An Introduction to Financial Independence: Part Two – Expenditures, Basic Accounts and Debt

Overview

  • Covers basic expenditures, account setup and debt
  • Split across three major sections
  • Intended to provide some information to enable you to improve your financial situation *today*
  • Approximately 4,000 words

This is part two of my series on Financial Independence. In the first part we covered the basic concept of FI as well as the psychology required to obtain it. The full series list is as follows

Now that we have covered the psychology and basic concept of working towards FI we can shift on to the more practical concepts. Expenses, security nets, investments, taxes, withdrawals and the like. I’ve listed them in the order which I think is most important, beginning with spending.

I touched on this concept in the Value of Money section but here we’ll need to take it to it’s logical conclusion.

The FI equation is quite simple once you get down into it:

Expenses <= Investment Capital x Average Rate of Return

Here:

  • Expenses – your total annual expenses for everything, food, bills, housing, travel, consumer goods, clothes. This is the total sum of everything you spend in the year. This will also include taxes.
  • Average Rate of Return – What you can expect to receive from your investments over the long run. A decent estimate is around 4% for complete safety.
  • Investment Capital – The total amount you have invested in the rate of return. This does not include your primary residence if you own your own house, unless you choose to take on something like a reverse mortgage to free up the capital.

The average rate of return you’ll earn over the long run is fixed. We cannot take into account any highly speculative returns. That’s not FI. One mistake and you’ll be absolutely wiped out and starting from scratch. Lower risk, lower return. As such this leads to the following conclusion:

How much you spend dictates how much capital you require and therefore when you’ll become FI.

Your expenditure is the main thing you have under your control. Every $1,000 you’ll spend will need an additional $25,000 of capital to fund this. A $40,000/year lifestyle (including tax) will require $1,000,000 in capital to fund this in perpetuity. Sobering I know. If this shifts to $60,000/year, you’ll need an additional $500,000.

It gets worse. Every additional dollar you spend now depletes the amount of capital you have to fund your investments. In FI terms this is known as your savings rate (SR) which is the amount you save relative to your total income. The SR dictates how quickly your capital grows and also encapsulates your expenditure as well. Simply put, a higher SR means you’ll achieve FI faster.

So the first component here. You must figure out how much your spending and track any expenditures you have. All of them. No exceptions. To control your expenses you should have an excellent grasp as to where all of your hard earned cash is going.

I use a program called GNUCash for this. It utilises a double entry accounting system and doubles as a decent net worth tracker. It can be a little bit intimidating at first, the reporting functionality is also a little bit sub par but it does one thing very well. It tracks expenses and places them into accounts (categories).

So, I have a record of every dollar I’ve spent over the past six or so months in this tool. It’s all backed up and I have control over my data (if that’s important to you). What this means is I can make informed judgements about where my money is going. Some major improvements since I’ve switched towards a FI mindset and tracking expenditures:

  • Managed to reduce housing and utility costs by $700/month – $8,400/year
  • Reduced insurance costs by $30/month – $360/year
  • Reducing monthly coffee expenses by $100/month – $1,200/year
  • Reduced dining expenses in favour of home cooked meals by $100-150/month – $1200-1800/year

Without any real reduction in my happiness or quality of life I was able to reduce my expenditures by more than $10,000/year without too much effort. I’m continuing to work on reducing other expenses. Cell phone bill is next on the chopping block ($600/year saving) and then I’ll look into other expenditures like gym memberships ($500-600/year possibly) and potentially riding a bicycle to work ($2000/year saving). Working on the grocery bill is also on the list but has been delayed as I really enjoy cooking and food and the marginal benefit hasn’t been worthwhile for me yet.

When I look at these reductions I haven’t experienced any real hardship. I used to crave a coffee in the morning. Now I have some tea whilst writing in the morning at home and have no such urges. Now that I’ve adjusted to it I don’t feel that I’m going without or anything equivalent. I simply make different choices.

I am trying to become much more conscious of my expenditure. Not just throwing out the credit card whenever a bill comes out but instead asking myself whether I really need it. I still have guilty pleasures here, I had an expensive holiday in the USA in June. I’ve been working towards a couple new hobbies and taking classes to improve. These all cost money.

But I’m not trying to limit my life to fit my expenditure goals.

Instead, I’m becoming smarter about where my money and resources end up such that I can maximise the amount of life I get from them.

