world.
    • If you have your assets are managed by a fund charging a 1% of all assets fee (AUM) then you now need to save up 33x expenses (3% withdrawal rate) to get a net 4% in your pocket. Ouch. If your expenses are $40k/year that’s needing $1,320,000 saved (33x) instead of $1,000,000 (25x) because of that 1% fee.
    • Federal and state taxes also need to be taken into account. If you pay 15% in taxes between capital gains, ordinary income (401k withdrawals) and state taxes on your money then you need to withdraw $47,000 a year to net $40k for your expenses. That means having to save an extra $175k ($7k * 25x) before you can retire! Said another way, that 15% taxation makes your SWR effectively drop from 4% (40k/$1M) to 3.4% (40k/$1,175,000) forcing you to save 29.4x of expenses. Taxes suck.
  • Stock and Bond allocations matter: Higher stock allocations increase the likelihood of your portfolio will support 4% (or higher) withdrawal rates over longer time horizons. The best inflation adjusted success rates are all in the 50% or more stock portfolios. However, many lifecycle funds and traditional investing advice moves you into bond heavy funds in retirement. If your portfolio is large enough to cope with a 3% WR then this makes perfect sense. However, if you need a 4% or greater WR then only higher stock allocations will get you there. Don’t assume that the 4% rule will work for you if you have more than 50% bonds. it hasn’t worked historically and in lower interest rate and/or high inflationary environments it will only get worse.

Conclusions:

So what does this all mean for you? I think that table 3 of the study does show that based on historical data you do have a high likelihood (95%+) for success if you have at least 50% stocks, stay invested and withdraw an inflation adjusted net 4% of assets. You can’t extend the study to longer time horizons though so if you think retirement is 40 or more years I would plan on 3.5% unless you have other income sources or expect your expenses to decrease over time. I would recommend calculating in tax impacts and see the impact. You want a net 4% WR after taxes so adjust your FI number to include the impacts of taxes.

Action Steps:

  • Figure out your current annual expenses.
  • Calculate your FI number using the 4% rule. What is it?
  • If you’re closer to retirement calculate how much taxes may change your FI number.
  • Keep learning! Big ERN’s sequence of return series goes much deeper into the topic helping you apply this concept to early retirement. Highly recommended! https://earlyretirementnow.com/safe-withdrawal-rate-series/
  • Sign-up for the ManagingFI newsletter and get new blog articles and free tips delivered to your inbox. Sign up now!

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Article Sources:

  1. AAII. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable” by Cooley, Hubbard and Walz. https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf. Accessed April 3rd, 2021.
Categories
Expenses General FI

Credit Scores: How they work and how to increase yours

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BLUF: Your credit score can have a substantial financial impact on your life. Many people don’t understand them, pay attention to them or put in the work this one thing that can save them or cost them a lot of money. Putting in the work to increase your credit score can save you a lot of money over a lifetime.

Note: Some links include affiliate referrals and the blog will receive a benefit if you sign up for a service using that link.

What is credit?

Credit is the ability to borrow money or access goods or services with the understanding that you’ll pay later. The creditor is the person or business extending credit to you with the expectation that you pay them back the full amount at a later date including interest. Some common borrowing examples include:

  • Store cards (Target)
  • Credit cards
  • Car loan
  • Mortgage loan (home)
  • Personal loan
  • Boat / Motorcycle / ATV loan

What is a credit report?

To calculate a credit score, though, you need data. That’s where the three main credit bureaus: Equifax, Experian and Transunion come in. These companies each collect information on all the credit related activity that you have from each lender and compile that data into a credit report. This includes information like account type, payment history, loan balances and available credit.

When you use a credit report service on the internet it’s pulling a credit report from one or multiple of the credit bureaus. All of the information reported to them in that credit report then is used with FICO’s formulas to calculate a credit score.

What is a credit score?

Have you ever loaned a friend money and they didn’t pay you back? Not fun. Creditors that loan money as their business certainly don’t like it either. They needed a way to understand the likelihood that a person will pay back borrowed money so that they could decide whether or not to loan them money. The two main pieces of data used by creditors to extend credit are your income and your credit score.

A credit score is a numerical way to summarize your personal credit risk based on your credit data. The FICO score, originally developed by Fair, Isaac and COmpany in the 1950’s has become the most widely used method for calculating a credit score. FICO scores generally range from 300-850 although some industry specific scores do go up to 900. It isn’t a static formula though as they keep tweaking it and evolving it based on lender needs and consumer behavior.

[1] Credit: https://www.ficoscore.com/faq

There is a second type of credit score that exists called the VantageScore that was created in 2006 by the three credit bureaus. The VantageScore 3.0 is very similiar to the FICOScore in that it ranges from 300-850. It uses 6 categories that are similar to the FICOScore 5 categories below but are slightly different in percentage weighting.[12]

In this article I will largely talk to the details of your FICO score although I’ve used some additional screenshots and data from CreditKarma which is using the VantageScore 3.0. The tips and advice for how these scores impact your life and how to improve them still hold regardless of which score is used. If you’d like to read more about the differences between the FICOScore and VantageScore systems you can do so here.

What makes up your credit score?

The exact formula of how a credit score is calculated isn’t public information but what is known are the factors that make up your credit score. I’ll go into the factors in detail using information from FICOscore.com (FICO), myFICO.com (FICO) and CreditKarma.com (Vantage). These factors apply to all credit accounts on your credit report.

[2] https://www.ficoscore.com/education#CreditDecisions

Payment History (35% of the credit score)

Payment history is whether you make payments on time or late each month. The lateness of the payment matters as well and are bucketized as either 30, 60 or 90 days late with each step being a bigger hit to your score. Typically after 90 days late the next step is going to collections where it becomes a derogatory mark.

How much could it impact your score being late? “With a FICO® Score of 780 (on a scale of 300-850), being just 30 days late on a payment could drop your score to between 670 and 690, according to FICO. If your score was 680, having a payment reported as 30 days late could drop your score to between 600 and 620 according to FICO.” [3] Ouch!

CreditKarma.com shows this view as a percentage of on time payments. If you had a single credit card for 10 years then you’d have 120 payments. If you had just 2 late payments in that time then (120-2) / 120 = 98.3% on time payments which is already in the yellow. It doesn’t take much to impact your score so it’s best to avoid any late payments.

CreditKarma.com view of my VantageScore 3.0 payment history

Derogatory marks such as a bill that goes to collections, a bankruptcy, tax lien and civil judgements. Even a single derogatory mark is high impact and the worst part is that they can stay on your credit report for 7-10 years!

If you thought late payments had a negative impact on your score, hang onto your hat for the impact of a bankruptcy. “Bankruptcy could have an even bigger impact, according to FICO, potentially dropping a FICO® Score of 780 to between 540 and 560, while a 680 score could fall to between 530 and 550.” [3]

It is important to note that a late payment or a derogatory mark does negatively impact your score immediately, but that score impact starts to fade over time if you don’t have any other bad marks.

CreditKarma VantagScore 3.0 view of my derogatory marks

Amounts Owed (30% of the credit score)

There are 5 different factors that FICO uses in the amounts owed category that feed into the 30% weighting:

  1. The amount owed on all accounts – Even if you pay off your cards in full you’ll almost always show as having a balance on your credit report. This is just the timing of when the balance is reported compared with your payoff date.
  2. The amount owed on different account types – The type of account like an installment loan for a car is viewed differently than a revolving credit account like a credit card.
  3. How many of your accounts have balances – If all of your cards have a balance you appear to be higher risk than a borrower with mostly zero balances.
  4. How much is owed on an installment loan compared with the original loan – If you take a $200,000 mortgage your credit score will improve as you go from a balance of $200,000 (100%) to $160,000 (80%)
  5. Credit card usage ratio – This is the total balances / total available credit. Just like with #1 your credit report likely won’t show a zero balance even if you pay off your cards in full because of the timing of reporting the balances. Example – if you owe $500 on a $2,000 limit card and $1,000 on a $15,000 limit card then your usage would be $1,500 / $17,000 or 8.8%. [4]
CreditKarma VantageScore 3.0 card usage view.

