Article by Noah Sheidlower, Business Insider, Sep 1, 2024, 6:02 PM GMT+9
“Not all millionaires have big houses, boats, or fancy cars. In fact, six of them told BI their strategies to grow wealth — and keep it — are the exact opposite. “‘We aren’t flashy with our wealth because money isn’t our ultimate goal,’ one said.”
This Business Insider article focuses on 6 people who grew their wealth the old-fashioned way — spent less than they earned and invested the difference.
From the article: “I push back against the worn binary of either make money to have purpose or retire early and sit at the beach all day sipping fruity drinks,” Hall said. “I strongly believe that early retirees can have fulfilling lives without the paid work.”
Read full article at Business Insider here. Since there is a paywall, you can also find the article on Yahoo!Finance here.
Post photo credit: From Business Insider: Getty Images; iStock; Natalie Ammari/BI
I was recently interviewed on the EverydayFI podcastwhere I shared my FI story, how I fully embraced minimalism, became a full-time nomad, and some philosophy on the FI movement and choosing contentment over happiness. Cheers!
“I want to be happy” was how I replied when asked as a youth what I wanted to be in life. Likely inspired by our country’s Declaration of Independence, I bought into the enticing desire of achieving full happiness. It doesn’t work that way.
In the pursuit of a life of bliss, I read several books and listened to numerous podcasts on happiness. I was struck by the happiness science finding that 50% of a person’s happiness is based on genes, 10% individual circumstance (environment mostly out of your control), which leaves just 40% under your control. More than half of a person’s happiness (or lack thereof) is out of one’s control.
This finding is eye-opening on why happiness is so elusive for so many people. If I was born with a 5% genetic predilection to happiness, and I somehow maxed out my environmental circumstances AND all happiness related measures under my personal control, I could achieve a maximum of a 55% state of happiness.
That is a failing grade, and I doubt I could consistently maintain a 100% achievement of the areas in my personal control, especially when my genetic disposition was fighting against me.
I’m More of a Piglet Than a Pooh Bear.
I have found that my normal state is not one of default happiness. Do I think I am an Eeyore with a 5% genetic happiness disposition? No. But I also don’t think I’m a Pooh Bear with a 45%+ genetic good humor and gentle kindness.
Unlike Pooh, happiness doesn’t come naturally to me. I am more like a Piglet. I naturally worry. I look for security and close friendships. Sure, I’ll be brave at times with my friends, but my default is not the blissful happiness of Pooh.
Happiness carries too much weight.
Happy moment sitting on a dune in the Sahara
I have learned that I don’t need to achieve the joy of happiness in all the day-to-day things I do or own. My wardrobe, meal, or wherever I’m staying the night isn’t responsible for my happiness, it just needs to fulfill its job. A car doesn’t need to spark joy, just get me where I need to go safely.
Happiness has a short lifespan and it is fundamentally based on comparison (with others and with personal expectations).
I think about the sheer joy my 14 year-old daughter expressed on her first business class flight experience. Through a series of crazy events, she unexpectedly was upgraded to business class flying home from Barcelona. She didn’t know until she was on the plane. She reveled over each item in the bag of sundries provided and in her ability to order all the pineapple juice she wanted. She was so grateful for the experience.
But conversely, I have seen people who travel business class frequently who complain about some aspect of the service and take the experience for granted. They have lost that first-time joy because business class has become routine.
The latter is an example of hedonic adaptation where humans will reset expectations as new experiences become expected. As we quickly adapt to life’s changes (e.g., new exciting car quickly becomes our regular car), we are continually chasing the next level item (oooh, look at that better and more expensive car!!!).
As a corollary, getting rid of unhappiness does not necessarily bring happiness. Happiness researchers share that negative emotions such as sadness and fear are necessary for survival, and that suffering is part of the human condition. Achieving 100% happiness would require humans to ignore these other important emotions and states of being. It is just not humanly possible to be fully happy all of the time, and yet we humans continue our endless pursuit of this holy grail.
The more I pursued happiness, the more elusive it became — always just around the corner, but never with me for long.
Instead, I pursue contentment.
Pursuing contentment addresses the hedonic adaptation treadmill problem that the pursuit of happiness tends to create. I have determined what is enough in my life–enough money, enough stuff, enough commitments.
Minimalism was a big help in this. In embracing minimalism, I lessened the emotions and value I placed on items I owned. The things I own, such as a car, watch, clothes, boat, home, etc., are no longer symbols of myself, any of my achievements, or my love of other people. I don’t need to dress nice for other people. I don’t need new things to impress others.
I also fluctuate my life’s experiences to help me maintain an appreciation for the lucky life that I live. In the past year, I have slept on an inflatable camping mattress, two bunk beds, a rock-hard bed that made my hips ache, and several gigantic and comfortable king beds, and many beds in between (62 in all).
The variation keeps my perspective in check. If the bed does its job, then I am content with that. I don’t need an incredible bed every night to appreciate my daily life. The same applies to my food, clothes, transportation, and excursions.
Instead of asking myself “Am I happy?” I ask myself “Do I have what I need?” The bar for responses to the latter question is much lower, and I achieve contentment at a far higher rate than happiness. Attaining 100% contentment feels achievable in a way attaining 100% happiness never has.
Of course, I still feel many moments of happiness as I sit on a dune in the Sahara desert in Morocco or hike along a Roman road to the Bachkovo Monastery in Bulgaria, but these highs are no longer my measure for daily success. I instead measure my daily success by my level of contentment – having enough to meet my needs and pausing to notice that.
Yesterday, I had a nice take-out meal from Seven Eleven in Japan and I enjoyed it in a park with my wife. Nothing fancy. We had lots of ants join us. There were lots of weeds around. My seat on the concrete step was hard. The sky was beautiful. The mountains in the distance were nice. The buildings around us were interesting.
The (ability to) retire early part is the primary thing that makes the Financial Independence Retire Early (FIRE) community different from all the other personal finance approaches. We CAN retire early, and we as a community should own it.
The following chart illustrates how FIRE principles compare to that of other, non-FIRE personal finance voices:
Personal Finance Principle
FIRE Community
CFPs, financial counselors, Dave Ramsey, Suze Orman, 50-30-20, et al.
Track Spending
X
X
Budget
X
X
Separate discretionary and non-discretionary spending
X
X
Make cuts from spending to enable savings
X
X
Increase income
X
X
Pay off consumer debt
X
X
Build strong emergency fund
X
X
Tax planning
X
X
Save and invest
X
X
Savings percentage target (i.e., time to retirement choice)
40, 50, 60%+ (ability to retire 20 plus years earlier and much earlier than age 62)
10-20% (retire at traditional age 62-67)
As you can see, most of the principles are essentially the same. The key difference that sets the FIRE community apart is the high savings rate and the ability to retire early.
The push for a high savings rate has driven the community to devise creative ways to reduce spending and/or increase income to achieve that savings rate, while stillmaintaining a quality lifestyle. It is the prospect of early retirement that drives the high savings rate and the subsequent ingenuity to achieve it.
