As promised, here is my first post in a series of five which will focus on the steps towards financial independence. Let’s kick things off with a big one! We will talk about lowering our expenses.
I’m already starting to lose you, aren’t I? In Quebec, we are so afraid of being perceived as cheap that we spend money like there is no tomorrow. Want proof? The average household debt in 2018 was 170%. You understand, as I do, that this means that for every $1 of disposable income, $1.70 is being spent. This is insanity!
In addition, these indebted people will tell you how much better it would be if they made more money. Yet, when they get a raise or a promotion, what do these people do? Instead of trying to get out of debt or save, they spend even more. They finance a car. They go on a trip, paid with their credit card. They Buy Now, Pay Later for a Home Theater System. So they struggle to keep their head above water again, with no money to spare, and they’re already anxious for the next raise.
When, in fact, we should start by applying a very simple concept: spend less than we earn. The statistics cited above unfortunately confirm that people spend (way) more than they earn.
Where to Start
Now that I made it clear that earning more does not solve the problem, let’s get down to business. What if we start by lowering expenses? When you think about it, it makes sense. Every $100 we don’t spend is $100 more in our bank account. On the other hand, working more to get an additional $100 ends up being $60-70 after taxes and deductions, in addition to costing you additional time. It’s easy to see which method is the most effective.
So, what should we cut back on? Here’s a rough translation of something Daniel Germain said in his recent article L’épargne, une déclaration d’indépendance!:
“It doesn’t mean giving up on a car, a house, children, a cat and a lawnmower. That doesn’t mean giving up on fun either. On the contrary: independence means knowing how to recognize what gives us true pleasure, not illusions and disappointments. Only what’s essential, really.”
To focus on what expenses are essential, we first need to know where our money is going. It’s a good start to make an approximate budget and assume it’s accurate enough. However, have you ever bothered to track each one of your expenses? And I really mean each and every one. Every morning coffee at the drive-through, every $50 bill at the grocery store while we were “just getting milk”, every lottery ticket bought while paying for gas, and so on.
If you want to try tracking your expenses, I invite you to read my monthly reviews to see what my own expense tracking looks like.
It’s Optimization Time!
Once this exercise is done, it will be much easier for you to target what can be eliminated or optimized. It’s a bit like the principle that Marie Kondo applies to tidying up: we only keep what sparks joy, and we get rid of the rest.
Does it spark joy to pay $100 a month for your cell phone plan? No. So switch carrier for one that offers a better price.
Does it spark you joy to know that your neighbour is paying $50 less than you for the same TV service? No. So call your provider and negotiate a lower price (or just cancel the service, because is that really essential?)
Does it spark you joy to see your car insurance premiums increase year after year? No. So ask for quotes from other companies, increase your deductibles and reconsider your need for collision insurance.
Does it spark you joy to travel? Oh, that it does! What about the bill, though? A little less. So learn about travel hacking (or how to travel the world on points).
Once you’ve screened and optimized all expenses, you should be left with more money in your bank account at the end of the month.
So it’s all good, but what do optimized expenses look like? I don’t pretend to have a perfect level of spending, far from it. However, I’ve already done some optimization over the last few years and I wanted to share the results with you. Additionally, sometimes we simply have no clue that the price we’re paying for service X is way higher than it should be. So, by comparing your expenses with mine, maybe it’ll prompt you to make a few phone calls.
Currently, my fixed expenses look like this:
– Home insurance
– Auto Insurance
– Oil Change
– Cell phone
– Hydro (power)
– Home Internet
This does not include impulsive, unforeseen or exceptional expenses, but it does provide a good picture. If some amounts seem abnormally low to you, you must understand that I live in a 2-bedroom apartment with my sister. This way, most expenses are cut in half. Had I decided to live alone, I would have to cover the full expenses myself. It is a financial choice I made that allows me to lower my expenses considerably.
You’ll notice that $22,822 in annual expenses combined with a net income estimated to $49,000 at the end of the year leaves me with extra money ($26,178) for savings and other expenses.
Other Optimization Possibilities
Of course, there is always room for more optimization. Here are a few examples.