Length of Credit History (15% of the credit score)

The length of your credit history deals with the age of the credit accounts on your credit report. Very logically, the longer you’ve had lines of credit and shown responsible use of them, the lower the risk you are to a lender. There are three things that the FICO score takes into account in this category:

  1. How long your credit accounts have been open including the age of your oldest account, the age of your newest account, and an average age of all your accounts.
  2. How long specific credit accounts have been open.
  3. How long it has been since the account has been used.[5]

CreditKarma shows you information on the average age of open accounts which is doing just that – averaging the time each account has been open across all of your open accounts. 7-8 years on average is the start of the good area for a VantageScore 3.0 so as you can see this kind of thing takes time. This is one reason why it’s bad to close old accounts if you aren’t using them. It could substantially drop the average age of your credit.

Snapshot at CreditKarma VantageScore 3.0 showing how long accounts have been open.

New Credit (10% of the credit score)

When you attempt to open up a line of credit there is what’s known as a hard inquiry to your credit report. These hard inquiries stay on your report for two years although only one year is used to calculate your FICO score.[6] There are three main items that FICO looks at in the new credit category:

  1. The number of new accounts that you have.
  2. How many recent inquiries you have – this is anytime that a lender requests your credit score or report. When this is done to open an account it’s known as a hard inquiry and is more impactful on your credit score. A soft inquiry on the other hand does not impact your credit score. Soft inquiries include things like checking your credit score personally, getting a copy of your credit report and getting pre-approval from a lender for credit.[7]
  3. The time since opening up your last new account – borrowers who open many new accounts in a short period of time are higher risk.[6]
Accounts opened within the last two years show on your report.

Hard inquires stay on your credit report for a little more than two years. Their impact on your score is still minor and that impact also decreases over time.[7]

Hard inquiry view from CreditKarma VantageScore 3.0.

Credit Mix (10% of the credit score)

Credit mix refers to the different types of credit accounts that you may have on your account. There are two main types of accounts:

  1. Revolving credit accounts – these are accounts with an established credit limit that you can reuse and make payments on. Examples include credit cards, retail store cards, gas station cards and even a home equity line of credit (HELOC).
  2. Installment loan – a fixed balance is paid off progressively over time. Examples include a car loan, mortgage loan, student loan, furniture loan, boat loan and motorcycle loan.

I wouldn’t create new loans just to satisfy the mix the accounts here being that it’s only worth 10%. To me this is just something to be aware of as a low credit impact.

What credit score is good?

That’s how credit scores work, but what is a good credit score? The table below is a good general guideline for what each score means for a FICOScore.

[11] FICOScore.com breakdown of what each score range means.

To qualify for the best credit card offers you often need at least 690. In the mortgage example down the article the top rate is achieved at a 760 FICO score. Once you’re in the upper 700’s you can feel pretty confident that your score is good enough to get the best rate.

How a credit score impacts your life:

Okay, enough going on and on about how credit scores work. Why should I care? How does this impact my life? Well, your credit score follows you forever and is used in an increasing number of ways because it’s an easy assessment of risk based on your consumer behaviors. Here are examples of life situations when your credit score and/or report are used:

  • To qualify for a loan – Fairly obvious but your credit score is a big part of being approved or denied for a loan. Each lender has their own standards for risk and if your score is too low many lenders will deny you.
  • To determine the interest rate offered on any loan – if you are approved for a loan, the rate that you pay is HIGHLY dependent on your credit score. See the mortgage example in the next section. This translates into a low credit score costing you a lot of money over the course of your life.
  • To get approved for the most lucrative credit cards – who doesn’t love cash back and travel rewards? Unfortunately only high credit scores are eligible for the best cards. If you don’t have at least a 700 score you can’t get the best cards.
  • To rent a place to live – Landlords sometimes check your credit. A landlord isn’t extending credit but they do need to be paid monthly just like an installment loan. They want low risk tenants that will pay reliably. They may not rent to you or ask for a larger security deposit. Foreclosures and evictions show up on a credit report which could be grounds to deny your application.
  • To get insurance – insurance premiums are payments and insurance companies they want their money. You could receive higher rates or be denied if you credit report shows a poor payment history.
  • To get a new job – they need written permission but prospective employers can request a copy of your credit report. Some jobs require the use of company credit cards and they want to ensure that the applicant will be able to both get approved for a credit card if needed and is also trustworthy in their use of that card.
  • To get utilities setup – yet another payment that a utility company wants made. You could be forced to provide a security deposit if you have bad credit.[9]

Credit score impact on a mortgage

Here’s a great example of why you should care about your credit score. Even if you came from the Dave Ramsey camp and don’t believe in credit cards, chances are you’ll have a mortgage at some point in your life. In the example below the different between a 760 credit score and a 639 credit score is $166/mo and $63,472 more paid in interest over the life of the loan! You pay $63,472 extra and get absolutely nothing in return. It’s purely a tax on a higher risk borrower because you’re more likely to default based on your credit score. [10]

Not maintaining top credit can cost you, a lot!

Tips for increasing your credit score:

  • Improving Length of Credit History: Stop closing accounts! This may seem counter intuitive but it can actually damage your credit score to close old accounts. Why? The length of your credit history will decrease if you close a very old account. Even if you don’t use a card anymore keep it open and put one or two charges a year on it to ensure the lender doesn’t close the account for inactivity. If the card has an annual fee see if you can do a product change.
  • Improving Payment History: Did you know that you don’t need to have a payment due to register an on-time payment with the credit bureau? The screenshot below is the payment history for a credit card that I use once a year to keep it active.
  • Improving Length of Credit History & Payment History: Add overdraft protection to your checking account. My overdraft protection shows up as a loan on my credit history. It’s the oldest thing on my credit report! That’s an easy way to build credit.
  • Improving Payment History: Make your payments FAR in advance of the bill. Why screw around waiting until the last minute and risk a problem that could give you a late payment? I pay my credit card balances in full every two weeks on the day that I get paid. Just because the credit card company gives you an extra month doesn’t mean you have to wait until a statement is issued to pay your card.
Paying those credit cards like clockwork, every two weeks.
  • Improving Payment History: Turn on autopay for your credit cards for the minimum payment due as a backup. Then you know you’ll never be late. You can still pay your cards on whatever schedule you want manually. I have autopay turned on even though I pay my cards every two weeks. Screenshot below showing the wide variety of autopay options.
  • Improve payment history: Have a system to ensure you never miss a payment. Create a payment schedule for bills so you know what bill is due on what day. I do this in YNAB by writing the due date next to each bill.

Improve Amounts Owed: This seems counter intuitive but open up another credit card. If you have a $3,000 balance on a $5,000 limit then you’re using 60% of your available credit. If you open another $5,000 limit card then your usage drops to 30% instantly. This is why credit card rewards can actually increase your credit score. Amount owed has a 30% impact on your credit score while new accounts have a 10% impact. The positive impact of reducing amounts owed with a new card outweighs the the temporary hit of a hard credit inquiry.

  • Improve Payment History: Open additional credit card accounts to reduce the impact of a late payment. More accounts = more payments which will more quickly lessen the impact of a missed payment. If you have a single card with 1 late payment in 1 year you have 11/12 or 92% on time payments. If you keep that same card for another year you have 23/24 on time payments or 96%. Still in the red. However, if you opened a second card for year 2 then you’d have 35/36 or 97% on time payments. If you opened a second and third card in year 2 you’d have 47/48 or 98% on time payments. You recover faster.
  • Figure out the ideal credit score range to be approved for credit before applying. Hard inquiries ding your credit score so do you homework first. For example, Nerdwallet.com gives you a recommended credit score range in order to be approved for a card.
Nerdwallet.com example credit card information.