The RE part of FIRE is what attracts media attention and gets people reading the MMM blog, listening to ChooseFI, and engaging with so many other FIRE content creators. Without the RE, we would be essentially the same as all of the other voices in the personal finance space.
The RE is what drew me into the FIRE movement. I learned about FI in 2017, and I was super excited about the prospect of early retirement. (I honestly didn’t realize I could buck the norm.) I left my government job in 2020 at age 52. While the FIRE community shares lots of interesting and valuable resources on personal finance, it only hooked me because of the RE option.
Even though I later worked full time for one year in a new career field (personal finance education for the military), I didn’t HAVE to work. By achieving full FIRE (i.e., the ability to retire) I have the complete menu of life options to do whatever I want and to weather any financial storm (OK, except maybe not the zombie apocalypse).
Naysayers of RE
We often hear members of the FIRE community, including numerous FIRE content creators, complain about the RE part of the FIRE acronym. They say things such as the following:
I don’t want to have to retire and just sit around on a beach all day–I’d be bored.
Achieving FIRE means achieving Financial Independence with the ABILITY to Retire Early. But FIWTATRE is a long and crummy acronym, and FIRE is a really cool acronym.
Having the ability to retire never meant I must. It is my choice.
But even if you do retire, that doesn’t mean your only option is to sit on the beach all day or sit on the couch eating Cheetos all day. Seriously, we need to stop using these ridiculous binary stereotypes when describing early retirement.
FIRE community members think differently to include how they spend their time. I have yet to meet anyone who retired early and spent every day at the beach sipping fruity drinks. Even traditional mainstream retirees generally know to keep themselves engaged in interesting hobbies and connect with family and friends to enjoy their retirement. The list is long and fascinating of the many things financially independent, early retired people do with the time they’ve earned.
I got rid of work and other commitments that didn’t make the top of my list (such as maintaining a house and car), and I increased all of the things I wanted to do more of. I get plenty of sleep, stretch, travel full-time as a nomad, read, hike, walk, write posts for this blog, spend time with family and friends, and follow my curiosity. I easily fill my days and I am consistently happier and more content than I ever was working full time.
We as a community need to stop letting those on the outside define our terms for us.
I love my job, so I don’t need to save so much money, because the RE part of FIRE isn’t my goal. I plan to work until I’m 65 (Coast FIRE, Barista FIRE, etc.).
I am sure there are a few jobs (as well as some self employment) out there that are amazing and enjoyable. But achieving RE is still the key to this movement because things can and often do change in our work lives. Changes that may make a person really glad they are financially independent and CAN retire early if they wish include:
A new, terrible boss rolls in.
Your company lays off employees due to downsizing, a merger, going out of business, etc.
You’re injured and can no longer work.
You change your mind about how great the job is.
A pandemic strikes and closes down whole industries (to include many entrepreneurs).
You decide to travel full time instead of working.
Your parent or child needs more care than your job allows you to give.
I’m sure there are many more good reasons.
The ability to retire early provides all job, sabbatical, and retirement options if (when) any of these events occur. While Coast FI and Barista FI are really cool options, they both still require some level of continued work and therefore they do not give you all the options and safety net of achieving full FIRE–the ability to retire early.
People outside of the community call me a hypocrite when I claim to have achieved FIRE but continue to make money, so I think we should drop the RE part.
Why would we let the outside world control our narrative? RE means the ability to retire early. After achieving that, we can do anything we want, to include ignoring what naysayers are saying. If that somehow seems too hard, then just state that FIRE stands for Financial Independence Retirement Eligible.
Retiring means I can’t work any more.
Nope. Many traditional mainstream retirees work for money (gasp!). Why would FIRE retirees be any different? Again, the RE is not mandated retirement, but rather having all the choices to design a life that the ability to retire enables.
It sounds nice to retire early, but I don’t want to be deprived or unhappy to get there.
This is just not true. Being frugal and saving money actually has its own rewards, and it does not have to cause deprivation and unhappiness. A frugal life can actually be happier. As modern-day philosopher Naval Ravikant explains, “Money doesn’t buy happiness – it buys freedom.”
Conclusion
FI = 25 X expenses = passive income covers expenses = ability to not work = RE
We don’t need to rebrand FIRE to somehow get rid of the RE. We need to own and embrace the RE and control the narrative on its definition–the ability to retire early. Instead of diluting the definition of FIRE to include people who save 5-10% each year and retire at age 67 and labeling it “Career FI”, we need to embrace the higher savings rate that an early retirement goal drives. This is what sets us apart from the cacophony of all the other personal finance “experts.”
FIRE, all four letters of our acronym, are what make our movement powerful.
And as a corollary, frugality does not mean deprivation, suffering, or unhappiness.
Spending more does not equal more happiness just as spending less does not equal less happiness. While frugality is core to how we achieve FIRE, it does not have to mean a life of deprivation. The FIRE community is too creative for that.
Setting the Stage
Recently many FIRE content creators have espoused the view that the FIRE movement has recently “evolved” from deprivation, driven by extreme frugality to, now, increased spending on stuff we “value” somehow causing increased happiness along the way. (“I like expensive cars, so I should buy a new expensive car since I VALUE expensive cars and now I am happier” — at least until the shiny newness wears off.)
Definition of Deprivation: “the fact of not having something that you need, like enough food, money, or a home; the process that causes this
neglected children suffering from social deprivation
sleep deprivation
the deprivation of war (= the suffering caused by not having enough of some things)” – Oxford Learners Dictionary
That deprivation-to-value narrative should not be conflated with an unhappiness to happiness narrative.
As Mr. Money Mustache’s (aka Pete Adeney), Vicki Robin (author of Your Money or Your Life), and many others have long demonstrated that frugality while pursuing FIRE does not have to mean either deprivation or unhappiness.
Pete and Vicki advocated for finding contentment in “enough.” Pete did this while living on less (~$25K a year with a paid-off house). He didn’t (and doesn’t today) live a deprived or unhappy life. Pete and many other FIRE content creators since 2013 have demonstrated replicable, creative ways to spend time with family, stay healthy, commute, eat well, etc. without spending a lot of money.
Frugality Increases Happiness
I realize this may sound counterintuitive (especially with the marketing world trying to convince us otherwise), but I have found that spending more does not lead to increased sustained happiness, while spending less frequently does lead to increased sustained happiness. How could that be?
There are three main reasons for this surprising truth:
Main Thing #1: I can usually get or do essentially the same things for much less
Frugality is the superpower of FI. It is the core that enables us to create margin that we can use to pay off debt, save, and invest. Even a high-earner making $400K+ has to reign in spending or risk having a low net worth, as well illustrated in Thomas J Stanley’s book The Millionaire Next Door.
Cutting back on spending does not mean that we have to live a life of deprivation. My favorite cutbacks enable me to save money while still enjoying the same or close to the same goods or services. These are the “invisible” cutbacks–those that are not noticeable or barely noticeable with a little research and planning.
