Expenses, SWR, and Holy Sh&%#t

[Rich_by_the_Bay]

So we just decided to pay off our remaining mortgage. Did all the usual calculations and handwringing, decided it would save us about $1300 a month. Nice.

Suddenly it occured to me as I switched from my SAVING FOR RETIREMENT mindset to my EXPENSES ELIMINATED mindset: there is $412,500 in assets I no longer need, using the 4% rule. Heck, it only reduced my net worth by $170,000 to do this. A $242,500 return on my 170K investment!

It's not like I didn't know this intellectually, but until it got "real" over this latest transaction, it just never occurred to me how much room to play you can get, in real world bucks, by cutting your basic expenses in retirement. Yeah, yeah I have that much smaller of a nest egg to compound, etc. etc. Still, this was sobering.

Sorry to be stating the obvious here, but ... geez... duh... time to sell the dog.

 

[tiredofwork]

How did it reduce your net worth $170,000 to pay off your mortgage? Didn't you just use cash to reduce a liability -- effect on net worth $0??

 

[Rich_by_the_Bay]

How did it reduce your net worth $170,000 to pay off your mortgage? Didn't you just use cash to reduce a liability -- effect on net worth $0??

Of course you are technically correct. However, by convention, your housing equity is excluded from your net worth in most analyses done for ER planning so this shift had that "virtual" effect.

My point is how powerful an effect on your FIRE planning a long-term reduction in expenses can have.

 

[Cut-Throat]

Rich,

I think most of us here do not include a house payment as part of our expenses. Mostly because there is an end to house payment. Unlike food, property taxes, fuel etc.

I still have a House Payment - But it is only made up of Property Taxes, Association Fees, Utilities

But no principal or interest.

But it is great not to have a House Payment!

 

[doushioukanaa]

Generally, if you can pay down your mortgage while keeping enough emergency cash it makes sense to do so unless the tax adjusted cost of the loan is significantly lower than the expected returns you would get from investing the incremental proceeds. This of course ignores the emotional benefit of owning your home free and clear which also has some value...

In any event, congratulations!

 

[cute fuzzy bunny]

My point is how powerful an effect on your FIRE planning a long-term reduction in expenses can have.

Ding! Ding! Ding!

Now consider the second half of the benefit...without a need for higher monthly cash withdrawals, do you maintain the same risk level of portfolio, raise your risk/return because you dont need the money every month and can take more volatility, or lower your risk/return because you dont need the money and can improve your 'sleep at night' factor?

 

[Rich_by_the_Bay]

Ding! Ding! Ding!

Now consider the second half of the benefit...without a need for higher monthly cash withdrawals, do you maintain the same risk level of portfolio, raise your risk/return because you dont need the money every month and can take more volatility, or lower your risk/return because you dont need the money and can improve your 'sleep at night' factor?

Oooh. You mean just like if you bought an immediate annuity?

Just kidding. Really -- just kidding. It's a joke. Please..

 

[wabmester]

I'm having trouble following the logic here. Just for argument's sake, let's say your loan interest rate was 0% and your principal was $100K.

Are you guys saying that even though each payment is increasing the equity in your home, and each payment gets implicitly lowered by the effects of inflation, you'd still pay off that $100K loan just because it reduces your monthly burn rate?

You can't be saying that, right?

 

[modlair]

Of course you are technically correct. However, by convention, your housing equity is excluded from your net worth in most analyses done for ER planning so this shift had that "virtual" effect.

This is the cause of all the consternation that followed in the thread.

I am not aware of such a convention, and this is not intended to be at all critical. I'm sure many do this. I don't see why.

It is perhaps a valid convention for those who want to live in the same house in the same place for 40 years to end of life. I suspect it's not a valid convention for those who don't. I also suspect the second group is larger than the first.

Home equity is part of net worth. You sell it, you put cash in your pocket, you go somewhere else and maybe even rent for a time. Or if you sell big in California maybe you buy 3 low price places all over the world and move about with the seasons.

It's just dollars, people. Nothing sacred about 2 X 4s and concrete and shingles.

 

[azanon]

...  However, by convention, your housing equity is excluded from your net worth in most analyses ....