Tips for establishing credit from scratch:

How do you build credit when nobody will extend you credit…because you have no credit history? It’s a cruel catch-22 situation. Here are some ideas to build a credit history if you’re just starting out:

  • Apply for an overdraft line of credit on your local bank checking account. This establishes a long term loan and if you have a savings account with cash in it this is low risk to the lender. Ask far a small amount as any amount will build credit.
  • Ask to be an authorized user on a relative or friends credit card. Even if they never hand you the physical credit card it’s still building your credit. That would be one way to make their risk zero (you don’t have a card to charge their account) and it’s still building your credit.
  • Get a secured credit card. These are credit cards where you put up cash as collateral. For example, they’ll make you provide $500 if your credit limit is $500 to ensure there’s no risk to the lender.

Action Steps:

  • Get a free copy of your credit report and credit score from a site like CreditKarma.com.
  • Review your credit report closely. Does anything look wrong?
  • If you have any errors contact the credit bureau (Transunion, Equifax, etc) and request that it’s fixed.
  • Take action from the tips section!
  • Take advantage if you have great credit with credit card rewards. I save $265/yr buying groceries with a card that requires excellent credit.
  • If you’ve increased your credit score drastically since opening up lines of credit call and ask them to reduce your APR. Refinance installment loans to lower rates.

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How have you improved your credit score? Did you learn something new? Did you take action and improve your score? Comment below!

Article Sources:

  1. FICOScore. Do I have more than one FICO score? https://www.ficoscore.com/faq. Accessed March 27th, 2021.
  2. FICOScore. YOUR CREDIT DECISIONS HAVE A DIRECT IMPACT ON YOUR SCORES https://www.ficoscore.com/education#CreditDecisions. Accessed March 27th, 2021.
  3. CreditKarma. Payment history: What it is, and why it matters to your credit. https://www.creditkarma.com/advice/i/payment-history-credit-report. Accessed March 27th, 2021.
  4. myFICO. What is Amounts Owed? https://www.myfico.com/credit-education/credit-scores/amount-of-debt. Accessed March 28th, 2021.
  5. myFICO. What is the Length of Your Credit History? https://www.myfico.com/credit-education/credit-scores/length-of-credit-history. Accessed March 28th, 2021.
  6. myFICO. What is New Credit? https://www.myfico.com/credit-education/credit-scores/new-credit. Accessed March 28th, 2021.
  7. Experian. Hard vs. Soft Inquiries on Your Credit Report. https://www.experian.com/blogs/ask-experian/credit-education/report-basics/hard-vs-soft-inquiries-on-your-credit-report/ Accessed March 28th, 2021.
  8. myFICO. What Does Credit Mix Mean? https://www.myfico.com/credit-education/credit-scores/credit-mix. Accessed March 28th, 2021.
  9. thebalance. People Who Check Your Credit https://www.thebalance.com/people-who-check-credit-report-960517. Accessed March 28th, 2021.
  10. myFICO Loan Savings Calculator. https://www.myfico.com/credit-education/calculators/loan-savings-calculator/ Accessed March 28th, 2021.
  11. FICOScore. What is a good FICO Score? https://www.ficoscore.com/faq. Accessed March 28th, 2021.
  12. VantageScore. VantageScore 3.0 White Paper. https://vantagescore.com/pdfs/VantageScore3-0_WhitePaper.pdf. Accessed March 29th, 2021
Categories
Income

How I Make $265 a Year Buying Groceries

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BLUF: Food is always a big spending category. Strategic use of the best credit cards can get you the most money back on groceries.

Note: this post contains affiliate links and the blog will get a benefit if you signup using the link. If you want to support us consider using the link when signing up. Thank you!

I love food. I mean, who doesn’t it? It is a great part of life that you get to enjoy on a daily basis. What’s a little depressing though is that food, and largely groceries, are my second largest expense behind housing! I spent just short of $8,000 at grocery stores in 2020 between groceries, toiletries, cleaning supplies, prepared foods and alcohol. That’s for two people and spending about half of it at a local discount grocer called Aldi’s.

I’m always looking for ways to save money or get money back which is why I was blown away when I found this cash back option. I also found myself feeling bad for the people around me paying in cash, check and other credit cards that are just giving free money away. It seems weird to approach strangers at the store about saving money so I’ll do it via blog instead.

Show me the money

The American Express Blue Cash Preferred gives you 6% (!!!) cash back on the first $6,000 you buy in groceries at grocery stores. Every. Single. Year. That’s 6%, everyday, at normal grocery stories. It’s not some special rate that only works for 3 months and then rotates to another category. 6% cash back x $6,000 in a year is $360 back in your pocket. Score.

There is a catch though. And before I tell you please promise to hear me out. It has a $95 annual fee. The horror! Many people see an annual fee and it’s a non-starter for them. They see that they have to pay $95 every year to have a credit card and they’re out. It’s important, though, to keep an open mind in life and not dismiss any idea before you do the math and see if it actually makes sense.

To the math, smart consumer!

In calculating the true value of a credit card I think you must include any fees into the equation to be fair. In this case, the $95 annual fee. In other words, the true value in this card is $6,000 * 6% = $360 – $95 = $265 a year for groceries. You could keep spending more but it drops to 1% so you should be putting that on another card.

But how does that compare to a 2%, no annual fee card like the Citi Double Cash which I also love and carry in my wallet? Let’s dust off our high school algebra. The equation 0.06x – 95 = 0.02x, solving for x, will tell me the exact amount I need to spend in grocery stores in a year (x) for these two cards to give the same total cash back.

  • Solving for X:
  • 0.06x-95 = 0.02x
  • 0.06x = 0.02x + 95 – Add 95 to both sides
  • 0.06x-0.02x = 95 – Substract both sides by 0.02x
  • 0.04x = 95
  • x = 95/0.04
  • x = $2,375 at grocery stores

We can check our work easily.

  • $2,375 * 0.02 (2%) = $47.50 for the Double Cash card.
  • ($2,375 * 0.06) – $95 = $142.50 – $95 = $47.50 for the Blue Cash Preferred

$2,375 a year at a grocery story is only $198/mo. Pretty easy to hit in just groceries, let alone buying toiletries, alcohol and prepared foods there. Anything spent more than that and the Blue Cash Preferred is the easy winner. Spending $500/mo on average for even my family of two is no problem to hit the $6,000 max value. Worst case I could always buy gift cards there which is conveniently at the end of the year at Christmas time.

But wait, there’s more

The card would be worth it for me if I just stopped there at groceries. You also get 6% on streaming services and 3% on gas, tolls and ride share? Here’s a little snip from my account showing those sweet sweet cash back numbers.

The usually have some kind of sign up bonus but right now it’s an even sweeter deal. A nice sign up bonus AND the first year annual fee waived.

Current offer at the time of writing in March 2021.

Action Steps:

  1. Review your budget and spending history. How much do you spend in grocery store purchases in a year?
  2. Take a look at your current credit cards and how much cash or other rewards you’re getting from them. Are you maximizing your rewards?
  3. If not, consider opening the American Express Blue Cash Preferred. The the sign up bonus it’s a no risk option to try.

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Join the conversation. Comment below if you have this card! Comment below if you have another card that you think is better!

Categories
General FI

Emergency Fund: Part 2 – Where to store it?

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BLUF: There are many options for where to store an emergency fund. The question is actually how you want to finance an emergency. Saving money in a bank is a common option but selling assets and financing an emergency with credit are options too. Most emergency fund plans include a combination of more than one of these options.