Some examples:
Taking great trips using home exchanges (free lodging and lower food costs) and travel reward points (super low-cost airfare)
Going camping with our family instead of paying for high-priced hotels and eating out.
Arranging free pet-sitters through an online pet sit platform, such as TrustedHousesitters.com, instead of paying for pet care.
Making high-quality coffee at home and putting it in a reusable travel mug instead of buying disposable cups of expensive coffee on the go (which is also better for the environment).
Getting free books (physical, digital, and audio) and movies (physical and digital) from the library and not buying or renting them.
Having my wife cut my hair instead of spending the time and money to go to a barbershop (as a full-time nomad, this is fantastic as I would hate finding a new barber everywhere I go). Note, Pete (aka MMM) has a video on how to cut your own hair.
Switching to a low-cost cell phone carrier
Hanging out with friends at one of our houses instead of paying high drink and food prices going out.
Repair your appliances using YouTube videos and inexpensive parts ordered online AND have a great feeling of accomplishment!
But wait! Many of these suggestions require (1) more of my time or (2) adjusting what I get or do, or (3) both, to save some money. How could I be happier by doing that?
As Dan Ariely and Jeff Kreisler illustrate in their book Dollars and Sense, we humans love getting a bargain (perceived or real). However, instead of being duped into buying over-priced merchandise that is “marked down” (dang marketers using this truism against us) we in the FIRE community find ways to buy the things we need for less and reap the enjoyment of a true bargain.
I have found that spending more either (1) leads to a feeling of disappointment if I feel like I spent to much for something OR (2) has provided only a fleeting amount of enjoyment. (See one of the many good articles on hedonic adaptation.)
It makes me happy to get good value for a lot less money. I can live the same typical middle-class life, but spend way less than most middle-class Americans by making some simple adjustments of what I buy or do.
It makes me happy to repair my refrigerator, microwave, dryer, vacuum cleaner, car side mirror, and lots of other things, saving thousands in repair costs–AND I have increased my skills and confidence along the way.
It makes me happy to save time. If I didn’t repair something myself, I would have to spend time researching a repair company, calling to make an appointment, taking time off to be at home during the appointment, keeping an eye on the repairperson, and paying them a lot for their service (which took me time to earn). I actually save time doing it myself, and I get to do it when I want to, not when the repairperson is available.
KEY POINT: We can do essentially the same stuff AND reap the enjoyment of saving money for our future to buy more time to do what we want!
Main Thing #2: Happiness is primarily derived from family, friends, nature, health, learning, and helping others–not from spending more money.*
*This isn’t just my opinion, check out the extensive research by Dr. Arthur Brooks, Wes Moss, et al. While visiting family and some hobbies may cost some money they can often be done for a lot less (see Main Thing #1)
I have increased my long-term happiness without spending a lot of money.
My best memories with my family involve family game nights (homemade pizzas and hours of playing games), camping and hiking together in the woods, home exchanges to great destinations with travel rewards points paying for most of the airfare, and reading great books from the library out loud together.
My best memories with my friends are from pot-luck parties and hanging out in our backyards around a fire pit enjoying a high quality beverage, or going camping and hiking together. I don’t watch a lot of movies, but when I do, I have a lot more fun watching a video at home free through Kanopy at my public library or renting it online where we can pause and chat about the movie. In contrast I find spending $16 each to go to a movie theater that is so loud I need to wear ear plugs and I can’t chat or take any breaks a lot less fun or interactive.
My wife and I love taking free extended fitness walks along the trails around our quasi-urban house on the edge of DC. We walk along the creek and see deer and birds and lots of other people walking, jogging, and biking. We enjoy the benefits of nature and increase our happiness without spending a penny. As we travel the world, it is a rare location where we can’t find some close-by place for spending time in nature.
Happiness is rarely about the stuff we buy or the amount we spend, but about the time we spend with family, friends, learning, and helping others.
I didn’t need to spend a ton of money going to a restaurant, hotel, or buying books to increase my happiness. I have found that when I spend a lot of money on a meal out or other expensive endeavor, I am often less happy because my expectations were higher and I was underwhelmed.
While we all have felt a jolt of pleasure from buying something new, we need to recognize and separate happiness from these fleeting moments of enjoyment.
Main Thing #3: I am happier when I have less – both stuff and commitments
Separating our identity from our stuff enables us to pursue happiness in less-expensive ways.
As my wife and I sold, gave away, or otherwise disposed of 98% of our personal belongings, I became a different person. Minimalism changed who I am for the better!
By getting rid of my musical instruments, canning equipment, lawn care equipment, cars, house, tools, old files and collections, I released myself from numerous commitments and freed up enormous time and resources.
I jettisoned my lower-priority personas of musician, canner, home owner, etc. to focus on what I truly valued and made me happier and content. Now I’m more aware of the alluring promises of new personas through purchases, and I don’t buy that stuff anymore. I travel, spend more time with family and friends, read, exercise, and learn. I am a different, more content person.
My happiness increased when I bought less.
Conclusion
The FIRE community should not conflate frugality with deprivation or unhappiness. FIRE adherents can live happy and fulfilling lives while also saving a much larger percentage of their income than mainstream Americans.
As modern-day philosopher Naval Ravikant explains, “Money doesn’t buy happiness – it buys freedom.”
The convergence of the widespread use of 401k and similar retirement accounts coupled with the rise in index fund investing has created a Ponzi scheme-like dynamic with the stock market over the past 30+ years..
What is a Ponzi scheme?
From Wikipedia, a Ponzi scheme “is a form of fraud that lures investors and pays profits to earlier investors with funds from more recent investors.” Is the stock market truly a Ponzi scheme? No, but since 1980 it has taken on some similarities with a Ponzi scheme that investors should be aware of.
Stock Market Valuation to Scale
Most graphics of the stock market (the Dow Jones Industrial Average) that include performance data before the 1980s, use a logarithmic scale. The log scale distorts the long-term variations in market value to make it appear that the changes over time are more consistent. On the chart below which uses a logarithmic scale, it visually doesn’t look like anything unusual happened around 1980. The only sizable blip in the trend is the Great Depression.
I was shocked to see that, relative to the performance in the last three decades, the previous eight decades were basically flat to include the Great Depression (now a very minor blip on the chart) and the industrial economic growth of the 50s and 60s. I wondered what happened around 1980 that exponentially changed the dynamics for stock market valuation.
What Happened Around 1980?
Four major things: 1) invention of index funds (1971), 2) Individual Retirement Accounts or IRAs (1974), 3) the 401k plan (1978), and 4) increased institutional investment of pensions in the stock market. (Note that for this post I am using “401k” to mean all similar plans to include 401a, 403b, 457b, and the Thrift Savings Plan (TSP).)
Jack Bogle invented index funds well before 1980, but they did not take off on a mega-scale until the 401k, IRAs, and remaining pension plans began growing in number and size and therefore dramatically increased their share of the stock market.
