Author Topic: What does it mean to live off the interest?  (Read 7038 times)

DTech

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What does it mean to live off the interest?
« on: May 08, 2015, 07:06:02 PM »
I've read several posts on the site and other sites about investing enough money so that you can retire early by covering your living expenses with the interest that your investments are generating each year. Would it be correct to assume that such a setup involves investing into funds that give you dividends? Otherwise, how exactly can you use your investment's interest?

Say you invested $500,000 over the course of ten years and that produces a certain amount of interest each year...how can you access the interest? Would you set it up so that the interest is deposited into your account? What if the market doesn't do so well for several years in a row? Does that mean you'd get less interest?

Financial.Velociraptor

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Re: What does it mean to live off the interest?
« Reply #1 on: May 08, 2015, 07:19:14 PM »
I've read several posts on the site and other sites about investing enough money so that you can retire early by covering your living expenses with the interest that your investments are generating each year. Would it be correct to assume that such a setup involves investing into funds that give you dividends? Otherwise, how exactly can you use your investment's interest?

Say you invested $500,000 over the course of ten years and that produces a certain amount of interest each year...how can you access the interest? Would you set it up so that the interest is deposited into your account? What if the market doesn't do so well for several years in a row? Does that mean you'd get less interest?

I think it is a fuzzy concept.  My portfolio generates just enough in distributions to cover my living expenses.  That comes from a mix of dividends, non-dividend distributions, and interest on bonds.  It is kind of controversial around here whether or not it is better to set things up that way or to just buy an index with no yield and sell 4% a year.

DTech

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Re: What does it mean to live off the interest?
« Reply #2 on: May 08, 2015, 07:21:14 PM »
Thanks for the response, Financial.Velociraptor. Would it be a bad idea to start investing buy looking into stuff that gives a dividend a few times a year? I know that MMM recommends Vanguard so I was thinking of throwing some money that way for fun and to get a feel for it.

forummm

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Re: What does it mean to live off the interest?
« Reply #3 on: May 08, 2015, 07:37:00 PM »
You'll find 100 threads here where people think that in order to live off your investments, you have to buy stocks that pay a lot of dividends. There's no difference between good businesses earning the same amount of profit that pay dividends vs those that reinvest in their businesses instead. It's the same effect if you live off of dividends vs selling the appreciated shares. Check out some of the old threads. And buy some good index funds instead of individual stocks.

kendallf

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Re: What does it mean to live off the interest?
« Reply #4 on: May 08, 2015, 07:45:44 PM »
When people talk about living off of their investments, it doesn't (necessarily) mean leaving the principal alone and living off of dividends.  In general, there's not much to distinguish between spending the dividends (and by necessity, not reinvesting them) and selling stock.  It's the amount that matters.

When you hear terms like " The 4% Safe Withdrawal Rate", that's based on studies that show that given X dollars invested, historically you'd be able to take 4% of that amount out (via stock sales, mutual fund sales, or dividends) and live on it without running out of money for 30 years.  "Success" is defined in this case as "not going broke".

Most people here would probably advise you to start with a very basic investment strategy of one or two broad market index funds.  This gives you diversity that you won't get by investing in just a few stocks, and is less risky.  Here's a good series on basic stock market investing:

http://jlcollinsnh.com/category/stock-investing-series/

Eric

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Re: What does it mean to live off the interest?
« Reply #5 on: May 08, 2015, 07:48:05 PM »
Living off of the interest is just a lazy way of stating that your investments can cover your spending perpetually.  It doesn't really matter if you've got rental properties, bonds, CDs, stocks, or whatever.  If the mix of their earnings + growth covers your spending amounts, then you're living off the interest.

If you buy a good index fund, say VTSAX, it will kick off 1.86% in dividend payments, and you can sell appreciated shares to make up for the remainder of your needed funds.

For the record, dividends aren't "free money", and there's basically no difference between collecting a dividend and selling an equivalent amount of shares.  This is because the stock price actually drops by the dividend payout amount. 