Note, this article includes affiliate links where the blog receives a benefit if the link is used. If you’d like to support the blog then use a link.

The traditional thinking on an emergency fund is 3-6 months stuffed into a savings account. My part 1 article challenged you to figure out exactly what YOU need to cover a loss of income, not just use a rule of thumb. Now that you’ve done that you have a number in mind that you need. You have done that, right? But where does that $10,000 come from? Do you save it and if so, where? Do you invest the money and sell assets? Do you finance it with credit cards or a HELOC?

One thing that’s so interesting about personal finance is that there are a million different options to solve the same problem. Our upbringing, life experiences and knowledge form our risk tolerance, biases and how we think about money choices. This is also true when it comes to the idea of an emergency fund.

The purpose of this article is to make you aware of the different options available to you and some pros and cons of each. The solution for most people is not any one bucket listed here but a combination of multiple options in a tiered approach.

Three types of approaches:

You’ll notice three groups of options in this article for financing an emergency:

  1. Withdraw Cash – These methods rely on saving cash pre-emergency in a location and then withdrawing the money when needed.
  2. Sell Assets – These methods rely on selling investments that you’ve previous acquired, turning them into cash and withdrawing the money when needed.
  3. Finance the Emergency – These options mean taking on debt to finance the emergency.

Keeping Perspective:

One thing that is important to keep in mind when thinking about planning to cover an a major loss of income emergency is that these should be tail events. A tail event, sometimes called a “black swan”, meaning a very low probability of occurring so they happen infrequently.

How often during your parents working life did they lose a job or income for an extended period of time? Hopefully only once or twice in their working life. Maybe never. It’s important to keep in mind that while it’s important to have a plan, we’re talking about events that may never happen. If they do happen, it might only happen every 10, 15, 20 years or more in a 40-45 year tadeonal working “lifetime”. In other words, 1-3 times in a lifetime.

two black ducks on grass lawn
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Evaluating each option:

In evaluating each option I’ll discuss four different characteristics:

Liquidity – how easily and quickly can that asset or money get into your hands as cash to use to fund your emergency.

Risk – what is the risk of the money not being there when you need it at the amount you need.

Costs – what does it cost you to use this option to fund an emergency. This includes fees and tax implications.

Opportunity Cost – how much are you giving up in growth to put your money here instead of a retirement investment option. For example, if an index fund returns 7% a year on average then keeping money in a low yield (.01%) savings account has a high opportunity cost.

Options to Cover an Emergency

Withdraw the money in a Low Yield Bank Account (Checking/Savings)

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  • What is this option?
    • A traditional account often offered at either a local bank or a national bank with local branches. Very low interest paid out against the money deposited.
  • Characteristics:
    • High liquidity – Often at a local bank with easy ATM access. You can get the money very fast.
    • Low risk – FDIC insured so very low risk of it not being there when you need it and no risk of it’s face value going down.
    • Low cost – free ATM and bank account withdrawals.
    • High opportunity cost – Earning almost no interest so it’s losing spending power over time due to inflation.

Withdraw from a High Yield Saving Account (HYSA)

crop female entrepreneur sitting sitting at desk and working on computer
Photo by Anna Shvets on Pexels.com
  • What is this option?
    • A bank account that offer 5-10x+ interest than a traditionally bank account. These are usually in an online only bank although some physical banks offer HYSA’s. I personally use Marcus by Goldman Sachs and have been happy with the service. You get an introductory period special APR if you sign up with the link.
  • Characteristics:
    • High liquidity – I’d still call this high although not as high as a local bank. Some HYSA’s have no ATM option so you need to do an online transfer taking 1-3 business days to get it to a local account.
    • Low risk – FDIC insured so very low risk of it not being there when you need it and no risk of it’s face value going down.
    • Low cost – free ATM and bank account withdrawals.
    • High opportunity cost – This is highly dependent on interest rates. At the time of writing the rates are 0.5% for many accounts making you lose to inflation.

Sell Assets from a Brokerage Account

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  • What is this option?
    • Selling stocks, bonds, mutual funds or ETFs from a brokerage account at the current market value. Then transferring the funds to a local bank account.
  • Characteristics
    • Medium liquidity – You need to sell the asset which can only happen during market hours. After the asset is sold you need to wait for funds to be transferred to a local bank. If you need to transfer a large percentage of the total account value you may have to wait for the transaction to settle before being able to withdraw the full amount.
    • Medium risk – Stocks increase in value on average of 7-8% / year. If you happen to be unlucky and an emergency hits during a recession or major correction you could be forced to sell at depressed prices. However, you are likely saving much more than needed for just an emergency so having enough should not be an issue for all but the largest emergencies.
    • Medium cost – You will likely be selling assets that have capital gains associated with them. This means paying short term or long term capital gains on the sold assets come tax time.
    • Low opportunity cost – Major emergencies happen infrequently on average so that money can grow with the market when it isn’t needed.

Sell Assets from a Roth IRA

  • What is this option?
    • Selling stocks, bonds, mutual funds or ETFs from a Roth IRA account at the current market value. Then transferring the funds to a local bank account. Unlike the brokerage account no taxes are due but you cannot withdraw more than your contribution amount penalty free if you’re less than 59.5 years old.
  • Characteristics:
    • Medium liquidity – You need to sell the asset which can only happen during market hours. After the asset is sold you need to wait for funds to be transferred to a local bank. If you need to transfer a large percentage of the total account value you may have to wait for the transaction to settle before being able to withdraw the full amount.
    • Medium risk – Stocks increase in value on average of 7-8% / year. If you happen to be unlucky and an emergency hits during a recession or major correction you could be forced to sell at depressed prices. However, you are likely saving much more than needed for just an emergency so having enough should not be an issue for all but the largest emergencies.
    • Low cost – No capital gains taxes to pay in a Roth account.
    • Medium opportunity cost – Your money is growing in the Roth when invested but you have a limited amount you can contribute to the account annually. If you withdraw it for an emergency it may take many years to replace that money.

Sell Real Estate

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  • What is this option?
    • Selling an investment property or private residence to pay for an emergency. Probably an unlikely occurrence for most unless an emergency with a massive financial cost occurs.
  • Characteristics:
    • Low liquidity – This is about as bad as it gets. Likely 1-3+ months to go from listing the property to having cash in your account.
    • High risk – Not because the property value may drop necessarily but in an emergency you’ll likely need to price it low for a quick sale.
    • High cost – You may not have to pay taxes on the gains if a primary residence but there’s a high transaction cost to selling a home. 6% to pay both agents typically plus all closing costs along with any requests from the buyer. If it’s an investment property then add on capital gains on top of that.
    • Low-Medium opportunity cost – Medium if this selling a primary residence in places with low property appreciation. Low if your area has high appreciation or if this is a good cash flowing investment property.

Sell Assets from a Pre-Tax Retirement Account

  • What is this option?
    • Selling stocks, bonds, mutual funds or ETFs from a Pre-Tax retirement account (401k, 403b, 457) account at the current market value. Then transferring the funds to a local bank account. Like the Roth no taxes are due on the sale of assets they are taxed as income when you withdraw the money. Additionally, there are usually penalties if you’re under 59.5 years old unless the emergency qualifies as a special situation where the penalty is waived.
  • Characteristics:
    • Low liquidity – You need to sell the asset which can only happen during market hours. Retirement accounts are not intended to have money removed before retirement so there is usually paperwork and a slow process involved in doing it unless you’re going to take a loan.
    • Medium risk – Stocks increase in value on average of 7-8% / year. If you happen to be unlucky and an emergency hits during a recession or major correction you could be forced to sell at depressed prices. However, you are likely saving much more than needed for just an emergency so having enough should not be an issue for all but the largest emergencies.
    • High cost – The money is taxed as ordinary income when removed and is usually penalized on top of that.
    • Low opportunity cost – Your money is growing in the account when invested but you have a limited amount you can contribute to the account annually. If you withdraw it for an emergency it may take many years to replace that money.