My current expenses for my car are extremely high at the moment. Fortunately, it will optimize itself once my car is paid in full in November 2021. As I mentioned in my September 2020 Review, I increased my payments to the maximum allowed by the bank to pay it off faster. This expense adds up to $10,500 per year, which is huge (46% of my fixed expenses). However, it also means that once the car is paid off, my fixed annual expenses will go down to $12,322!
Housing is also subject to optimization. It is already somewhat optimized considering that I live with a roommate, instead of on my own. The current price I pay for rent seems to me quite favourable compared to a mortgage on a condo or a single-family home and other related costs. However, moving further away from my work would be additional optimization. Now that we can work from home, I can’t help but reconsider the relevance of paying more on rent to be live near my workplace, even though I have not set foot there in seven months. Even in a post-COVID world, it would be very surprising if I was ever recalled full time in the office.
Of course, living close to my workplace will be useless once financially independent. At that time, this expense would benefit from Geographic Arbitrage. 🙂
The 4% Rule
I really have to insist on this particular step, since lowering your expenses really is the cornerstone of your path to financial independence. Even if you were to earn $200,000 a year, if you spend it in full, or God forbid, 170% of it, you won’t have a penny left at the end of the month. Remember our goal here is to be able to withdraw enough money from our investments to cover our annual expenses. So the fewer expenses we have, the less money we need to withdraw. Therefore, we’ll need a smaller amount invested as well!
In fact, the 4% rule should be calculated on expenses, not income. Never heard of the 4% rule? In this case, let me direct you to excellent resources on the subject:
- How Much is Enough? by Millennial-Revolution
- The 4% Rule: The Easy Answer to “How Much Do I Need for Retirement?” by Mr. Money Mustache
Long story short, 4% is what experts consider the safe withdrawal rate. In order to know how much we need in investments to cover our annual expenses (which we previously calculated) at a safe withdrawal rate of 4%, we have to do the reverse calculation (100 / 4 = 25). That means we need to multiply our annual expenses by 25.
For example, if we use my annual expenses previously mentioned, we come up with:
$22,822 – $25 – $570,550
This means that to cover my current annual expenses (which include payments on my car loan), I would need $570,550 in investments. On the other hand, once my car loan is paid off the calculation will go as follows:
$12,322 – $25 – $308,050
See the huge difference? I would need $262,500 less to cover my expenses at a 4% withdrawal rate! If you look at it this way, financial independence suddenly seems much more accessible, doesn’t it?
To get an idea of what an expense really represents in your quest for financial independence, I find it eye-opening to calculate the amount required in investments to cover one particular annual expense. For example, your cell phone plan costs you $100 a month, or $1,200 a year. With our simple rule, we understand that you would need $30,000 in investments just to pay your cell phone bill. However, if we manage to reduce the bill to $50 a month, then we only need $15,000 in investments. Food for thought! 🙂
You get it now why I insist on lowering expenses, don’t you?
Of course, the 4% rule is not completely foolproof. There are many factors to consider, including retirement age, life expectancy, asset allocation, risk tolerance, etc. Some might want to use a more conservative withdrawal rate such as 3%, for example. You would then need the equivalent of 33 times your annual expenses. However, I think the 4% rule is a good enough rule of thumb. From there, you can make your own calculations based on your situation and needs.
We Need to Take Action
Of course, you don’t go from a debt ratio of 170% to a savings rate of 50% overnight. It’s a long-term job. Each action you make has a cumulative effect over time (not unlike compound interest!). So one thing at a time, but the important thing is to take action. The sooner you start to lower your expenses, the faster you will reach your goal. Keep in mind that Rome wasn’t built in a day.
Finally, I leave you with a loose translation of an excerpt from Pierre-Yves McSween’s latest book, Liberté 45, which particularly appealed to me (rough translation):
The path to financial freedom is theoretically simple. In practice, it takes an iron will to stay the course. Above all, the false sense of deprivation must be transformed into a positive impression, bred from our quest for freedom. It’s all there. It is not deprivation to seek to leave the prison of the mad race to nothing. You just have to change your mindset, let your neighbour go to work in his $50,000 SUV while you’re secretly preparing to leave your prison. Free of charge.
Bye-bye, neighbour! I’m off to my cottage… Forever!
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