Author Topic: Trying to get a better understanding of that "25 times annual spending" rule  (Read 11589 times)

Jadambomb

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Hello all,

I have a few questions about the "You can retire as soon as you save up 25 times your annual spending" guideline.  I'm sure they have been addressed somewhere in the blog or forum, but I'm having a hard time finding them, so forgive me if I'm asking a question that's already been answered.

1. That 25 times amount, is the value of your investment assets/portfolio, NOT Net Worth, correct? 

2. If that IS indeed the case, it seems to me that savings should almost always be directed towards your investments and NOT your mortgage.  I mean, I understand the value of applying it towards your mortgage (you get a guaranteed rate of return equal to your mortgage rate), especially if that mortgage interest rate is high.  But, while that may be the case, and it increases your net worth, you are actually not much closer to retirement than you were before you made that extra mortgage payment.  Although obviously it reduces the amount of time it takes to pay off your mortgage.  Is that the whole point?  That if you can pay off your mortgage let's say, 10 years before you otherwise would have, then you are 10 years closer to retirement, because then your "annual spending" is reduced by that much?  I guess my confusion lies in the fact that if someone has a 30 year mortgage, and wants to retire in 10 or 15 years, it seems extremely difficult to get that mortgage down to that number (10 or 15 years) with extra payments.  It seems like you'd almost always be better off increasing your investment assets, unless you are so close to paying off your mortgage that you might be able to pay it off soon. 

Am I making any sense here?  Do you all understand where I am coming from?

Thanks for all your help!

Jadambomb

kvaruni

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1. Yes.

2. It makes sense, but in that case you will have to add your mortgage payments to the annual spending. Multiplying those by 25 might push your retirement back quite a few years.

NumberCruncher

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1) Yes and no. 25X is roughly based on the Trinity Study / 4% safe withdrawal rate  http://en.wikipedia.org/wiki/Trinity_study  1/25 = 4%  This assumes mostly stocks and some bonds (so yes). This gets more complicated, though (so also no)...

2) I recommend using calculators like http://www.cfiresim.com/input.php . Now, I'm not sure the best way to factor in paying off a mortgage while in retirement, but I'm sure someone else on the forums can help. In some cases, paying off the mortgage will almost always be better, and in some cases the opposite is true.

Technically/mathematically, you would want to invest if the projected rate of return (best way is probably historical #s) was higher than your interest rate, but some people just feel better with a paid off house.

benjenn

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I think the 25 times annual income savings just gets you to the point where you can live on 4% SWR.... if, for instance, your annual expenses are $40,000 - then you would need 25 times that amount, or $1,000,000 in savings.  4% of $1,000,000 is $40,000.  So you could safely withdraw your annual expenses from your savings and never deplete it.

As for the mortgage stuff... I just hate being in debt so we're paying our mortgage off as quickly as we can (this coming August is the plan).  Not having a monthly mortgage payment also reduces our annual expenses, meaning we'll need less savings to meet the 4% SWR.

frugalnacho

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I like to think of the 25X spending as separate from my mortgage/equity, but then I remove that from my expense.

for example:

I spend $40k/year while carrying a mortgage.  Mortgage is $1k/mo, and of that $400/mo is property taxes and insurance.  So really $7.2k/yr is the cost of carrying that mortgage. My logic would say once the mortgage is eliminated I can eliminate that $7.2k/yr from my budget, bringing my actual expenses down to $32.8k/yr, meaning I need $820k in assets separate from my paid off house. 

You could always just roll the house into the calculation for a rough approximation of how much "net worth" you need to sustain your current spending, but I think it makes more sense to decouple them because the mortgage payment is just a temporary expense and the fluctuation of the value of your house means nothing if you aren't going to move.  In my scenario above the math works out good if my house is valued at $180k, but if that balloons to $300k it doesn't change any of my other spending (thus the assets needed to sustain that spending).  And if my house value drops to $10k it also doesn't affect my other spending.


desk_jockey

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You won't get 100% agreement on the subject but in general people are aligned with:

1) 25x of investable assets if you're relying on stocks, bonds and similar investments.  That allows for a 4% withdraw rate which is generally considered safe over 30+ year terms especially with SS and withdraw flexibility in downturns.   

If you are heavily invested in rental real estate then you would look at cash flow which would likely be equivalent to << 25x annual expenses.    Most don't count personal property in the 25x asset calculations unless the are planning to see and move to a lower cost area soon after FIRE.

2) not necessarily.  If your rate is high it still could be fit to pay down early.   If your annual CoL is $50K with mortgage (20 years remaining) but $35K without, then you would need a lower  level of investments to sustain you living costs if you paid off prior to RE.   Still at today's rates it is hard to justify. 

FIPurpose

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I've thought about this topic frequently as well, and I've been wondering about the worth of a mortgage payment from the view of the 4% rule.