Section 401k of the Revenue Act, which became the namesake for the retirement accounts it authorized, was passed on November 6, 1978. The first 401k plan was implemented 3 weeks later. Since then, public and private employers have gutted the traditional pension plan. Employers have either replaced pensions entirely with a 401k (sometimes with matching funds), or they (often government entities) have deeply cut the value of their pension plans and then offered a 401k option to help offset the lost value.
According to a 2021 CNBC article, “401(k) and other defined-contribution plans like it quickly replaced traditional pension plans. From 1980 through 2008, participants in pension plans fell from 38% to 20% of the U.S. workforce, while employees covered by defined-contribution plans jumped from 8% to 31%, according to the Bureau of Labor Statistics.”
According to Annie Lowrey in an April 2021 Atlantic article, “[s]ome $11 trillion is now invested in index funds, up from $2 trillion a decade ago. And as of 2019, more money is invested in passive funds than in active funds in the United States.”
The issue here is that index fund investing works differently than other types of investments. Most IRA, 401k, and pension accounts invest in index funds each month regardless of the performance of the market or any particular company in the market.
Index funds are cap-weighted, meaning that if a large company like Google represents 5% of the value of the index (e.g. S&P 500) then every month passive investors (i.e., everyone with a 401k in the stock market) will invest 5% of their monthly retirement dollars on Google whether or not Google is a good investment right then. This monthly automaticity arbitrarily drives up the price of Google stock because the index must buy the stocks in the index at their cap weight. Likewise, every other company’s stocks in an index are also purchased independent of performance.
Many stock investors, especially those investing for retirement, are not selling their shares each month when these new index investment purchases need to be made. They want to avoid stock market volatility. This dynamic creates supply and demand price pressures that help keep the valuations going up.
The growing demand for index fund investments drives up the valuation of the stock market. This helps explain, at least in part, the meteoric rise of the stock market’s valuation over the last three decades.
It doesn’t matter if the company is actually worth what its stock is valued at as long as investors keep passively buying the stock at a high price and driving it higher. And if this dynamic sounds familiar, it is: this is similar to how new investors in a Ponzi scheme keep the returns high for the older scheme participants.
The expansion of retirement account vehicles like the IRA and 401k, with their strong tax incentives coupled with the increased ease and lower costs of stock investing, have helped this trend grow. The big question is, when will the new money stop rolling in every month and the first investors start selling off more than they are investing? This turn of events could cause a partial collapse of stock valuation, create great losses, and leave the more recent investors waiting for long-term returns holding the bag – again, similar to the effects of a Ponzi scheme collapse.
It’s Not Really a Ponzi Scheme, Right?
Right. A Ponzi scheme is illegal, and there is nothing illegal about the investment vehicles I’ve just described. BUT, there are some Ponzi scheme dynamics at play in today’s market. I recognize that a large part of the amazing overall stock performance that I have enjoyed over the last three decades, particularly since 2009, is in no small part due to my fellow index fund investors who continue to invest in the stock market every month, regardless of performance.
While the stock market will continue to respond positively and negatively to economic events (e.g., COVID-19, an oil crisis, AI, interest rates, etc.), market drops are dampened and gains are propelled by the drumbeat of the monthly capital infusions from index funds.
I agree with the MorningStar MarketWatch assessment that the market is overvalued based on any measure. Much of this overvaluation can be attributed to the relentless monthly retirement stock investments (passive and active). This overvaluation should not pose a problem unless (until?) the infusions of new investments in the market become significantly less than the amounts being withdrawn by investors over a prolonged period.
To prevent this devaluation, we “older” investors need to keep encouraging new index fund investing among our fellow citizens until we have sold our shares. Then those investors will need to encourage future generations to do the same. The current structure of the stock market will continue to need new investors, investing monthly regardless of individual stocks’ performances, to keep that line on the graph moving upward.
So while I remain fully invested in the stock market, I also remain vigilant to mega trends that might indicate the tide is turning on the Ponzi-esque dynamics on the market from index fund investing.
Accounting helps businesses track and organize financial information so business leaders can make informed decisions. Similarly in personal finance we all implement some level of accounting to help manage our finances to track, budget, spend, save, invest and file taxes. In a past life I managed multi-million dollar businesses with complex financial statements and taught basic accounting to US Air Force Officers. While individual people are not required to follow business accounting principles for their personal finance, key accounting concepts have helped me keep my personal financial path on course and helped me with many of life’s other important decisions. Here are my top 10:
Conservatism. When budgeting and forecasting (when exact numbers are not known), always estimate expenses on the higher side and estimate income on the low side. A conservative approach will build confidence in one’s financial plan. Having conservative estimates in our financial projections helped convince my wife and I that we could afford to quit our jobs and travel the world full-time.
Accounting Period. The accounting period is the timeframe (week, month, quarter, year, etc.) used for financial analysis and reporting. In my personal finance and rental business, I use a monthly period to track my expenses and an annual period for tax purposes. By tracking our spending and savings each month, my wife and I have a built-in opportunity to discuss our finances and progress towards our goals and make adjustments. I use an annual period for net worth tracking update and taxes (since that is the IRS’s cycle) and we see our progress over time (e.g., year-over-year). Establishing the accounting period(s) helps me better manage my finances and apply the revenue recognition and matching principles.
Revenue Recognition. The revenue recognition principle requires that revenue should be reported when it is earned, rather than when the cash is received. So for example, a catering business who receives a deposit in December on a wedding for the following June, should not recognize that revenue until the accounting period of June occurs, which leads me to the…
Matching Principle*. The matching principle states that an expense should be reported (“matched”) in the same accounting period as the revenue generated by the expense. This allows for a better understanding of profit and loss in the accounting period (month or year). For example, when I book airfare or a month-long AirBnB in one year for future use in another year, I keep a separate spreadsheet to track these major expenses so I can account for the expenses in the month I actually used them and I have a better understanding of how much my nomadic traveling life is costing me. Note, I only do this for “major” expenses which leads me to the principle of…
Materiality. Something is considered material if omitting or misstating it would impact a reasonable user’s decision-making. The principle of materiality requires businesses to properly account for all material items. For example, the purchase of a single $30 alarm clock for a large hotel would not require depreciating (more on depreciation later) the asset even though it would last for many years. However, purchase of 500 $30 alarm clocks for the same hotel would likely be material as the $15,000 total expense could significantly impact the current month’s financial statements. In an FI example, closely tracking and managing small expenses (e.g. daily lattes) is material for someone in credit card debt, and/or little savings, and getting started in turning their financial situation around. For those at FI or well on their way, tracking every minuscule expense is likely immaterial for that person. While my expense tracking is automated with Mint** Quicken Simplifi, I don’t track small cash expenses like tips and small street food and drink purchases – it is not worth my time and immaterial to my FI success now that I am FI. (**Update Aug 5, 2024: Intuit lost my business when they sunk Mint and tried to move users to Credit Karma. I switched to Simplifi and it works pretty good. Although I pay an annual fee now, not having the ads is really nice).