Your own personal circumstances will be different to mine. You will have different expenses, different priorities and different goals. Embrace them, work out an expenditure plan that works for you and try to make cuts in the basics first. If you’re renting you can often find much cheaper accommodation. Bicycles are a fantastic way of reducing commuting costs and ask yourself if you really need that $10 sugar/caffeine hybrid fix every day. For many of us the problem is “too much house”. Living in an environment where we need to buy extra furniture that we never use so that a room doesn’t look empty.

Understanding your expenses in an annualised fashion and linking it back to the capital required to sustain it gives you a clear understanding of the true costs of a habit. Understanding how long it takes you to earn that capital makes it starker still. Run a ruler over your expenses and check to see if they measure up. In the next section I’ll go over setting up some basic financial accounts that will assist you in your journey towards FI.

Holidays and Vacations

Holidays and vacations for many millennials are a giant money sink. It’s seen as a badge of honour to go travelling in some foreign country and come back completely broke, working for a few months to build up some additional cash and then going for it again.

If this is the kind of lifestyle you’re after then go for it. Financial Independence most likely isn’t for you.

On the flip side there are people who go on holidays and vacations to “relax”. Often these vacations are stressful, foreign countries, foreign sights, endless airport lines before finding a beach somewhere in a low wage country where the mohitos are cheap. Not going to lie. It’s pretty great and I’ve done it a few times.

But this isn’t the only way to travel, nor is it the only way to enjoy a relaxing vacation. It’s possible to go camping domestically and have a holiday for the cost of fuel only (once all of the kit has been bought it can be reused easily). These holidays may be just as relaxing, if somewhat less exotic than a beach in Thailand. Renting out cottages domestically is another option as well. The truth is, you can probably think of dozens of low cost alternatives to vacations as compared to jet setting off to a fancy destination where the rooms are hundreds of dollars a night.

When you’re working towards FI you should definitely take vacations. But you should also appreciate the cost they incur particularly at a time when that money could be invested to great effect in the markets.

Setting up Financial Safety Nets

Working towards FI means understanding the different kinds of taxation structures that are available to you by your government. These structures will likely have limitations placed upon them including withdrawal dates, tax deferment and other forms of restrictions.

What this means is your capital will grow faster (due to paying less tax on the proceeds) but it is locked away. You might have much less liquidity. Examples of this include “Super” in Australia (Access at 65). The 401k and Roth/Trad IRA account in America. In Canada the equivalent account is the TFSA I believe. Though there are other options available for Canadians.

As such, you’ll need to maintain adequate financial safety nets to deal with the ups and downs of life. These financial safety nets are one of the first things you should build before striving towards FI. These nets are liquid, cash or cash equivalent holdings that you can access quickly if necessary and are unlikely to have major swings in valuation. There’s nothing more depressing than believing you had some money tucked away to weather you through a situation and finding out that it’s been whittled away by market movements or fees.

The financial safety nets I have in mind are:

  • Day to day clearing buffer (to smooth out your cash flow)
  • Emergency shit hit the fan cash buffer
  • Access to good short term credit facilities
  • Limited high interest consumer debt (note, not all debt is created equal here.)

I have tried to place this into a rough order of priority. For financial security cash is king, any debts will eventually need to be paid off and as such are buffers, but not nets.

Short Term Clearing Buffer

The reality is that life happens. You may get paid on an irregular basis or a big ticket expense can come up that you weren’t planning for. (last minute flights, repair bills etc). These expenses require that you smooth over your cash flow. You don’t want to have to dip into investments accounts for this as they may trigger adverse taxation penalties. So cash or short term debt is crucial in this situation..

I try to keep one additional months worth of expenses in this account. As I get paid monthly at the start of each pay check (once all of the automated investments have gone out, more on that later) then I have two months of expenses in my account. Over the month this gradually gets drawn down. Rinse and repeat. Anyone who has looked at the wonderful website You Need A Budget (YNAB) should be familiar with this concept.

If you’re not, the idea is to stop you from living pay check to pay check with a scarcity mentality. You should never need to deprive yourself or delay important expenses or bills while you’re waiting for a transfer from an employer. That is the opposite of the resilience financial independence is meant to provide. Instead, over the months it will sometimes dip above a month, sometimes below. I deposit any extra cash above my defined limit into investments at the beginning of each cycle to keep things in check. If I draw below the safe limit then I may decrease how much I invest the following month or simply let the account build back up slowly over time depending upon my mood.