As my personal example:

My current mortgage is about 120k, 14.5 years left. 3.5% rate. My mortgage payments per year are $12,600. When looking at it from your current standing, that's an additional $315k that you would have to have in your portfolio to cover that expense, but mortgages do not last forever (though it can feel like it at my age when 15 years represents over 1/2 my life.)

Some people on the forum only consider the interest/tax portion as part of the expense. My view would be:

Take your current expenses less your mortgage but still include property tax.

That is your yearly expenditure.

Take your current investments less your full mortgage: that is your current ER investable assets.

So

Investments - Mortgage / 25 >=  Yearly Expenses - mortgage payments + property tax

is when you are FIRE.

Even though you are currently leveraging a mortgage, does not mean that those assets are yours. This is why you have subtract what you currently don't own. This is how you can analyze FIRE with an eventually ending mortgage. and feel ok in still gradually paying it off after FIRE.



HenryDavid

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It's important that the phrase "and never depleted" is a built-in safety factor here. Depending on a lot of unknowable ups and downs, the actual rate which preserves your savings "forever"could change quite a bit. The studies referred to show that over a given period of time 4% will make things work out. In real life of course you may not want to end your life with a big stash just sitting there unused. For this reason as people age they might decide to step up their withdrawal rate. The 4% thing has been demonstrated to be a decent guideline, with some built-in margin for the unpredictable, over a really long chunk of time.

brooklynguy

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Now, I'm not sure the best way to factor in paying off a mortgage while in retirement, but I'm sure someone else on the forums can help.

You can factor in mortgage payments during retirement in cfiresim by inputting them in the "other spending" field under "Extra Spending" -- put the maturity date as the ending date for that spending item, and set them to "not inflation adjusted" (because mortgage payments remain constant and do not adjust with inflation).

EDIT:  And make sure to only include principal and interest; the above doesn't apply to the portion of your mortgage payment (if any) for property taxes and/or insurance, which isnt really part of the mortgage payment and ordinarily will increase with inflation.
« Last Edit: March 18, 2015, 12:45:40 PM by brooklynguy »

NumberCruncher

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Now, I'm not sure the best way to factor in paying off a mortgage while in retirement, but I'm sure someone else on the forums can help.

You can factor in mortgage payments during retirement in cfiresim by inputting them in the "other spending" field under "Extra Spending" -- put the maturity date as the ending date for that spending item, and set them to "not inflation adjusted" (because mortgage payments remain constant and do not adjust with inflation).

Thanks, I'll remember that. ^_^

kaizen soze

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I split this up into two pieces, separating providing for mortgage repayment from other spending needs.  In particular, I figure I need to save at least 25X + Y = Z,

where:

Z = amount I need to save to call myself FI

X = annual non-mortgage spending, or more particularly all non-housing spending plus homeowners insurance, property tax, and any home maintenance items or homeowner's dues if you have them.  These are all the expenses you will have to keep paying for even if you pay off your mortgage.  So if you pay for insurance and/or property tax as escrow payments in your mortgage payment, those escrow payments will count towards X. 

Y = an amount equal to your current mortgage debt. 

So you can either pay off your mortgage, so Y = 0, or retain your mortgage in ER and save up an additional amount equal to pay it off.  Z will be a lower number than simply multiplying 25X all spending including mortgage payments, but that's ok because you don't have to pay your mortgage forever, and your investments should be able to beat whatever your mortgage interest is over the life of your mortgage.   It's arguable whether it's best to pay off the mortgage early.  On one hand, you might come out ahead keeping a mortgage and investing your money.  On the other hand, paying off your mortgage reduces your cash flow requirements, allowing you to be more tax-efficient and better able to weather downturns in the markets (b/c you can easily switch from beef to chicken, but not as easily downsize your mortgage payment.)  Curious what others think of my approach.
« Last Edit: March 18, 2015, 02:52:14 PM by kaizen soze »

brooklynguy

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Curious what others think of my approach.

That's the right way to think about it, but if your remaining life to maturity on your mortgage is long enough and your interest rate is low enough, it is conservative to use the full value of the outstanding principal for Y, because market returns will probably allow you to use a starting portfolio value of less than that to cover the mortgage payments (but I use the same approach and just think of it as part of my safety margin).

I don't agree that being mortgage-free necessarily allows you to be more tax-efficient, though.

And as long as the investment returns do outperform the mortgage, being mortgage-free does not better equip you to weather downturns (to say that it might do so is really just another way of saying that investment returns might not outperform the mortgage).

kaizen soze

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Curious what others think of my approach.

I don't agree that being mortgage-free necessarily allows you to be more tax-efficient, though.

And as long as the investment returns do outperform the mortgage, being mortgage-free does not better equip you to weather downturns (to say that it might do so is really just another way of saying that investment returns might not outperform the mortgage).

By tax effecient, I mean that you can recognize lower income to achieve your cash flow requirements, which could reduce your taxes.  This may be wrong, since you will get some kind of mortgage interest deduction if you carry a mortgage.   I do see your point regarding weather downturns.  Perhaps I am just saying it's a hedge against market downturns (which I think is the same thing that you say in your parenthetical).  I'll have to think more about these issues.

brooklynguy

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By tax effecient, I mean that you can recognize lower income to achieve your cash flow requirements, which could reduce your taxes.