Depreciation. Depreciation is a reduction in the value of an asset with the passage of time, due to use, wear and tear, or obsolescence. Keeping depreciation in mind helps me understand how much the stuff I own (cars, furniture, outdoor gear, etc) loses value over time (often immediately after I buy it). Depreciation also makes me think about the amount of money I need to set aside in my emergency fund to replace major items that break or wear out over time. I also use depreciation to think about the value of what I buy over time. For example, if I decided to buy a $50K RV to live in full-time, I would not treat it in my tracking as a single housing expense in one month, but I would calculate the monthly depreciation expense of the RV over its useful life and consider only that portion to be my monthly housing expense in my tracking. If I didn’t take out a loan, I would deduct an amount each month from my checking to my savings (where I pulled the money to buy the RV) so that I would show a monthly house payment in my tracking system.
Consistency. The consistency principle states that businesses must use the same accounting methods across accounting periods and financial statements or well-document any changes. Applied to your FIRE journey, maintaining consistency of how you track your finances will help you better identify areas for improvement as well as progress over time. For example, consistently tracking my alcohol expenditures separate from eating out and groceries, enabled me to see how much I was spending in this category and the significant cost reductions when my wife and I focused on having a drink at home on our deck instead of at a restaurant or bar.
Opportunity Cost. Possibly the most powerful financial concept on this list, opportunity cost is simply the loss of potential gain from other alternatives when one alternative is chosen. So my choice to maintain higher cash balances in my checking and savings accounts has an opportunity cost in terms of lost interest or growth. For example, spending $200 at a fancy restaurant has the opportunity cost of lost long-term interest and dividends from investing the $190 (the other $10 spent eating at home instead). But likewise, investing all of my money in long-term stocks has an opportunity cost of lost flexibility (or potential financial loss). This concept also applies to my finite time on this planet and what I decide to do or not do and who I want to be. The challenging part about opportunity cost is that it is often hard for me to see and value what I didn’t buy or do. For major decisions, I am in the habit of first asking myself what else could I do with this time and money before committing the resources. The answers frequently change my mind.
Cash Flow. Cash flow refers to the net balance of cash moving into and out of a business (or your personal finances) at a specific point in time. Cash flow enables a business (or a person) to settle debts, reinvest in its business, return money to shareholders, pay expenses, and provide a buffer against future financial challenges. For example, having cash on hand enables a business to take advantage of bulk-purchase discounts even though the item purchased may not bring in income for several months or years. For FIRE, I like to keep a good amount of cash available to handle my cash flow needs. For example, I use a large emergency fund to self-insure for auto comprehensive and collision, travel insurance, and extended warranty protections. To meet my cash flow needs, I keep a healthy balance in my checking and savings accounts to ensure I never have to worry about covering several credit card payments at once or making large advance purchase. Before starting my nomadic traveling, I was able to fund about 8 months of advance airline and AirBnB purchases so I could take advantage of discounts and lock-in preferred choices. If too much of my money was locked up in stocks or other long-term assets, I wouldn’t be able to cash flow my spending as easily.
Sunk Cost Fallacy. While not an accounting principle, no list of financial or business concepts should exclude the sunk cost fallacy. Simply, the sunk cost fallacy is our tendency to continue with an endeavor we’ve invested money, effort, or time into—even if the current costs outweigh the benefits. For example, the weight of spending well over $1,000 on my electric guitar, amp, and hours of lessons was keeping me from moving on even though I knew I no longer prioritized learning to play and wanted to travel and learn a language instead. This concept often applies to non-refundable purchases. If I had to miss a non-refundable show at the last minute the cost of that ticket is a sunk cost. This sunk cost should not impact my decision whether I should buy another ticket to the same show. I have to remind myself that purchases I made in the past should not prevent me from doing something different now or in the future, even if I can’t get my money (or time) back.
Accounting gets a bad rap for being complex and boring, but it is really an important part of our financial lives and provides valuable tools to better understand and manage our finances. Like knowing how to calculate fractions and percents, everyone should have a basic foundation in accounting principles.
If you would like to learn more about the basics of accounting, the best method is taking an introduction to managerial accounting class, but since that may not fit your time or budget, there are some simple accounting books that, based on their online reviews, may help such as Wayne Label’s Accounting for Non-Accountants or Mike Piper’s Accounting Made Simple. Less-formally, search the internet for each principle above (Investopedia.com is pretty good) to find more details and examples of each. You are also welcome to drop me a question in the comments.
*A note on the matching principle. I technically use a cash-accounting system for my small rental business (integrated with my personal finances as a sole proprietorship) instead of an accrual accounting system most businesses use. As a result, I am required to report expenses (e.g., rental furnace replacement) and income (e.g., advance payment for rent) at the time I receive it for tax purposes. I use this requirement to my advantage. I plan my rental house improvements to fall in the tax year that I am trying to minimize my income, so my rental business has a lower profit in that year. Likewise, when my renters prepay their rent 6 months in advance (yes, I have some great renters!) I am able to ask them to pay on either December 31st or January 1st to enable me to recognize the revenue in the tax year I prefer. This helps me smooth out my taxable income fluctuations over tax years or help me maximize my Traditional to Roth IRA conversions in the 12% tax bracket for a particular year. This fluctuation would not follow the strict definition of the matching principle, but it allows me to “match” the expenses and revenue to my tax advantage.
I used to be a (aspiring) musician, cyclist, gardener, canner, soccer coach, coin collector, stamp collector, home owner, and DIY handyman.
I am no longer those things. I found that by selling, giving away, or otherwise disposing of my guitars, soccer gear, biking gear, coin and stamp collections, work files, house, and many, many, other possessions related to these pursuits, I was freed from the personas that took away my time and focus from the things that I wanted to be and do the most.
In his time management book Four Thousand Weeks: Time Management for Mortals, Oliver Burkman challenges us to focus on the top items that we want to accomplish. He shares a story attributed to Warren Buffet, where the Billionaire allegedly advises to prioritize your top 25 things, focus on the top 5, and then actively avoid the remaining 20 items. Those items prevent us from spending the time needed to do our highest priorities very well.
Burkman is not this prescriptive and shares that “you needn’t embrace the specific practice of listing out your goals (I don’t, personally) to appreciate the underlying point, which is that in a world of too many big rocks, it’s the moderately appealing ones—the fairly interesting job opportunity, the semi-enjoyable friendship—on which a finite life can come to grief.”
This was an eye-opening revelation for me. In order to focus on what I wanted to be and do the most—husband, father, friend, and student as well as a nomadic traveler, camper, hiker, reader, personal finance coach, and historian—I needed to eliminate my many other personas and lower priorities.
One of my top priorities was to travel the world nomadically with a carry-on and a backpack. This goal required some major downsizing–I fully embraced minimalism with some surprising results.
When I sold my (barely used) electric guitar, amp, and case back to the music store I bought it from (at a fraction of the price), I felt free! I was giving myself permission to no longer be a musician. I no longer had this physical reminder telling me “You should practice music. Remember, it is the 9th thing you want to accomplish?” It was a conversation I didn’t want to have.