Example:
You have $100 worth of stock, it pays a 5% dividend, you now have $5 in your pocket and your stock is worth $95
You have $100 worth of stock, it pays no dividend, you sell $5 worth, you now have $5 in your pocket and your remaining stock is worth $95

I'd also recommend reading the Jim Collins posts that kendallf posted above.

DTech

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Re: What does it mean to live off the interest?
« Reply #6 on: May 08, 2015, 07:51:02 PM »
Thank you everyone! I really appreciate the help.

Eric, in the examples you mentioned...wouldn't a 5% dividend mean that you have $5 in your pocket and the stock is still worth $100? Also, would that $5 be taxed when you do your income tax each year?

skyrefuge

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Re: What does it mean to live off the interest?
« Reply #7 on: May 08, 2015, 08:09:03 PM »
"Living off the interest" is a concept that came out of an earlier investing environment, but it isn't particularly applicable to today's environment. Technically, "interest" is only paid when you loan money to another party, so it applies to things like bank accounts and bonds, but not to stocks. Once upon a time, interest rates were so high that buying some treasury bonds and living off the interest they provided was a reasonable retirement strategy. However, with today's low interest rates, you'd be enslaving your self to a job for far longer than necessary in order to amass a stash large enough to produce sufficient interest to live off.

But a lot of people are psychologically comforted by the feeling of interest payments, so yes, some have stretched the definition of "interest" to include stock dividends. This is a bad idea, because dividends are an illusory form of interest. Unlike bonds or bank accounts, where your principal is unaffected by an interest payment, a dividend payment from a stock reduces the value of your principal held in that stock by the amount of that dividend; it's really just the company taking part of your principal and giving it back to you. Furthermore, the "interest rate" (technically "dividend yield") on stocks today is also quite low, so you're still left working longer than necessary. And focusing on stocks with high dividend yields can add unnecessary and unexpected risk to a portfolio, particularly for people who are more comfortable with the "living off the interest" concept, which is inherently a conservative approach.

For these reasons, investment advisers, such as Vanguard, recommend against an "interest/dividends" approach to funding retirement, and recommend a total return approach (pdf) instead. As long as your portfolio can be sustainably tapped to fund your income needs, it's irrelevant whether than money comes from "interest" or capital appreciation.

skyrefuge

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Re: What does it mean to live off the interest?
« Reply #8 on: May 08, 2015, 08:11:43 PM »
It is kind of controversial around here whether or not it is better to set things up that way or to just buy an index with no yield and sell 4% a year.

Just for the record, no one here has ever advocated buying an index fund with no yield. I don't even think such a thing exists. The idea is to just take what the market gives you, with neither a preference for, nor against, dividends.

DTech

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Re: What does it mean to live off the interest?
« Reply #9 on: May 08, 2015, 08:13:35 PM »
Thanks skyrefuge. So when you want to tap your portfolio for funds that you need, is that simply a matter of transferring money from Vanguard into a bank account? Or is it a matter of selling a stock or an index fund and waiting for a check in the mail? And when you speak about adding risk to a portfolio...this is bad solely because you might lose money, right? Or are there additional reasons to avoid risky investments?

skyrefuge

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Re: What does it mean to live off the interest?
« Reply #10 on: May 08, 2015, 08:34:26 PM »
So when you want to tap your portfolio for funds that you need, is that simply a matter of transferring money from Vanguard into a bank account?

Are you planning on retiring tomorrow? :-) Yes, currently, you can transfer funds from Vanguard to your bank account. You might be able to get them to send you a check in the mail if you really wanted to, but in 10 or 20 or 30 years I wouldn't be surprised if that antiquated method no longer existed.

Suffice it to say, concern right now about how to access your money is entirely irrelevant when compared to the question of how to invest your money.

I'll be at least the third person in this thread to advise you to read Jim Collins's Stock Series:

http://jlcollinsnh.com/category/stock-investing-series/

Read that for the big picture. It will be far more efficient both for you and us to do your learning there than in a forum thread. And then if you're still concerned about little details, you can come back here and ask.