Yes, I know that's what you meant, and it may be true but it's not necessarily true (even putting aside the mortgage tax deduction, which probably won't help most frugal early retirees).  It is possible for a person (and especially a frugal early retiree) to engineer their income and investments to avoid realizing any incremental tax (and even avoid recognizing any material amount of additional income) as a result of carrying a mortgage.

MDM

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Curious what others think of my approach.
Highly enough to add it to the calculations in the reader case study spreadsheet.  Thanks!

That's the right way to think about it, but if your remaining life to maturity on your mortgage is long enough and your interest rate is low enough, it is conservative to use the full value of the outstanding principal for Y, because market returns will probably allow you to use a starting portfolio value of less than that to cover the mortgage payments (but I use the same approach and just think of it as part of my safety margin).
Agree here also.  For all the bells & whistles there is www.cfiresim.com, but for a quick estimate the approach above seems reasonable.

Livewell

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regarding #2, and whether you are closer or farther from 25x rule, it's six of one half dozen of the other.

say you have $1000 per month mortgage, using 25x rule you need to save $300K (the rule of 300).   If your mortgage is $300K, you would pay that money now and increase your net worth while decreasing the amount you need to save for the 25x rule.   

so really it's about mortgage vs. market.   

For me, I think of FI as no debt plus 25x annual spending.   I like the idea of no debt because it gives me flexibility (I could sell the house for example) in case my math is bad.   Check out http://www.mrmoneymustache.com/2011/10/17/its-all-about-the-safety-margin/

If you're going to buy a house, a poor investment but hey you have to live somewhere right?, then to me a mortgage is just like a bond allocation.   Instead of buying VBTLX, I paid down and then off my mortgage.

rpr

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I split this up into two pieces, separating providing for mortgage repayment from other spending needs.  In particular, I figure I need to save at least 25X + Y = Z,

where:

Z = amount I need to save to call myself FI

X = annual non-mortgage spending, or more particularly all non-housing spending plus homeowners insurance, property tax, and any home maintenance items or homeowner's dues if you have them.  These are all the expenses you will have to keep paying for even if you pay off your mortgage.  So if you pay for insurance and/or property tax as escrow payments in your mortgage payment, those escrow payments will count towards X. 

Y = an amount equal to your current mortgage debt. 

So you can either pay off your mortgage, so Y = 0, or retain your mortgage in ER and save up an additional amount equal to pay it off.  Z will be a lower number than simply multiplying 25X all spending including mortgage payments, but that's ok because you don't have to pay your mortgage forever, and your investments should be able to beat whatever your mortgage interest is over the life of your mortgage.   It's arguable whether it's best to pay off the mortgage early.  On one hand, you might come out ahead keeping a mortgage and investing your money.  On the other hand, paying off your mortgage reduces your cash flow requirements, allowing you to be more tax-efficient and better able to weather downturns in the markets (b/c you can easily switch from beef to chicken, but not as easily downsize your mortgage payment.)  Curious what others think of my approach.

kaizen soze -- That equation Z = 25 X + Y is exactly how I think of FI as well.

dude

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One thing to consider re: a mortgage is that, if you are using the 4% SWR rule, you are adjusting your initial dollar amount withdrawal by inflation every year after that.  So if you've included your mortgage payment in your annual expenses, it is a fixed payment, which actually gets cheaper every year as your withdrawal rises by the rate of inflation. So theoretically, you are getting a pay raise each year.  That of course, assumes other housing related expenses, like taxes, are not going up at a greater rate than inflation . . .

I personally plan to carry my mortgage into retirement for this reason, but also because I'll have a pension (and eventually SS) that will be COLA-adjusted.  Our mortgage is already well below market rents in our area, and 10-20 years from now will likely be a pittance in comparison.

arebelspy

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One thing to consider re: a mortgage is that, if you are using the 4% SWR rule, you are adjusting your initial dollar amount withdrawal by inflation every year after that. 

If you do the 25x+y formula noted above, you shouldn't count your mortgage payment in your "x" spending (just the taxes and insurance part of it, but not the P&I).
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Retire-Canada

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I guess my confusion lies in the fact that if someone has a 30 year mortgage, and wants to retire in 10 or 15 years, it seems extremely difficult to get that mortgage down to that number (10 or 15 years) with extra payments.

Yup. That's a problem.

I'm in that boat myself.

For ease of calculation I've just including my mortgage payment in my 25X formula. It's not like 25X is super accurate/flawless and 100% robust anyways. It's just a rough target to shoot for that doesn't require a complex spreadsheet to determine.

All kinds of stuff will come up during a long ER and being flexible is key.

For me that means having cash flow from liquid investments and their likely growth in the stock market. If I get 10-15yrs in and I have made a bunch of extra $$ than I had planned on I can always pay my mortgage off early.

-- Vik