The time and money I spent trying to learn to play the guitar took time away from what I really wanted to do – read, travel, learn a language, and take better care of myself.
Likewise, by getting rid of my canning equipment, lawn care equipment, cars, house, tools, old files and collections, I released myself from numerous commitments and freed up enormous time and resources.
Having newfound time and resources to focus on world traveling, my relationships, reading, sleeping, stretching, and hiking has been amazing. I have traveled more this year (2023) than any other year. I have read more books this year than any other (including college). I have spent more hours with my close family and friends than I had been. I walk and hike more than ever. I am constantly learning new things and tackling my foreign language proficiency goal.
Doing fewer things better is…better! Removing the physical possessions around these lower-priority identities made it happen. By getting rid of these possessions, I gave myself permission to be who I really wanted to be. Minimalism changed who I was.
If you want to learn more about minimalism and techniques to downsize, I highly recommend Fumio Sasaki’s book Goodbye Everything. While I did not minimize to the extent that he did, I found his minimalism philosophy and techniques to be invaluable.
In a recent episode of ChooseFI podcast (a favorite of mine), a visiting host (Katie, from MoneyWithKatie.com) talked about buying “a very nice car [a pre-owned Porsche Macan with 8,000 miles].” She was quick to acknowledge that this decision was “breaking the cardinal sin of FI/RE” but the main ChooseFI host, Brad, quickly said that because it was something she “valued”, it was no problem.
Hmmm. Is this still a FI podcast? Are these hosts even interested in FI anymore? We need to talk about this.
Over on her blog, Katie justified the purchase because she could afford it (thanks to her many devoted FI-minded followers, it seems). Buying new (or nearly-new in this case) cars, let alone high-cost luxury cars, is well documented in the FI community as a financial mistake.
It should still be recognized as a financial mistake, regardless of the changes in her income.
She justified the purchase by claiming this was the least expensive car she had ever bought as a percentage of her income. No. It is still the most expensive car she’s ever bought because–and I would expect a personal finance blogger to be clear on this point–it costs tons more than any previous car she bought.
She wrote, “Sometimes I think we just want to buy nice things for ourselves. They become symbols of our hard work.” She’s not alone in using that logic, of course. That logic is why many Americans are in high credit card debt, thinking, “I work hard, so I deserve this purchase.” But she may be alone among FI-minded bloggers in trying to pass off this logic as somehow connected to FI. In the FI community, our hard work does not need a luxury status symbol to show off what we have accomplished (to ourselves or to others).
In short, I have a simple response to Katie’s position on her new Porsche:
Buy what you want, but don’t try to change the definition of FI to justify it.
Honestly, it doesn’t bother me that she bought a high-priced luxury car. She can spend her money anyway she wants. It bothers me that she used her FI platform to justify her purchase in non-FI ways.
She wrote about how much she enjoys her car purchase and how excited she is about it. If she were approaching this from an FI-minded perspective, she might notice that her Porsche is an example of the hedonic treadmill: We get a temporary high when we buy something, but the high soon wears off and the new thing becomes the new normal. What more will she need to buy in a couple of years to be a symbol of her hard work when the luster of the Porsche (and the warranty) wears off?
But enough about Katie and her Porsche. I am bothered even more that Brad, the main host of Choose FI, a podcast that has been a great source of FI information for many, claimed a new definition of FI: that she should buy what she “valued,” and since she could “afford” the car and wanted it, then sure, OK.
Really?
ChooseFI is an influential platform in the FI community and this justification of a luxury car purchase is going to be confusing to many who are striving toward FI.
The definition of FIRE (Financial Independence/Retire Early) or FI hasn’t changed. Controlling spending is still fundamental to FI, and buying a very expensive luxury car (or any similar item) isn’t a FI-minded decision, even if we’ve always wanted one.
True value-based decisions are, of course, an important part of FI. Getting the best quality for the best price is a very good idea. For example, buying a high quality skillet that will last longer and cost less in the long run than a cheap skillet that will need to be replaced one or more times. A Porsche Macan, however, is not. Katie described the car’s unreliable quality (it has already been into the shop for a cracked axle), high insurance costs, her concerns over knicks in the doors, paying more for garage parking because of weather concerns, etc. Does it represent a good value over time in how to move herself from one place to another? Of course not.
We should not confuse buying anything that a person desires as an inherently value-based decision or as the new definition of FI. This is a dangerous slippery slope: we could kick our self-justification machines into high gear and say, “This X (put name of your favorite high-priced consumer good here) is what I value because I deserve it as a symbol of my hard work” regardless of X’s true value and its impact on our FI progress.
And, if I can justify buying X, then I can also justify buying Y, and Z, and XX, and YY, and ZZ, and soon I’m back to square one with a closet full of rarely worn clothes, numerous subscriptions I don’t use, eating out frequently, daily lattes, etc., and I’m left to wonder where all my money goes each month. Did this redefinition work out for me? No, thank you.
Just Because I Can Afford It Doesn’t Mean I Should Buy It
FI is different for everyone. Some people don’t want to live an extremely lean life to get to retirement or while they’re in retirement. But also, we can’t undermine the importance of controlling expenses when pursuing FI. By limiting what we spend, we can more readily put aside enough money in investments to produce perpetual income to cover our expenses in retirement.
I first learned of this concept through Vicki Robin in her book Your Money or Your Life, and Mr. Money Mustache hammered it home for me in his popular blog. The core of their messages is that we need to learn what is enough and resist all of the shiny trinkets that the American marketing machine pushes on our society. The result is a good life that is also good for the wallet and good for the environment.
Don’t touch my daily latte!
The Porsche Macan isn’t the only indicator that there are leaders in the FI community who may be eroding the concept of controlling spending. I keep encountering FI blogs and podcasts that have “evolved” in their thinking, and they now embrace a buy-whatever-you-value mentality.
I first noticed the change in financial debates around the daily latte. With voices like Remit Sethi saying not to worry about the daily coffee expense (who Brad has echoed on ChooseFI). I have seen many blog commenters who ask “Why can’t I spend $5 or more a day on coffee in a disposable plastic cup? It is what I value!” Or, “$5 won’t make a difference in my retirement if I focus on earning thousands more in income instead.”
Many FI content creators appear to be persuaded by this pushback and have seemingly stopped mentioning the lattes, and softened their guidance on controlling costs for cutting subscriptions and eating out less often.
A basic tenant of FI is to spend less than you make. A person interested in pursuing FI needs to control spending somewhere and the non-essential categories like daily lattes — or any small luxury you indulge in on a regular basis, such as bottled water, fast food, beers at a bar — are a good first step.
The daily latte is simply a good example of how many Americans can quickly save some money to pay off debt and start an emergency fund. This advice may not be getting clicks or new listeners, but the original FI advice is still the solid, simple, effective advice that is going to help get a person to their FI number.
We could skip the daily latte and buy a decent coffee maker, get some quality coffee grounds and a reusable, good-for-the-environment coffee mug (with a no-spill lid), and make our own. We’ll achieve the same quality (if not better) coffee while saving money and making a better environmental decision as well. There is almost always a way to get the same or similar value for less money with a little bit of effort.
