A Beautifully Simple Formula for Achieving Financial Independence

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.

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?

If earning:
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?

1. I’m always a fan of eye-openers, especially when they bring about realizations that I would sit in denial about if no one explained it to me in full detail. I’m also a big fan of netflix, it’s convenient and cheap…or that’s what I thought until now. It’s funny how we get caught up in how expensive things like transporation or electricity bills are and how much they set us back, but we try not to pick apart enjoyable things like netflix causing us to assume that \$9/mo isn’t so bad. Alas, I won’t cancel my account yet but it might be a good idea to use your equation and see how far it takes me!

2. Let’s see… I would like to get my gas for free. Which at \$300 a month I would need \$90,000 earning 4%. Dang!

3. Just a little correction, from the article you reference, if your savings account is earning 3% you would use a “multiply by 33” rule, or as you mentioned (100/interest rate) which would be 33.33 so your Netflix membership at \$108 per year at a 3% return would actually be \$3600 (108 * 33.33 = 3599.64)

My personal example:
Cell phone \$83/month = \$996/yr @ 3%
Need \$33,200!!! for financial independence!
I’m a long way away!

4. Are you really going to cut out the Netflix subscription though? I mean, for the cost, it’s a great deal and with all the streaming options they’re acquiring, I still can’t convince myself to drop them.

Please tell me you’ve watched The Wire…greatest show ever.

5. @Lance: Thanks for catching that…I’ve made the correction. That’s what I get for writing about formulas at 11:00 at night!

@writer’s Coin: No, I’m not canceling Netflix, but it is eye-opening to think I would need \$3600 just to sustain that \$9/month charge. And no, I’ve never watched The Wire. Where can I watch it?

6. I gave up Netflix in favor of free movies from the library. It was a no brainer for me, given how convenient the library is and how often I go past it. If they don’t have what I want, an inter-library loan request will usually get it for me within 10 days.

Applying your exercise to the current annual taxes and homeowner’s insurance costs on our home (a little over \$4500), I would need \$150,686.00 earning 3% to cover those costs. Interesting exercise.

7. I’ve always wondered, isn’t part of the point of having a huge savings account to spend the savings for living expenses? If you are entirely using the savings as a base amount to produce income, at what point does the savings get spent? Is it not supposed to be spent at all?

@FrugalDad, you should be able to rent tv series on DVD through NetFlix. Just look for the show’s title in your list and check it off. They send the whole series as a single item (from what I remember).

Just a quick thought on this formula. I completed a similar calculation several years ago and found the same thing.
I could live on \$20K – \$30K/year, but in order to account for inflation I needed a plan that didn’t involve me going back to work.
The solution that I came up with was dividend growth investing. Many high quality dividend paying stocks increase their dividends yearly at a higher rate than inflation – maintaining, and often increasing, spending power in retirement.

Disclosure: I also invest in income producing Real Estate along withe dividend growth stocks.

9. Kinda scary isn’t it? Saving money is basically sending yourself a Western Union Moneygram in the future. What you don’t spend today is exponentially larger in the future! And hopefully, by then you really won’t care about some movie you just HAD to see 30 years ago.

10. To feed the family dog, it would take \$10,400 at the 3% earning rate. I’m not really a dog person to begin with, so if you know anyone who wants a black lab… 😉

11. Good post, I use this thought exercise myself and it’s helpful for keeping things in perspective. When you’re building toward retiring early you can take this one step further and translate these expenses into time at work. For example if Netflix requires a \$2,700, and that translates into two month’s retirement savings (say), you can ask yourself if you’d rather have Netflix for life or retire two months earlier.

Actually the article says that 4% is inflation adjusted. A lot of people use 4% aka 25X as a rule of thumb because historically a typical 50/50ish stock/bond portfolio has returned 7.5% on average, and inflation has been 3.5% on average. So in an average year you can earn 7.5%, add 3.5% to the portfolio so that future earnings grow in pace with inflation, and spend the remaining 4% on living expenses.

I hasten to say that “average” is an important weasel word in the preceeding paragraph. There will be years, such as 2008, when inflation will be more than 3.5% and portfolio returns will be negative. So the value of that 4% will fluctuate from year to year, which may be uncomfortable for some people. Personally I think 4%/25X is too optimistic, and you need 30X or 33X to get a sensible margin of safety. This has been debated to death in certain circles.

@DavidK, usually the idea is that you amass so much capital that it becomes a “golden goose” and the interest alone provides for your family for the remainder of your life, if not indefinitely.

12. Yea, I get that one would live off of the dividends indefinitely if they could, but that’s not how, for instance, 401K works. You pay yourself from both the dividends and the lump sum for the next 30, 40 or 50 years once you retire and start taking payments. I was just wondering if people making their own “golden goose” accounts work more towards the dividend approach or the pay down approach.