Finance with credit cards

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  • What is this option?
    • Living off of credit cards if income is lost or covering a major expense with them.
  • Characteristics:
    • High liquidity – Assuming you have cards open already it’s very quick to pay for expenses.
    • Medium risk – Depending on your credit you might not be able to cover a sizable emergency.
    • Medium cost – Interest will be owed if you can’t payoff the balance in one cycle. If you’ve lost a job this could take quite a while to pay back. Additionally, some expenses like rent and mortgage can’t be paid with a credit card unless a 3rd party service is used. These usually charge a 2+% fee on each transaction.
    • Low opportunity cost – You don’t tie up any money so you can invest any available cash.

Finance with a HELOC

  • What is this option?
    • Living off your Home Equity Line Of Credit (HELOC) in a loss of income situation or financing an emergency expense with it.
  • Characteristics:
    • High liquidity – Assuming the HELOC is already open. If not then this would be low as this usually takes some time to close.
    • Low risk – 2008 showed that credit giveth, credit taketh away. The bank can freeze credit if they really want to and they did in 2008. If you plan on waiting for an emergency to open a HELOC then timing adds to the risk.
    • Medium cost – Interest is low but there is usually a non-trivial cost to setting up a HELOC in the first place. If you’re using the HELOC for other purposes you may call this cost low.
    • Low opportunity cost – You don’t tie up any money so you can invest any available cash.

My approach:

I use a combination of 3 different accounts as my plan, but I have other accounts available to me if necessary:

  1. ~$1,000-2,000 in local bank funds. Not earning much but highly liquid.
  2. $3,000 – in an online HYSA. $3,000 is my true emergency fund but our travel sinking fund is also stored in a HYSA. So, there’s other money sitting there that could be used in an emergency.
  3. The rest – brokerage account. Still fairly liquid and my money is invested to stay growing when no emergency occurs.

I chose these options because it gives me a combination of accounts where I have quick access to money for small things but then the larger emergencies that are infrequent can use accounts where my money is growing.

Actions:

  1. Review the part 1 article and calculate how much of an emergency fund you’d need.
  2. Review the options on this page. You should at least one option that is high liquidity to handle small to medium size emergencies.
  3. If you have a higher risk tolerance, consider utilizing an option with a low opportunity cost to fund very large large emergency.
  4. Write down your plan! Think through your plan if your large emergency happens to get cash in your hands. Adjust the plan if necessary.
  5. Relax. There is no perfect answer here. The fact that you have a plan makes you far ahead of many other people.

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What is your plan to cover an emergency? Comment below!

Categories
General FI

Emergency Fund: Part 1 – Size – How big should it be?

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BLUF: An emergency fund can help you handle the tough financial situations that life can throw at you. There is no one size fits all answer that will be appropriate for you. Size your fund based on your current expenses, income situation, life flexibility and the planned worst case event.

A core piece of financial advice from the personal finance space is that everyone should have an emergency fund. If you follow Dave Ramsey it’s actually baby step #1 in his 7 steps to get people out of debt. There’s not much debate about that although we’ll challenge that idea in part 2 of this article.

What is all over the map is the advice for how much you should have in your emergency fund. Having 3-6 months of your expenses is a commonly thrown around rule of thumb. But why 3-6? I don’t believe in blindly following advice without understanding the detail behind it and neither should you. Having 3 months saved up and finding out you need 9 months worth to find a new job doesn’t sound like much fun! On the other end of the spectrum, there’s an opportunity cost to holding cash so making an unnecessarily large emergency fund will cost you money long term too.

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Like most things in personal finance, you need to figure out what sized emergency fund works best for you. In this article we’ll explore the different things that go into sizing an emergency fund and show some examples of how you can calculate it for yourself.

Emergency Fund: What is it?

An emergency fund is money readily available to you cover a life situation that requires money to fix it. This is something where you don’t have enough money on hand or in your normal spending budget to cover it. At the low end of the spectrum this could be a unexpected car repair. The high end of the spectrum could be a loss of income for an extended period of time.

What kinds of things you use your emergency fund is a debated topic with lots of opinions. Personally, I don’t really care what you use it for. In the end you need to replenish the fund as a high priority item so when you dip into it is your choice.

Emergency Fund: How to calculate it

Step 1: Determine the worst case situation that you want to plan for.

The life situation that you want to cover is an important driver to the fund size. Covering an unexpected car repair is a very different issue than being out of work for 6 months. Think about some potential life events that could occur. Two of the most common events are a large unplanned expenses (car repair, home repair, medical expense) and a loss of income (job loss, medical issue).

Unplanned expenses can be costly but compared with having to cover your living expenses due to a loss of income there’s almost never a comparison between the two. Since an emergency fund should be sized for the worst event you think you need to deal with we’ll focus on loss of income.

Not only is loss of income is one of the biggest and scariest situations for many, it also can be the most difficult to determine. It’s highly personal because everyone’s income situation and life expenses are highly personal.

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Step 2: What expenses do you need to cover?

Are you noticing that many things with FI depend on knowing how much you spend on life? Tracking expenses and budgeting are really a necessity to be successful financially. I gave a few tips at the end of this article for how to get started if you don’t track them already.

I break down the expenses of life into two high level categories that I call Core Expenses and Discretionary Expenses:

Core Expenses

Core expenses are what I call bills that you will need to plan to pay no matter what the life situation is. It’s easy to think about the bills that come due monthly like food, housing and internet. However, you still need to plan for the large infrequent bills like taxes and insurance. Sinking funds for things like pet expenses, home and car repairs should be included too. Little Johnny doesn’t care that you lost your job when he throws a ball through your window on accident.

2021 Core expenses planned spending

I use an Excel spreadsheet to plan my rough budget for the year and that makes it easy to approximate monthly spending. In this case $2,919/mo.

Discretionary Expenses

Discretionary expenses are what I call everything else that isn’t essential spending. Things like travel and shopping, for example. What you put here is completely personal but it should reflect things that you consider non-essential and could cut in an emergency.

2021 Discretionary expenses planned spending

Total expenses to cover

To calculate the expenses I need to cover per month I take 100% of the core expenses because those will be required in an emergency. I take 25% of my discretionary expenses and include that too. Why? Because you still need to have some fun when your dealing with a stressful situation like a loss of income. You could go line by line and remove some things and keep others but this method is quick and good enough for me.

There you have it, a number. I need $3,300 a month on average to cover living in a lost income situation. Note that I’ve completely left out any saving during this time. I assume that in an emergency all saving is paused until the emergency situation is over. With expenses understood we need to move to the income side of the equation.

Step 3: What would your income become in an emergency?

This is an important but sometimes difficult question to answer. It’s highly dependent on your personal situation and the worst case scenario that you’re planning to cover. If you work for someone and are single then if you lose your job you’ve likely lost all income until you can an unemployment benefit. You need to understand in that situation what your income would become in a job loss.

Single income example

For example, if you make $60,000/year gross and after taxes $4,000/month, a 9 month block of time in normal circumstances would look like this.

Now the worst happens and you lose your job. How much will you get for unemployment? In NY I can use the state benefits calculator to figure out how much I would get.

Unemployment benefits calculation for a $60k/year earner

In this case a $60,000/year job will get you $504/week. I like to be conservative so I’ll assume that it takes 1 month for benefits to kick in and I get 4 weeks of benefit a month. In NY unemployment benefits last for 26 weeks maximum (6 months). If I lost my job for 9 months then my monthly income would roughly look like this. There’s a couple of bonus 5 week income months in there but I’ll ignore those for simplicity.