FI requires some effort to get the same or similar outcome for less.
My favorite spending cuts are ones where you don’t end up losing much if any value from the cut back in spending (e.g., brew your own fresh coffee as mentioned, drink with friends at home on the patio/deck instead of at a bar, watch free movies through your town’s public library Kanopy account, negotiate discounts for the same service for less, etc.). Fundamentally, we need to control spending to make progress toward FI. Same as it’s always been.
But what if I just make more money, right?
Well, no. If we don’t control spending, additional income can disappear just as fast. This is well explained in The Millionaire Next Door, where a person making $400K or even $800K a year can still be living paycheck-to-paycheck and not build much, if any, wealth. Authors Dr. Stanley and Dr. Danko refer to these people as Under Accumulators of Wealth. No matter how much you make, there must be some control of spending.
Even doctors married to doctors have to put a limit on the number of boats they own, and amount spent on luxury cars, eating out, high-priced luxury real estate if they want to be able to stop working at some point and enjoy a fat FIRE lifestyle. Controlling spending is a key FI tenant, and we content providers in the community should not shy away from this.
We as a community need to continue to emphasize that controlling spending is essential to FI, even if it is not sexy or popular. Cutting daily $5 lattes is still a good example–it builds a strong habit each morning to decide to live a little differently that day–and for those still digging out of consumer debt, the small extra money does add up and make a big difference! We need to help hold each other accountable on our discretionary spending so all of us can successfully make it to our FI goal.
FI content creators in particular need to keep the definition of FI focused on controlling spending and having enough. Let’s not dilute the definition of FI to justify buying whatever we want in the moment. People just finding FI for the first time deserve to hear from us what really works. Let’s keep it real.
The FIRE community talks a lot about the rent vs. buy discussion. Which is the optimal financial decision for your personal housing and how to calculate that? While there is great information out there to help you decide, I see two important considerations often left out of these discussion:
(1) Many compare a short horizon for buying a house with a long horizon for investment of down-payment funds by renters (opportunity cost). A long-term horizon should be used for both.
(2) Many overlook the long-term impact of inflation on this financial calculation.
If you treat your personal home as an investment (for example, avoid unnecessary house upgrades and be willing to rent out your home if you need to live elsewhere for a while) and use the same long-term buy-and-hold strategy that an index-fund investor uses (a 20 to 30-year horizon that smooths over the ups and downs), then buying a home for your personal use (in other words renting to yourself) is often a good investment – especially due to the power of inflation.
The pendulum has swung on this topic. For years, the common advice was that “renting is throwing your money away” and “your house is your biggest investment.” In response, many prominent articles, blogs, videos, and podcasts have weighed in on this decision arguing the wisdom of renting. These include:
While each of these pieces have great information, they didn’t fully include the power of inflation over time for both increased rent prices and the inflation-hedge of a fixed-rate mortgage. The one exception is the NYT calculator. It did include inflation, but it did not appear to weigh inflation appropriately if you own your house over a long time (based on my testing of the calculator parameters). I believe that omission misconstrues a key part of the Rent vs. Buy financial evaluation.
This post is responding primarily to the first article by JL Collins and uses JL’s comparison formula as a starting point.
Why does Inflation Matter?
(1) Because rents generally increase over the long-term, but fixed-rate mortgage payments (P&I portion) stay fixed. And (2) while the value of a home rises slower than the stock market index, that smaller increase is for the entire value of the home — not just the down payment and other accrued principal. For example, $100,000 in the stock market getting say a 12% avg annual return is the same as a 3% return on a home valued at $500,000 with a 20% down payment of $100,000 – both gain $12,000 in value the first year (excluding taxes on those gains).
We have seen recently how the increase in inflation and increased demand for remote work have generally increased home prices across the nation. Rents have also dramatically increased. One article indicates the U.S. medium rent amount has increased by an average 8.85% per year since 1980 (although not in either of the two areas I own homes). But even in times of lower inflation, house prices and rents tend to rise over time. In recent memory, only 2010 gave the U.S. real estate market a very short period of rent deflation.
So the longer you hold your low fixed-rate mortgage property (assuming you refinanced at the historically low rates between 2012-2021 timeframe), the greater benefit you will have from inflation as the majority of your house payment will stay the same over time. The amount you would pay in rent would increase over that same period. To illustrate below are a couple of examples from my own experience below.
But first, a couple of caveats and assumptions:
Real estate is local. I use a Midwest example and an east coast example.
I’m not asserting that buying a house is the BEST possible investment. I contend that it can be a GOOD investment (part of a diversified investment portfolio) and often better financially than renting a comparable house when all numbers are considered.
I assume you’re familiar with investment returns and other general financial concepts, so I’m not getting into lengthy explanations here.
My buy-and-hold strategy for houses means that if I decide (or am forced) to move I will rent the house until I can return — I won’t sell. Selling a home too soon changes the calculations and makes buying less likely to win the financial comparison.
If I do need to rent my house, I do not hire a property manager (more on this below).
I ignore renter’s insurance. I agree with Jeremy at Go Curry Cracker that I can self-insure. If you can’t (many landlords require it) or don’t wish to self-insure, add that cost to renting.
Running The Numbers
I fully agree with JL that the key is to run the numbers for your specific situation and not assume one choice is automatically better than the other. However, JL’s example (and formula) appears to undervalue inflation benefits over time for principal and interest. For example, in his blog post comments he equates rent inflation increases to be equal with inflation increases in property taxes, insurance, and maintenance and thus offset each other. However, my data indicates otherwise because the majority of the mortgage payment is P&I which remains the same over time.
Also JL provides a very high repair, maintenance, and insurance cost of $7000 average per year (in 2012 and prior). National averages for repair and maintenance are approximately $3,000 per year and insurance certainly doesn’t cost $4,000 (I hope!). My records for the two houses I own show a much lower average for maintenance and repair costs. The breakdown for each is as follows:
For my large Ohio house, even after reroofing ($13K); completing a $3500 tree trimming; replacing the fridge, dishwasher, air conditioner, furnace, garage door opener, new bathroom floor, and decking (Trex composite); having the whole interior repainted professionally and completing numerous other small repairs and maintenance, I have averaged $3,784 per year over 13.5 years. I expect this average to go down now that I have upgraded the primary systems, and if I add insurance, it increases to $4,548 average per year — still significantly less than JL’s $7K figure.
My home in Virginia has cost me much less in maintenance and repair ($1635 per year for 10 years). In part because I enjoy doing a lot of repairs and maintenance myself, but primarily it’s because I’ve had fewer major system replacements (I did paint the interior, re-roof, replace the gas lines, install new windows, and replace the stove).
So, while I had a couple of expensive years with repairs and maintenance for both houses (especially those new roofs), the key is that these costs even out over time IF you hold onto your house. Those roof shingles usually need replacing only once every 30 years.
