One of the basic principles of reaching Financial Independence (FI) is having an above average savings rate. Your savings rate ie how much of your net income you save directly depends on how much you spend. Therefore the lower your living expenses, the higher your savings rate, the faster you will reach FI.
The theory goes that if you save 25 times your living expenses, you will be able to live off this amount forever, by withdrawing 4% per year from this invested amount.
For example, if your living expenses are $40 000 per year, then you will need to save 25x $40 000 ie a million dollars before you can retire. This means you can withdraw 4% of a million dollars ie $40 000 per year and reinvest the balance. Then the next year, withdraw another 4% and so on for your living expenses.
There are of course, a lot of assumptions – the chief being that your investments / savings provide a higher return than inflation. In other words, a million dollars today may not buy the same things as a million dollars in 30 years or 50 years’ time. Therefore, your investments or savings must beat inflation.
Returning to the example above, if you can reduce your living expenses then the amount you need to save for retirement will be less. For example, if you can live on $30 000 per year, then you only need to save $750 000.
This incidentally is the same formula that is used to calculate how much you need for traditional retirement. The difference is that pursuers of FIRE actively reduce living expenses in order to aggressively increase their savings rate, aiming at a 50% or more savings rate.
Numerous blogs expound on this eg mrmoneymustache.com in this article, The Shockingly Simple Math Behind Early Retirement. According to this article, if you save 5% of your pay, it will take you 66 years to retire but if you can increase it to 60%, you can retire in 14.5 years. That is a whopping 51.5 years shaved off!
Therefore using the article as a reference, if I want to retire at 55, a mere 8 years away, my savings rate would need to be a massive 70%! Now, that is a scary number.
At this stage, I had no idea what my savings rate was so it was time to start tracking my expenses … yikes! I have never budgeted in my life, not consciously, at least. I have always lived below my means so I never felt the need to stick to a budget.
I use ASIC’s free track my spend app on my phone to record all my expenses – it does require discipline to enter ALL expenses especially little cash transactions without receipts eg a take away cappuccino. I have only been doing this since March. I have noticed though that since I started recording expenses, I am more mindful about my expenses.
My monthly savings rate have fluctuated wildly depending on whether it is a month when utility bills are due, once off expense such as fence replacement or when annual professional association fees are due. So far my best month was 72% and the worst month 26% with an average of 54%.
Conclusion? I have a LOT of work to do to increase my average savings rate to 70% if I want to retire earlier at 55 instead of 60 or 65.