A far cry from that $4,000/month you were making but you need to be realistic about what to expect in going through this process.

Dual income example

You can do the same thing for a dual income household where you’d want to plan for the higher income earner losing their job. In this case a household with a $6k/month and a $2k/month earner.

Since we’re worried about the worst case the high earner loses their job for the same 9 months as our previous example. The income situation now looks like this for that dual income household with the same previous assumptions of one month for benefits to kick in and then 6 months of benefits.

As you can see the $6k/mo earner didn’t get anymore money than the $4k/mo earner did. They get the same $504/week even though they make an extra $24k net a year. It’s important to understand your unemployment benefits and where they top out based on income.

Business owners can do the same kind of analysis and assume that their business stops producing income for some period of time. Or perhaps you’re a consultant with most of your business coming from a single client. What happens if you lose that key client?

Step 4: How long will it take to replace that income if lost?

You know your expenses to cover and you have an estimate of what your income will become an emergency. The last piece of the puzzle is to figure out how long to plan for an emergency with that income loss to last. Since job loss is the most common we’ll explore that situation.

Information from the U.S. Bureau of Labor Statistics can help us plan.

To summarize the data of how long it statistically takes for a person to find a new job as of January 2020:

  • ~ 1 month or less (5 weeks) – 38% of people
  • 3 months or less (14 weeks) – 67.6% of people
  • 6 months or less (26 weeks) – 81.3% of people

Quite a wide range of possibilities. There’s also an open ended 18.7% of people that took over 6 months to find a job. That could be 7 months or 17 months.

What should you plan for? It depends on your situation. If you are a professional working in a very niche field with high salary requirements and a hesitance to move then it might take you 12+ months to find a job. If you work as nurse and aren’t tied to a location you could very well find a job in less than a month.

focused woman with documents in hospital
Photo by Laura James on Pexels.com

Here is some very broad guidance on how long to plan for losing your income. You should take into account your personal situation and what you’d be willing to do to find new work:

  • 3 months – Desirable skills but not as unique, lots of job options or flexible with location. Could be early career professionals with basic salary expectations.
  • 6 months – Somewhat niche skills, less jobs in that industry. Less willingness to move. Could be mid-career with larger salary expectations.
  • 9-12 months – Niche skills, limited jobs in an industry or unwilling to move. Could be mid-late career with high salary expectations.

Said another way, the pickier you are about where you live, what you do and what you make, the longer you need to plan to be out of work for if you lose that job.

Step 5: Calculate the emergency fund size

Time to put all the pieces together an figure out what you care about most – the amount of money you need! From steps 2,3 and 4 you have the following information:

  • Step 2: Your monthly expenses in an income loss situation
  • Step 3: Your monthly income in an income loss situation
  • Step 4: How long you will plan to not have income

For example, piecing this together from our previous examples let’s assume the following:

  • Single Earner making $60k/year, $4k/month after taxes in NY loses their job.
  • Monthly expenses for core + 25% of discretionary are $3,300/month
  • Monthly income is $2,016 on unemployment starting one month after they lose their job and lasting for 6 months (state limit)
  • It takes 9 months to find a new job.

I’m an Excel nerd so it’s my easy go-to tool for this stuff but you can do this manually just the same. And the verdict is…

Single earner emergency fund size calculation.

In this situation you would need just under $18,000 in an emergency fund to cover this job loss situation without going into any debt. Time to break that piggy bank!

person holding coin
Photo by maitree rimthong on Pexels.com

Double Income Example Calculation

For example, piecing this together from our previous examples let’s assume the following:

  • Double income household. High earner making $85k/year, $6k/month after taxes in NY loses their job. Second earner makes $30k/year, $2k/month after taxes and keeps their job.
  • Monthly expenses for core + 25% of discretionary are $5,000/month
  • High earner claims unemployment and starts receiving $2,016 ($504/wk) one month after they lose their job and lasting for 6 months (state limit).
  • It takes 9 months for the high earner to find a new job.
Double earner emergency fund size calculation.

Given this situation the couple would need just under $15,000 in their emergency fund to get through this situation without going into debt. You could certainly go down the rabbit hole of details

Emergency Fund: Where to store it

An emergency fund first and foremost needs to be in a location where you have quick and easy access to the money. You don’t want a dependency on selling an asset (stock, bond, property), waiting through a slow financial transaction or some other situation that is out of your control. Remember that it’s important to focus on the things that you can control.

My preferred location to keep an emergency fund is a high yield savings account. There are a lot of good options out there and you’ll typically make 10x+ the amount of interest as you would with traditional savings account at your local bank. I list a bank I use here or just google “best high yield savings account” and decide for yourself. One thing to keep in mind is that it can take 2-3 business days to transfer funds. That’s plenty of time for most life situations that I’ve encountered. If that is a problem to you consider keeping a small percentage of your emergency fund in a bank with more instant access to the money via debit card, ATM or check.

Part 2 of the Emergency Fund series goes deeper into the options of where you can store your money and even explores the use of credit and investments options in place of savings as part of an emergency fund plan.

abundance bank banking banknotes
Photo by Pixabay on Pexels.com

Action Steps:

  1. Talk through with a partner or a friend what emergency situations you’re worried about covering. Job loss is usually the most substantial.
  2. Figure out your core and discretionary expenses on average per month. This article has some tips if you don’t track expenses currently.
  3. Map out what your income would look like in that job loss scenario. Consider all sources of income including unemployment. He honest with yourself about what will happen.
  4. Make an assumption about how long it will take to find a new job.
  5. Calculate your fund size!
  6. Make a plan to start saving monthly toward that goal in a high yield savings account. Don’t be discouraged if it takes a while to hit the end goal. Every dollar added to the fund increases your safety net!
  7. Read Part 2 of my Emergency Fund series on where to store your money.

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Do you have an emergency fund? How did you calculate how much you would need?

Categories
General FI Happiness

Focusing on what you can Control: My New Life Superpower

blue and red superman print tank top shirt
Photo by Pixabay on Pexels.com

BLUF: Focusing on the things in your life that you can control to energize yourself into taking action. When you know all actions taken are achievable you stay motivated and in problem solving mode. Not worrying about the things that you can’t control will make you happier by freeing your mind of anxiety and doubt.

“There is only one way to happiness and that is to cease worrying about things which are beyond the power of our will.”

Epictetus, Discourses

2020 was a tough year for most people. The pandemic turned our world upside down and we were restricted from living our lives in a variety of ways. There were many feelings of helplessness and anxiety over these world events that all felt outside of our control. One positive of that year was more time to read and by sheer luck I came across a concept called the trichotomy of control that would change my whole outlook on life.

Trichotomy of Control

The trichotomy of control is a concept that comes from an ancient Greek school of philosophy called Stoicism. I have Mr. Money Mustache and this post to thank for introducing the concept. I know, it sounds like some academic concept that doesn’t apply to real life but it actually does. The idea is that all things in life can be put in three different buckets:

  1. Things that we have no control over
  2. Things that we have complete control over
  3. Things that we have some control over
Trichotomy of control Venn diagram

Things we have no control over

There are a lot of things that we actually have no control over and many are related to our external world.

  • Other people – unless you have some special puppet master abilities. As much we’d like to control the actions of others sometimes, we can’t.
  • Nature – a pandemic, earth quake, hurricane, asteroid heading at earth.
  • Genetics – no control over what you were born with, however feel free to blame your parents if it makes you feel better.
  • The Past – as much as sometimes we want to, the past has happened, never to be changed. The Stoics argue that you can’t change the present either as it’s instantly happening and then becoming the past.
  • External events – probably either nature, the actions or others or a combination. This is really anything around us in the world that is just happening.

Things we have complete control over

“Some things are within our power, while others are not. Within our power are opinion, motivation, desire, aversion, and, in a word, whatever is of our own doing.”

