I do my best to avoid complicated mathematical formulas (like the one featured above). In my experience, mathematicians do a great job of taking a relatively simple process and making it overly complex by applying a series of inexplicable formulas. I guess that’s why I was happy to run across an interesting concept the other day called “the multiply-by-25 rule.”
The idea is that you can estimate how much is needed in savings to generate enough income to pay for an item. The only factors you need to know are how much something costs you now, and at what interest rate your money will grow. Of course, determining both in this period of a inflation and fluctuating interest rates is tough, but you can get a general idea of how the math works by looking at a real-life example.
Photo courtesy of Behdad Esfanbod
A Working Example
We are fans of Netflix because it offers a relatively frugal entertainment option for family movie nights. It’s cheaper than going to the theater, and cheaper than an expanded cable package. At roughly $9 a month, our Netflix membership sets us back $108 per year. To continue paying for Netflix out of passive income earning 4% per year, I would need a $2,700 ($108×25) savings balance. Since most of my savings are now earning closer to 3% I would need to multiply my costs by a factor of 33.33% (100/interest rate). This increases the amount needed to pay for Netflix after reaching financial independence by $900 to $3,600. Maybe I should just cancel Netflix!
A Bigger Example
I have heard stories of people paying off their homes, cars and all other debts and living quite comfortable on a couple thousand dollars a month, or less. Assuming our goal is the high end of that estimate, how much of a savings balance would be required to spin off $24,000 a year in income?
3% interest, you would need $800,000
4% interest, you would need $600,000
5% interest, you would need $480,000
And you thought you needed to be a millionaire to retire early! This exercise does fail to account for inflation, both in terms of cheapening dollars and the costs of goods and services over time. I doubt Netflix, or a similar company, will continue to offer one-at-a-time unlimited rentals in the year 2030 for $9. However, running these numbers does emphasize the importance of minimizing the number of expenses you commit to early on.
Our Netflix membership alone puts us $3,600 further away from financial independence. Our cable bill, although relatively small at $12/month, puts us $4,800 away from retiring early. When you start to convert monthly expenditures to the amount of money required to cover their upkeep it really helps you prioritize what is important in your budget.
Homework: Apply this formula to some recurring expense in your current budget and report the results in the comments below. Does this required savings amount change the way you feel about continuing to pay for the item?