I did not include any costs for upgrades. I find most upgrades (such as an upgraded bathroom or basement renovation) tend to be net financial losers as they rarely return full value for the cost in increased home value, especially when you look at opportunity costs of using that money elsewhere.
Similar to JL’s buy-and-hold strategy for stocks, we need to buy-and-hold when we buy a house. Just as you should hold your stocks for 20-30 years, hold your house for 20-30 years or more to get the long-term investment returns and most benefit from inflation.
These returns get better with each year as the mortgage payment typically grows at a much slower rate than rents do and homes tend to increase in value – on average around 3.5% to 3.8% per year.
Again, real estate is local. My home in Arlington, VA has increased in value by ~48% since 2013 (avg 4.6% per year) while my home in Dayton, OH has increased ~37% since 2009 (avg 2.4% per year). But I am not selling either house any time soon as I am enjoying how inflation is my friend in both markets.
Apples to Apples
JL compared his large house he owned to a small apartment he planned to rent when he was downsizing. As he states in his comments, he did an apples to oranges comparison. But an apples to apples comparison may be more relatable for many people looking to make a buy vs. rent decision between two comparable houses.
When my wife and I went from being a couple to having a family, we shifted from an apartment to a house. We wanted the larger space, the yard for the kids, and the good schools that often come with SFH neighborhoods. We knew where we wanted to live and the size of the home we wanted–we just needed to decide if we should buy or rent that house.
So instead of comparing the rent for a small apartment to rent for a family-sized home as JL did, I believe comparing renting a 3+ bedroom/2 bath home to buying a 3+ bedroom/2 bath home is a more common situation when considering whether to rent or buy in a particular location. So in his example, renting vs. buying comparable apartments.
In Arlington, VA in 2013, rent for a comparable house to the one we bought would have been $3,400 per month while our mortgage house payment was $2783 (3.25% interest). Our first month’s principal of that payment was only $857. Since principal increases a little every month, I use the mid-year monthly numbers when calculating the annual amounts to track the opportunity costs.
Getting to the Math
To make the financial comparison, JL’s basic formula is:
Opportunity cost (equity * annual investment return %). [Note: JL used VGSLX because he would otherwise invest in real estate. This number needs to be lowered for taxes (JL’s formula did not appear to do that)].
+ Total annual cash expenses which comes from adding up these annual outlays:
Maintenance & repair & insurance
Real estate taxes
Mortgage interest (note: excludes principal)
Subtract tax deduction savings
Total annual cost of owning and operating the home = Opportunity Cost + Total expenses.
Subtract annual rent to get annual premium (or savings) to live in the house FOR a single year.
JL’s formula doesn’t appear to factor in inflation over time. I have created a spreadsheet (see images below) using the detailed numbers for my Virginia and Ohio homes over time to indicate that, early on, renting is likely better (depending on your investment return and inflation variables). But, over the long-haul, buying (depending on your variables) is likely better–due primarily to inflation.
In my spreadsheet, I factored in opportunity cost for the down payment AND the amount of principal that is tied up in the house over time using the same investment return rate compounded annually.
But even with a high average investment growth rate (12%–much higher than JL’s 3.5%) and lower than average real estate value growth (2.5%) both houses were more profitable to buy AFTER several years (9 years VA and 7 years OH), and they got better over time even after the tax benefit was reduced by the Tax Cuts and Jobs Act of 2017. Based on actual property growth rates I saw profitability at 3 and 7 years, respectively.
Here are the Virginia house results:
Screenshot of Arlington, VA house calculations
…and here are the Ohio house results:
Screenshot of Beavercreek, OH house calculations
If you would like to play around with the numbers yourself (e.g., adjust investment returns, inflation, or add your own house numbers), you can download the unprotected spreadsheet here:
Be careful not to change the cells with formulas, as that could break the spreadsheet’s functionality. If you see an error or something missing, please let me know in the comments and I’ll take another look.
A few more notes:
While some locations may not achieve 2.5% inflationary growth, they can still be the better financial choice over renting, but you will need to hold the property over a longer period for the inflation-related benefits to make it worthwhile.
In the year you sell the house, reduce the opportunity costs from renting by the amount of the taxes/capital gains on those investments. Houses that you have lived in for at least two of the last five years provide a generous capital gains exclusion ($250K for single, and $500K for married filing jointly).
You might be wondering, “what about closing costs?.” Good question. I paid ~$6K to close on my VA house in 2013. I would have locked up around the same amount on first, last, and deposit on renting a house, so that’s a wash. After 20+ years, the $6K is a deflated pittance on either score sheet. (Note that the landlord often increases the deposit amount if they raise the rent.) I did account for selling costs in my spreadsheet when calculating the capital gain for each house.
Property manager costs: I did not include hiring a property manager if you need to rent your house out. This is a whole separate article, but like self-insuring instead of paying the renter’s insurance, I do my own property management. I have found the time costs to be negligible and property managers not worth the money in my experience.
Making additional principal payments toward the mortgage isn’t supported by my data. By doing so, you would lose some of the benefit of paying off a fixed P&I amount with future inflated dollars. Many people’s wages receive inflation adjusted raises and make paying off their mortgages easier over time. Also, the more money added to the principal will negatively impact the opportunity costs comparisons as the house value will change (usually it will increase) regardless of how much principal is paid.
Bottomline: Inflation makes a big difference
My decision to buy instead of rent in Arlington, VA returned roughly $206K over the last 10 years than I would have gained with renting a comparable house and investing the down payment and principal.
Likewise, my Ohio house returned roughly $24K more in the last 13 years than a comparable rental. This is despite having lower than average capital appreciation (2.4% vs. 3.5%).
While $24K may not sound like much, don’t forget that these returns are above and beyond what I would have gained if I rented a comparable house and invested my available down payment cash at a 12% annual average return. This difference would be even higher if I had invested in real estate index funds (e.g., VGSLX which returned ~7% per year 2013-2022) or the 3.5% dividend amount that JL used for his calculation.
This only works if you keep the house for the long-haul. If you are going to sell before you breakeven, then renting is the better financial choice.
I hope this helps you to calculate the long-term financial value of renting vs. buying a comparable house, and helps you make a decision that’s best for your situation.
Addendum: After completing my analysis I stumbled onto Nerdwallet’s Rent vs Buy calculator. This has comprehensive variables you can input to make your comparison. I like the graphic that shows when the cross-over point will occur for buying vs. renting. However, I cannot access their formulas, so I’m not sure how they work behind the scenes. It uses statewide average property tax rates which do not reflect many local tax situations. Likewise, I find using a percentage of property value as a poor measure for repair and maintenance costs. For example, my less expensive OH house cost a lot more to maintain than my more expensive VA home.
I think my spreadsheet, updated each year using actual annual investment returns and inflations rates, will provide a more accurate picture if you wish to track your house’s real time performance and whether it’s better to rent or sell if you need to leave your home for an extended period of time. Note, high investment returns or capital appreciation percentages later on are less valuable than high returns early on due to sequence of returns and the power of compounding.