Epictetus, Enchiridion

In the end what we think and what we physically do are what we have complete control over. Said another way, our thoughts and actions. Don’t get me wrong, just because thoughts and actions are in our control doesn’t mean controlling them is easy. You have complete control over how you react when someone insults you but it doesn’t make it easy to walk away if they hurt your pride.

Things we have some control over

Many complex events and life situations end up falling into the bucket of some control. The key here is to recognize that and break down a complex concept into its actionable pieces that can be put into the bucket of full control. You may find it helpful to think through items in the “no control” bucket but I haven’t found that to be of much value to me.

I think it’s most helpful to explore this concept with some real world examples.

Putting the idea into practice

Example: I want a promotion at work

I brought up this example in my goal setting post. I didn’t explicitly talk about Stoicism or the trichotomy of control there but that’s the tool that I was using. Most people want to advance in their career but it’s important to focus on the things that are within our control. Being a manager at a large company myself I’ve been through this process many times.

Let’s break down a goal of getting promoted at work into the components that you can and cannot control.

close up of human hand
Photo by Pixabay on Pexels.com

Things you can control:

  • How hard you work and how well you perform – If it’s a true performance based work environment then how you perform is critical to having any shot of a promotion. As Steve Martin once said “Be so good they can’t ignore you.”
  • Making your manager aware of everything you do (sell yourself) – To get promoted a manager usually has to submit paperwork with justification for a promotion. Getting promoted is really convincing two or more people that you deserve it. Selling your manager (1) that you deserve it with evidence to prove it. Your manager selling his manager (2) or a promotion review board (2+ people) that you deserve it. Your manager risks a personal reputation hit if they put forth a weakly justified promotion request.
  • Acquiring the skills and experience needed for the position – The best candidate for a position is the one that has the highest probability of being successful if chosen. Work on the skills and gain the experience needed in advance to make you the best option on paper.
  • Making others aware of what you want – Do other people know that you’re looking to take on greater responsibility? Change jobs? It may seem obvious but you need to let people know what your aspirations are or you may never be considered.
  • Looking for other positions that come with a promotion – If there are no open positions above you to fill, look in other parts of the company where the position comes with a promotion. Maybe this means looking at other companies because there are no internal opportunities.

Things you can’t control:

  • If the job you want is available – Sometimes the job you want is not a “promotion in place” job. Someone else might be performing the higher responsibility role that you need to be promoted. You can’t control when someone will leave so you would need to wait for the position to open.
  • The selection process for an open position – Someone less qualified could be chosen for the position just by their networked connections. The best friend of the CEO or your managers work buddy, for example.
  • If a promotion is currently possible – Maybe the company is in financially rough shape and promotions have been frozen. Maybe there are too many promotions this quarter or year. Maybe there’s a promotion limit and your case wasn’t strong enough to make the cut this time. There can be a multitude of reasons why a promotion is roadblocked at the moment.

At this point start taking action on all the things that you can control. If you do all the things possible in your control in your current position and nothing happens then you need to decide if you’re willing to look elsewhere. Again, focus on what you can do.

Example: I’m afraid of being fired… and not having the money to live.

Many people have the fear of being fired. That’s really not the root the fear though as the wealthy aren’t worried about this happening. As much as you may love your coffee break gossip or Monday morning quarterbacking, most aren’t worried about being fired because of losing at work friends. It’s a financial concern.

Most people live paycheck to paycheck. A poll done by Charles Schwab in 2019 showed that 59% of adults live paycheck to paycheck. Yikes. It should be no wonder then why people stress about a potential job loss. They don’t have the savings to pay all life expenses until they can find a new job.

young troubled woman using laptop at home
Photo by Andrea Piacquadio on Pexels.com

Things you can control:

  • Create an emergency fund – A buffer of either available cash or credit that you can tap to pay for all life expenses until you find a new job. Many sources recommend a 3-6 month fund but how much is situational and depends on how many earners you have, how long you think it will take to be rehired, your mobility/flexibility and your risk tolerance. Future post alert, I’ll dive deep on this topic soon.
  • Your job performance at work – Unless your entire company collapses in an unexpected ball of flame (Enron style), layoffs happen progressively and somewhat predictably. The best performers with skills most helpful to the future success of the company are usually the last ones to be let go.
  • Be likable – Research discussed in this article states that: “Likeable people are more likely to be hired, to be listened to, to have colleagues offer help and to be promoted. Research by Northwestern’s Lauren Rivera found that where backgrounds and skills of job candidates are similar, the person seen as more likeable gets hired almost 90 per cent of the time. And a study at the University of Massachusetts found that when likeable managers present plausible arguments, even colleagues who disagree tend to buy into their recommendations.” Wow! It pays to be likeable. Sounds like something to add to that to-do list for people that want to be promoted too.
  • Not committing a fire-able offense at work – No matter how good you are at your job, most companies have certain policies that will get you fired if broken. Learn what they are and don’t do them. Stealing in any form is usually a no-brainer. I don’t just mean stealing money, Office Space style for example. I mean stealing anything. Lying on your timecard, lying on your expense report, physically taking company property…the list goes on.

Things you can’t control:

  • Your company falls on tough times and they go bankrupt – The 2020 pandemic bankrupted many companies at no fault of the employees.
  • Your company merges with another resulting in layoffs – In 2020 Schwab and TD Ameritrade merged and 1,000 were let go.
  • Your company changes strategic direction resulting in layoffs – Sometimes a company decides that a product or project that you are working on isn’t the best strategy for the company long term and cuts the whole team associated with it. You could be the best performer on the team and it may not matter.

Unexpected benefits

An interesting realization that I’ve made since adopting this mentality is that the focus on things that I can control has made my mind not even think about the things that aren’t in my control. I don’t have to think “I can’t make my boss give me a promotion so don’t worry about that”, it just doesn’t even enter my mind. My brain stays in problem solving and taking action mode freeing it from mental stress and anxiety.

One of the worst feelings is the feeling of being helpless. Seeing a situation in front you that you want to change but you don’t feel like you can do anything about it. Using the trichotomy of control has been a way to escape from stuck feelings of helplessness. I never get stuck because I only focus on the actions that I’m capable of controlling and therefore achieving. I know I have the power to be successful in those actions which energizes me to keep pursuing them.

Action Items:

  1. Practice taking problems and situations that are complex and thinking about them in terms of what you can and can’t control. Start by making a list of things that you can control that can either solve or work to solve the problem.
  2. Prioritize the things that you can control and take action on them.
  3. Re-evaluation the current situation. If your action didn’t resolve the situation then repeat the process.

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What problem or situation will you try to use this method on first? Add a comment below.

Categories
General FI

Financial Independence: Why pursue it?

BLUF: Our time on this earth is limited and not in our control when we have to work. Financial independence is a way to give us back control over our time and giving ultimate freedom.

Independent (adjective): not subject to another’s authority or jurisdiction; autonomous; free.

Dictionary.com

Americans love the idea of freedom. We love the idea that we have control over our lives having the power to choose what we want to do with our lives and how we spend our time. But most of us aren’t really free. We’re slaves to one necessity in life: money.

We need food, shelter and clothing as basic necessities to live and most of us exchange money to get them. Then there are the “wants” on top of the needs. Elaborate housing, fancy cars, exotic vacations, latest tech gadgets and luxury fashion goods. As the spending goes up, the debts and income needs go up. You’re trapped in that job to pay for that lifestyle of wants.

Lifestyle inflation and spending keeps you chained to your job longer.
Photo by Dziana Hasanbekava on Pexels.com

And what are we ultimately offering up to get that money via our job? Our time. Time is one thing in life that we have a finite amount of left but we don’t know the amount. We could have decades, years, months or just days left and none of us know exactly. If you have days left and you’re spending it reading this blog then I’m truly honored. And confused. Or both.

