Know Your Expenses
Episode #4 of the course How to retire early by Maureen McGuinness
So far, we’ve learned about what early retirement is, why we want to retire early (or just become financially independent), and how being open to alternative ways of living can unlock opportunities to retire earlier than many.
This lesson will cover one of the biggest factors affecting your ability to become F.I.R.E.: your expenses. These impact your ability to retire early in two ways:
• the amount you need to live on when you stop working for money (future)
• the amount you can invest (while saving for early retirement) (present)
The Math of Early Retirement
Your expenses are an important starting point for knowing when you can retire. After all, you need to know how much your lifestyle costs to ensure that your investment income is sufficient. Here’s how much you’ll need in your F.I.R.E. fund: Take your monthly expenditure and multiply it by 300. You can also multiply your annual expenditure by 25. Let’s use an example: Your current lifestyle costs $3,000 per month ($36,000 per annum):
$3,000 monthly expenses x 300 = $900,000
$36,000 annual expenses x 25 = $900,000
What is this calculation based on? This calculation assumes the following about your F.I.R.E. fund:
• It generates a return of 7% per annum after tax.
• Inflation is 3% per annum.
These two assumptions help us calculate the safe withdrawal rate of 4% per annum. This means that you only live off the gains (7%) from your investments minus inflation (3%) and thus withdraw 4% per annum to live off of:
4% of $900,000 = $36,000 per annum (or $3,000 per month)
How Can I Earn 7%?
With most bank accounts offering, at most, 2% interest on your savings account, you might be wondering where this 7% rate of return comes from. As mentioned, you need to live like no one else so you can later live like no one else, which means that you’ll also need to save differently. You have to save and most importantly, invest like the few who retire early do. In the early retirement community, a common way to invest is to buy index funds that have low management fees and have historically returned 7% annually. This figure accounts for the peaks and troughs in the stock market, so for some years, this may mean a negative return, and for other years, this may mean a return as high as 12%.
Biggest Expenses
The most common big expenses we all pay are housing, healthcare, and childcare. For the average household in America, these three expenses alone account for more than 60% of their income after taxes and deductions.
Housing
You may have heard about spending no more than 30% of your gross income on housing, i.e., the place where you live and bills, including water, gas/electricity, internet, TV service (whether it’s cable or streaming), and property taxes if you own your property. If you can pay less on your housing, even if it’s just 5% less, the extra money can go toward your F.I.R.E. fund. Here are a few ideas:
Review your providers every six months. Are you getting the most competitive rate on your gas, electricity, internet, water, etc.? If not, look into the options for switching without paying a penalty, i.e., avoid breaking a contract within the term.
Be the ideal tenant. If you rent, having an excellent relationship with your landlord can help you save on rent. Landlords are keen to keep reliable tenants who pay on time and report issues early to avoid huge maintenance costs. Reducing the frequency you move can help keep your rent steady over time. I am in the fifth year of renting the same apartment, and in that time, my rent has only increased in total by 6%.
Remortgage. If you own your property and your mortgage rate is about to increase, it’s worth exploring remortgage options. Remortgaging may help you get a better interest rate (so you pay less in the long run), reduce your monthly payments (so you can divert money), or help you reduce the term of your mortgage (the shorter the term, the less compound interest you’ll pay).
Overpay your mortgage. Many mortgages allow you to overpay a certain percentage above your monthly payments. By paying off 5-10% more every month, you can shave a few years off of your mortgage term and pay less interest.
House hack. As well as living with a roommate to reduce the cost of living, you can use Airbnb to rent out a spare room or a sofa bed for short periods.
Healthcare
If you don’t live in a country where healthcare is free, you’ll need to account for the cost of health insurance, medical services, and medical supplies. This only takes into account what you pay while you’re working, but it’s prudent to consider how much these costs will increase when you’re retired and less healthy than you are in your 30s. Some continue to work at their jobs (albeit part time) to continue to access their healthcare benefits.
Childcare
You can see why I suggest thinking carefully about your desire to have children, especially if you aren’t sure. After some soul searching, I decided that having children is not a priority for me. For parents and future parents, these are your options: 1) Don’t have children and eliminate this cost, or 2) get creative with your childcare arrangements. This could mean avoiding a full-time nanny (costing as much as $34,000 per annum), adjusting your work schedule as a couple (e.g., instead of working five days a week, each parent works four days a week), and only using a daycare service three times a week (costing $120 per week instead of $200).
I’m hoping it’s becoming clearer why it’s worth adopting a lifestyle that goes against the status quo, which encourages you to spend every paycheck, save no money, and take out debt to get a bigger house than you need (or actually want).
Tomorrow, our focus will be on the second most important element of your early retirement equation: your income.
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