And when you speak about adding risk to a portfolio...this is bad solely because you might lose money, right? Or are there additional reasons to avoid risky investments?

"Risk" can mean a lot of different things, but yes, in general it has something to do with losing money. In the case of stocks vs. bonds, stocks are a lot more likely to lose money than bonds, so people replacing their low-interest bonds with stocks in the hope of generating higher "interest" are also increasing the risk that their portfolio could drop in value.

hodedofome

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Re: What does it mean to live off the interest?
« Reply #11 on: May 08, 2015, 10:33:30 PM »

"Living off the interest" is a concept that came out of an earlier investing environment, but it isn't particularly applicable to today's environment. Technically, "interest" is only paid when you loan money to another party, so it applies to things like bank accounts and bonds, but not to stocks. Once upon a time, interest rates were so high that buying some treasury bonds and living off the interest they provided was a reasonable retirement strategy. However, with today's low interest rates, you'd be enslaving your self to a job for far longer than necessary in order to amass a stash large enough to produce sufficient interest to live off.

But a lot of people are psychologically comforted by the feeling of interest payments, so yes, some have stretched the definition of "interest" to include stock dividends. This is a bad idea, because dividends are an illusory form of interest. Unlike bonds or bank accounts, where your principal is unaffected by an interest payment, a dividend payment from a stock reduces the value of your principal held in that stock by the amount of that dividend; it's really just the company taking part of your principal and giving it back to you. Furthermore, the "interest rate" (technically "dividend yield") on stocks today is also quite low, so you're still left working longer than necessary. And focusing on stocks with high dividend yields can add unnecessary and unexpected risk to a portfolio, particularly for people who are more comfortable with the "living off the interest" concept, which is inherently a conservative approach.

For these reasons, investment advisers, such as Vanguard, recommend against an "interest/dividends" approach to funding retirement, and recommend a total return approach (pdf) instead. As long as your portfolio can be sustainably tapped to fund your income needs, it's irrelevant whether than money comes from "interest" or capital appreciation.

+1

Only our grandparents lived off the interest.


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mohawkbrah

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Re: What does it mean to live off the interest?
« Reply #12 on: May 09, 2015, 06:45:06 AM »
I've read several posts on the site and other sites about investing enough money so that you can retire early by covering your living expenses with the interest that your investments are generating each year. Would it be correct to assume that such a setup involves investing into funds that give you dividends? Otherwise, how exactly can you use your investment's interest?

Say you invested $500,000 over the course of ten years and that produces a certain amount of interest each year...how can you access the interest? Would you set it up so that the interest is deposited into your account? What if the market doesn't do so well for several years in a row? Does that mean you'd get less interest?

I think it is a fuzzy concept.  My portfolio generates just enough in distributions to cover my living expenses.  That comes from a mix of dividends, non-dividend distributions, and interest on bonds.  It is kind of controversial around here whether or not it is better to set things up that way or to just buy an index with no yield and sell 4% a year.

very true. at the moment im invested in an index fund with 4% div rates. technically i could live off the interest (that's if i didn't only have 2k invested atm) but it could get fuzzy if the value of the index fun drops dramatically

NoraLenderbee

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Re: What does it mean to live off the interest?
« Reply #13 on: May 09, 2015, 11:13:57 AM »
Thank you everyone! I really appreciate the help.

Eric, in the examples you mentioned...wouldn't a 5% dividend mean that you have $5 in your pocket and the stock is still worth $100? Also, would that $5 be taxed when you do your income tax each year?

Yes, dividend income is taxable. It's taxed at different rates from ordinary income, and the exact rate depends on your total income--but it is taxable.

Financial.Velociraptor

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Re: What does it mean to live off the interest?
« Reply #14 on: May 09, 2015, 11:44:44 AM »
DTech, just to be clear I'm not suggesting a dividend centric approach is necessarily better than a 'total return approach'.  I primarily live off of options premiums.  Dividend paying stocks is just where I personally prefer to put surplus away for a rainy day.  Indexing is good too.  Pick what is right for you.