Of course, large lump sums are why the inheritance tax or “death tax” was invented. The government wasn’t going to let such a large pie like that go by without getting a slice for themselves. Do the projections worked up by investors also take this into account? It could be devastating to save it all up and then lose 15%, 25% or even 55% of it to the IRS when passing it to your kids.

13. It’s a matter of personal choice. Some people plan on “drawing down” their portfolio until it just about hits 0 when they die. Others plan on building an “evergreen” portfolio that lasts indefinitely. The draw-down approach requires a smaller multiplier, say 25 vs. 33, so it requires less saving and/or supports a higher standard of living. However it is impossible to predict exactly how long you’ll live, and a rather unpleasant topic to think about extensively, so I prefer the evergreen goal.

On inheritance tax, again it’s a personal choice, some consider it, some don’t. Often people that plan on leaving an inheritance transfer some of that wealth while they’re alive, in the form of gifts, contributing to college savings accounts, etc. If your IRA is set up properly, your beneficiaries can inherit it tax-free as an IRA. Taxable assets can be transferred with a trust, but you need to analyze whether that’s actually better than just paying the estate tax.

14. Here’s a thought – invest that \$9/month at 3% interest for 23 years, and you’ll have your \$3,600.

In fact if you could invest \$2,000/month for the next 23 years at 3%, you’d have over \$800,000 to fund your \$2,000/month lifestyle. And if you were lucky enough to get a 5% return, you’d have 1 million in 23 years!

Ah the power of compound interest.

15. “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.”

That “OR LESS” would be me right now 🙂 Way less 🙂 Nice part about being debt free!

When one finally retires tho, one needs to add in the income from SS (if there), any pension, any retirement plan, IRA’s, investment income, and property income….So one won’t need all that much saved up income to make it. Actually I will be living a lot higher on the hog in retirement than now! (meaning, more income)

16. My 2nd rig (1974 Datsun pickup) – insurance costs me \$87/yr on it. By your figures that would be \$2175. The tags are \$20/yr, or \$500. However, by using the truck to get free firewood, worth way more than \$107/yr, my electric bill stays under \$45 all winter long.

So If you are actually getting a benefit from the use of something, does that negate the 25X rule?

17. I like this not for its accuracy, but for the perspective it provides. Dog toys that get destroyed in a few days and DVDs I’ll only watch two or three times are two things that fail this test!

18. This works – we’re in our 70’s, and I figured this out 45 years ago.

Right now savings and CD’s are paying between 3% on the savings, and 4.75% on the CD’s – combining the 2 (plus our social security), life is good – we don’t do anything terribly ‘fancy’, but we eat; sleep – relax, and enjoy regular forms of entertainment and recreation.

As to Netflix? I wouldn’t have one thing in my house that requires me ‘sitting and watching’ – the trick is never become a slave to the television; to the computer – to the You Tube; to Hulu – we took out our senior annual park pass today (\$15/year), and spend our time enjoying nature (free); walking (good for your health) – reading the free pick-up newspapers in our town, and listening to the radio (free) while we drive to our favorite points of interest.

We pay for minimum cable and I-net services; use the web (for free), and limit our time ‘watching and sitting’ to only viewing helpful web-sites (like this one), and doing nothing but LEARNING…

We would never ‘rent a video’ – nothing on the ‘screen’ is real, and it requires you to ‘sit and stare’ – that is not living (frugal or otherwise)

• Diane, I like your style. I just turned 50 and reading this comment I have decided to make you a mentor. Will look for your posts in the future, and thanks again for the inspiration!

19. Want to figure out how much you need if you want to index it for inflation?

All you have to do is subtract inflation (3% average) from your return and then just use your formula w/ the new number.

Example:
4% – 3% = 1%
1% is now your new interest rate.
So to pay \$108 indexed for inflation and you get a 4% return on your money, you need \$10,800. Ouch now that is expensive.
*Note, if you are getting 3% or less, you will never have enough to pay for it when you index it for inflation. This is more of an argument to put your money in the stock market and not the bank!

20. I fail to understand why the numerator has to be 100? Is that the assumption for our age ? Can anyone help me on this? Shouldn’t the numerator vary in accordance to our age? Thanks

21. David –

Your math is really impractical. For instance, if something costs \$108 per year and inflates at 3% per year, then you only need \$5,948.41 NOW, buried in a can in your backyard, to pay for 33 years without considering any return on investment.

If you managed a 1% real return on investment of that \$5,948.41, then it would last 38 years. 38 years might be problematic if you’re only 30 years old, but that’s not a bad number if you’re 50 🙂

\$10,800 will last you 55 years.