One thing to note is that this buffer is different from any short term savings accounts you may also be utilising (i.e. holidays/travel, one off purchases). Those accounts should be separated and utilised separately. Any short term savings that you have available that have been earmarked for a particular purchase cannot be counted as savings. Instead, they’re simply delayed expenditure and should be treated accordingly. You’re just presaving for them to minimise the cash flow hit.

The Emergency Account aka The Shit Has Just Hit The Fan Account

If the shit has just hit the fan, you will need access to your money quickly in order to cover an unexpected medical bill, getting laid off from your job or some other form of emergency. There are two basic ways to handle this:

  1. Hold everything in a cash account with the highest interest rate you can find.
  2. If you can handle 3-5 days without all of the cash and have access to strong credit then look at investing this in a safe investment which has liquidity.
  3. If you’re holding a much larger emergency buffer and want much less tolerance towards deviation (e.g. 2 year buffer for individuals with irregular work) then a rolling debt ladder of Term Deposits (fixed duration, expiring every three months) may be a better approach.

The important thing here is having this shielded to an extent from the marketplace and to diversify your risk. Holding all of this in shares of your company for example would be a terrible idea. The company goes bust, you lost your job and the shares are worthless. Likewise, having this money fully exposed to the volatility of equities may not be a good idea either. Times when the market is turbulent are often bad for the wider economy as well and the potential for you to lose your income source is higher.

Holding it in speculative crypto-currencies is also a bad idea. Too much volatility. Be safe with this money as it’s your parachute when life does unexpected things.

A generally safe rule of thumb is between three to six months of expenses held in this account. This includes covering things like rent, food, medical bills, insurance and the like. Your month to month expenses may also include entertainment and other discretionary expenditure. You don’t necessarily need to save six months here, the better you are at estimating your expenditure and the more liquid your investments are the less you can hold. Keep in mind that holding thousands of dollars in additional cash for decades incurs a substantial opportunity cost that you should take into account. Be smart about this though.

The Role of Debt

The next two sections will focus upon the role of credit in your financial planning. Credit is a contentious topic, people get themselves into all manner of strife with debt. It’s pretty easy to see why Usury (lending money at exorbitant interest rates) was banned in antiquity. But access to high quality credit facilities gives you a huge advantage. The ability to draw upon financial resources at will (i.e a credit card) can give you the much needed time to access your emergency accounts. Furthermore, debt can often be utilised in investment planning as well. A mortgage is a form of leveraged investment in a housing asset for example.

Visa, Mastercard and American Express are ubiquitous in the modern world and having a good credit facility you can call upon in times of need is a wonderful asset and should be part of your financial safety planning.

If you’re interested in truly maximising the facility of short term consumer credit then investigate credit card churning. Churning involves opening multiple credit cards to access sign on bonuses before closing the accounts. If you’re going to roll with this form of strategy then be aware that opening and closing large numbers of credit facilities can impact your credit rating which can impact your ability to access debt in the future. Do your own research and go from there. My understanding is that this is largely an American phenomenon, other countries typically have substantially reduced bonuses that make the pay off’s substantially less.

Bad (and Good) Debt

To understand the concept of debt we must first understand that debt isn’t evil. How most people use debt is likely to get them into strife but the tool itself isn’t evil at all. Debt is agnostic. Debt is a tool. Understand it and your financial wisdom will increase in leaps and spades. What can be construed as evil is a lifestyle that has been funded upon credit based consumption. Maxed out credit cards to buy consumer goods which instantly depreciate are poor uses of debt. Throwing money on credit at a brand new car that deprecates 30% just driving it off the lot is also a poor use. of the facility.

Good debt on the other hand can be invested in productive assets. A mortgage for example allows you access to high quality housing facilities which may or may not increase in value over your stewardship. Furthermore, if the interest rate is low enough then you may be able to invest that money in other more productive usages or via a credit offset facility. Alternatively you may choose to leverage up on investment assets that if you know what you’re doing could be lucrative.

If you’re currently sitting on a huge chunk of high interest debt then your first priority should be to get yourself out from under it. You can still invest, tax advantaged accounts may still make the trade worthwhile but any investment will need to return more than the interest cost of carrying that debt to be worthwhile. As many credit cards are in the double digits you should pay these off as soon as possible. A standard investment return could be considered to be 7%. Any debts that you have that are higher than this are likely losing you money.

There are two primary strategies towards debt reduction. One is more financially sound in the long run but has less psychological benefit:

In the Snowball you pay down the smallest debt first and once each has been paid off you roll the repayment on to the next largest. Regardless of the interest rate you’re paying. To do this you simply make minimum payments on all other debts. This has the psychological benefit of closing accounts. However, in the long run you will pay slightly more in total costs than the Avalanche.