Until you no longer need to work for money, you are missing a special type of independence that traditionally has been thought of for the 60+ crowd and the really rich. Until that point you can’t go to the park whenever you choose to. You can’t take a vacation without asking the permission of someone else. You are living on someone else’s schedule.

Financial Independence: What is it?

Financial Independence is a point where you’ve built a money machine large enough to work in place of you and pay for your life. Your money and investments are working for you, 24/7, making money so you can do what you want with your time. Sounds much cooler than a money tree, doesn’t it?

Money machine
Photo by Pixabay on Pexels.com

Financial Independence with a Portfolio

How much does this money machine need to make? Well, now that you’re tracking your spending you know what life costs you to live right now. A retirement planning study was done at Trinity University, which has since become known as “The Trinity Study,” showed that a 75% stock, 25% bond portfolio had a 98% chance of not running out of money after 30 years if you withdraw 4% a year. This also accounts for inflation adjusted withdrawals.

This has developed into what people refer to as the “4% rule” of thumb. Make a portfolio that is large enough so that you can cover your expenses by withdrawing 4% a year and you have an extremely high chance of success over 30 years. That’s because the stock market returns roughly 8% a year on average over the history of it. 8% returns – 4% withdrawals – 2-3% inflation > 0. On average, your stock investments grow faster than you can spend them accounting for inflation. That’s why this works.

How do you figure this out for yourself? Divide what you spend in a year by 4% or multiply it by 25 (1/.04). If you spend $60,000 a year: $60,000 / 0.04 = $1,500,000. $60,000 * 25 = $1,500,000. This portfolio size based on the 4% rule is what people refer to as your “FI number”.

What’s magical about this is that you have the power to change this amount DRASTICALLY by your spending. Say you make some smart choices and are able to live on $50,000 a year? You’ve just reduced how much you need by $250,000 to $1,250,000! That’s taking years off your working life. Want to do some geo-arbitrage and retire in cheaper Mexico or southeast Asia? Maybe then you can live on $40,000 / year and retire with $1,000,000

Financial Independence with a Business

The FI concept can be achieved just the same with a business as it can with a portfolio. Business can mean a variety of things beyond opening up another Subway in the neighborhood. An online store is a business. A YouTube channel can be a business. Real estate can be a business. You don’t need to invent a product or build the next Google to reach FI. You just need income streams that exceed your expenses.

Real Estate is a particularly popular business vehicle to reach FI in the community. Say your personal expenses are $60,000/year. If you can make a rental provide you with $500 a month in income after all expenses, that’s $6,000 a year. Build up 10 rentals over the years that cash flow the same? You’re now bringing in $60,000 a year covering all your expenses and you’ve reached FI. The only work required is managing those properties. If that $500 profit already includes paying for a management company then you don’t even need to do that.

FI versus FIRE

The more popular term floating around the media is actually FIRE – Financial Independence Retire Early. It’s a lot more exciting for people to talk about FIRE because on the surface the idea of quitting your job before 65 or 60 sounds appealing.

On this blog you won’t hear me talk about FIRE much because I never really plan to stop working. Change my career along the way? Quite possibly. Stop traditional office work? Certainly. But I’ll always seek out work that adds meaning to my life. It’s part of the reason I’ve started spending so many hours writing this blog.

outdoor fireplace during nighttime
Photo by Matheus Bertelli on Pexels.com

More to the Financial Independence story

Don’t get me wrong, the 4% rule of thumb is a simplification of the total story and I encourage you to learn more. When you get closer to your “number” you need to make sure to take into account taxes, changes in spending and healthcare costs just to name a few things. It’s a target to work towards though. Something that’s easy to wrap your arms around.

Don’t feel bad if you’ve never heard of financial independence or that the being able to retire early is within reach for the middle class. Nobody talks about the idea that your retirement age and how much you need is tied to your spending. Here’s a retirement calculator from AARP and it’s typical of the common approach that you’ll find. Notice that the question is “At what age do you plan on stop working?” Whaaaaaaat? They’re asking you for the answer to the problem that you want to solve: When can I retire? People need a calculator to tell them what age they can stop working given their saving and spending. I think it would be pretty eye opening to many if they realized they could stop working much earlier if they spent less money. A famous FI blogger, Mr. Money Mustache, has a beautiful article on this concept called “The shockingly simple math behind early retirement.”

Credit AARP.com – https://www.aarp.org/work/retirement-planning/retirement_calculator.html

Here’s another retirement calculator example from a large investment company. In this case they assume that you saved spent 85% of your income and saved 15% to get to retirement. In retirement you stop saving and the spending stays the same.

Saving rate of 15%? Only if you want to live like everyone else.

Financial Independence: Why pursue it?

I started this post talking about FI really being about time. Time is a funny thing in that the older you get, the more valuable it becomes to us. It’s the one commodity that you can’t really buy more of so as you age you value the time you have much more so than you did when you were young and weren’t worried about death. It’s not a linear relationship, it’s an exponential one.

value of our time over a lifetime

Since we trade our time for money, the inverse value relationship is true with money. The older we get, the less we value the time for money trade. That’s one reason Warren Buffet once said in his 80’s that he’d trade all his wealth to be 25 years old again.

The traditional path is to work until you reach age 67 and then hope your mind and body haven’t degraded too much to enjoy the years that you have left in your life. In the US, that’s until 78 on average.

US life expectancy
Source – World Bank http://datatopics.worldbank.org/world-development-indicators

If you assume the last year of your life is probably spent with degrading health issues then that leaves you with 10 good years on average. 10 years of freedom to do whatever you want…if you’re lucky to make it that long. My mom died at 63 of cancer so she didn’t even make average retirement age. That was one catalyst for thinking about how I could live a different life. That’s my “why.” Life is short and you never know when it could abruptly get even shorter.

Yes, I love my job, now. Doesn’t mean I want to work it until 67, or 65, or 60. There’s power in the options that FI money brings and I want to be in the drivers seat to choose my own path.

Discoveries along the journey

The road to accumulating 25x your expenses is long. Even with a 50% savings rate it takes roughly 17 years to be able to retire. But there have been noticeable benefits as my financial security has increased and I’ve learned more about the ways to make things fit the life that I want:

  • 3 month emergency fund – Having 3 months of living expenses means zero stress about any financial speedbumps that life throws at us. Roof needed to be replaced last year, no big deal. Furnace goes this year? Okay.
  • 1 year of expenses – Having a year living expenses to me is the definition of what people call “Fuck You” money. If your employer put you in a situation that you weren’t happy with you can say no. They can fire you or you can walk away and you aren’t worried. You want me to work weekends? No thanks. You need me to work 60 hours next week? Sorry, not interested.
  • Awareness of my budget and spending has put me in control of my finances. I know where the money is going and where I could cut if I had to.
  • Learning and life hacks – I’ve always been a problem solver but now I feel like I have a whole different toolbox of life hacks to draw from to make things easier. Tax optimization, geographic arbitrage, travel rewards, minimalism, time efficiency and many more. Every problem in life I now approach in a completely different way which has been a lot of fun. I question the conventional ways of doing things constantly. I’m excited to share many of these tools as this blog gets larger.
pexels-photo.jpg
Photo by Miguel Á. Padriñán on Pexels.com

Action Steps:

  1. Understand what your expenses are.
  2. Take meaningful steps to reduce expenses that don’t add value to your life. Make goals related to this and track them.
  3. Using this post, calculate your FI number.
  4. Play around with your yearly expenses. How does that change your FI number?
  5. Calculate given your current saving and investing plan, what age you will hit FI. More help coming on this step in the future.

Are you pursuing financial independence? If so, what is your “why” for doing it?

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