In the Avalanche you pay off the highest interest rate first, regardless of the balance of each account. If you can stick to this strategy you will pay less in the long run. Psychologically speaking, you may not get the same thrill as being able to close out the smaller accounts first. Ramsey has stated that he believes debt repayment is 20% knowledge, 80% behaviour and the Snowball focuses upon the behaviour component.

Personally, I would take a holistic view and track everything in a spreadsheet to determine the total position of debt and interest rates that are being held. Tracking this over time can give the same thrill as seeing the accounts close but your mileage may vary.

Mortgages

A mortgage is often the single largest piece of debt that an individual will take on. In many situations this will be multiples of an individuals salary. Where I live, in Australia, with a housing bubble raging all around the multiple is as high as 8x an annual salary. Huge quantities of debt are being taken on by individuals across the wealth spectrum in order to buy into the Australian dream.

So, is this a good idea? Maybe. It depends if house prices continue to go up.

In other parts of the world house prices are largely stagnant. There isn’t a huge quantity of wealth to be made by owning and holding on to a single home. If you’re interested in real estate investment and flipping houses it can be quite profitable to do this. The standard strategy of buying a house and letting the land value appreciate under you won’t necessarily work however. You could also become a landlord, charging rent on the properties you own. If you’re interested in this approach then some further research required.

Without dwelling too much on whether you should buy a house I do want to spend a little bit of time discussing whether you should pay off your mortgage.

Counter intuitive I know. But let’s look at it rationally.

A mortgage is a long term debt that is secured against a single piece of property (in this case, the house and land). As such, mortgage interest can be compared against the cost of renting a home (principal can not, though it potentially should be considered part of the opportunity cost). Let’s say you have the option to pay off additional principal on your mortgage. Should you do it?

In many cases. No. At the moment credit is very cheap in the world. You can gain access at miniscule interest rates and use these to live very cheaply. At the same time, the return on equities has been very high. Now. Both of these two scenarios are not likely to last forever. But at the current interest rates being offered it doesn’t make sense to pay down debt quickly. The money invested in the stock market will return many multiples of the cost of interest that is being born. We can consider this with a basic model.

Let’s consider the following:

  • Mortgage rate at 4.5%
  • Investment Returns of 7%
  • Mortgage amount of $100,000
  • Exclude opportunity cost of deposit
  • 30 year mortgage term base case
  • Annual base repayment ~$6,100
  • Once the mortgage has been paid off the full amount is invested in the shares to be comparable.
  • Inflation is ignored.
  • Final asset value is checked over the 30 year period for comparison.
  • Numbers aren’t precise.

The table below outlines the base scenario (apologies for the table as an image). On a related note, I’m 99% sure I’ve butchered a formula somewhere. I think due to a double counting on the amount investable in the year that the mortgage is paid off. Will fix in the near future, which will tilt numbers more in favour of investing vs paying off the mortgage however.

Comparison of paying off a mortgage early vs investing additional quantity in an investment returning 7% per annum. Figures have been annualised and are not expected to be exact.

In the first scenario, you can see that investing an additional 500/year in paying off the mortgage would prevent almost $14,000 of interest costs. However. The final value of the joint scenario, investment + principal is almost $18,000 instead. In this situation, the bank is essentially allowing you to invest on their behalf.

Vehicle and Car Loans

An addendum to this section on good and bad debt is vehicle related debt. Vehicles loans can be a necessary evil in the modern world. Quite simply, you may need a vehicle to get to work or live your day to day life. As such, a vehicle isn’t quite a consumer good but nor is it an investment. It’s a cost of doing business.

When looking at vehicles don’t get sucked in to the extra features that the salespeople are trying to sell you. Look into used vehicles. If possible, organise any credit facilities before you go to pick up the vehicle. The dealer you buy from (unless you’re buying privately) will rarely have the best interest rate or terms. Shop around, be cautious and do your research here.

Conclusion

Hopefully you now have a decent overview of the basics behind finances. Understanding the impact your expenses play will come to the foreground in the more technical sections that will be coming up. Likewise, it’s foolish to begin an investment strategy and work towards FI if you’re currently snowed under by debt and struggling to make ends meet.

I appreciate that I’ve taken a fairly blase approach towards some of the fundamentals here. The point of this chapter is still part of the gentle introduction towards finances. In the next couple sections we’ll get on to the nitty gritty.

 

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