I wish there were a kind way to say it, but i cant think of one except for less accurate ways of saying it, so here goes.  Anyone that eliminates their house equity from any net worth analysis is an idiot.    Or an idiot with respect to finance 101.   If this were true, then i could spend 100K to pay off my remaining mortgage, and you would have me believe my net worth just dropped by 100K. 

Houses are assets/investments that can be both bought and liquidated (aka sold).  Moreso, they are also, on average, appreciating assets.  Just because you can also use (aka live in) this asset, doesn't make it any less an asset.   Last i checked, it is possible to sell a house you own to free up cash, and rent one in its place.  Anyone who wants to bring up some Kyrasoki or whatever his name is anti-logic on this please refer to the many threads where we make fun of that guy.

 

[preben]

Ofcourse house equity (primary residence) is part of a "normal" net worth calculation. I also include the market value of a car Etc.

But for SWR calculation/investment return purposes one does normally not include it. Let's call that "liquid net worth/investable net worth" or whatever.

Cheers!

 

[Rich_by_the_Bay]

This is the cause of all the consternation that followed in the thread.

Gettin' way more technical and serious here than the original post intended.

The point of the post was that just as many novices are surprised to learn they need something like 25x anticipated year 1 expenses in order to retire safely, it is equally surprising to remind youself that by reducing a long-running expense after retirement, you get a serious lowering of how much you need in assets to sustain your (cheaper) lifestyle.

Just a psychological eye-opener when you are actually faced with it.

Oh.. and feel free to include home equity in your net worth for our retirement planning. In fact, I strongly recommend including it if you get cranky when you don't . Certainly if you plan to sell, borrow against it, or reverse mortgage, it can affect your financial state quite alot (or that of your heirs).

It's just a good reminder that frugal living after FIRE leaves you with lots of room in your nest egg expectations. All other things equal, if you reduce your ongoing post-FIRE expenses by a buck you need $25 less in your savings to spin off everlasting 4% earnings.

 

[azanon]

But for SWR calculation/investment return purposes one does normally not include it.

Speak for yourself. I will definitely include it in mine.

 

[wabmester]

I guess the problem everybody (except CFB) is having with this revelation is that you're not balancing both sides of the equation.   You're including interest and principal in your expenses, but your not including the fact that the borrowed money is working for you investment-wise and the principal payments are going to *you* (with inflation working to your advantage)!

I can see how you like the psychological benefit of a lower burn-rate, but it might not be such a great move money-wise.

(And Azz -- you're still the King of Uncouth, d00d.)

 

[azanon]

it is equally surprising to remind youself that by reducing a long-running expense after retirement, you get a serious lowering of how much you need in assets to sustain your (cheaper) lifestyle.

I'm a glass is half-full kind of person.  I have several expenses during the month;  the equity portion of my mortgage payment is not one of them.   That is an investment, not an expense.   I just happen to live in that investment.

In quicken 200 dollars in cash goes to 200 dollars in equity. I can get a reverse mortgage if i needed to, and make the money go the opposite direction. No expense there at all. Just swapping the equity around, from cash equity to house equity.

 

[preben]

Rich in Tampa; yes and that is a very good reminder indeed! Lowering those expenses certainly makes a huge difference!

I often joke with my friends back in Europe that my job is to "live in Thailand" - due to the much lower cost of living, that is all I have to do while still having a w/r of 2% - I.e. adding to my nest egg.
Should I move back to Europe I would have to push a much higher w/r thereby not adding to the nest egg.

Cheers!

 

[azanon]

Lowering those expenses certainly makes a huge difference!

So does using less money for investments, such as stocks, bonds and real estate.

Now if we can only learn the difference between an expense (money spent on something where the money is completely unrecoverable) and an investment (money used for something that has intrinic value that can be converted back to money, and has appreciation potential).

 

[wabmester]

Another (sick) way to look at this is with imputed rents.    If you own a house free and clear, you're happily thinking that you've reduced your expenses.   But the house is an income-producing asset, and by living in it, you're losing that potential rental income.   In effect, you're paying yourself rent, and that rent should show up in your expense column.

(I told you it was sick.)

 

[free4now]

My home (condo) has a value of about half my net worth, so this question of how to account for the home in SWR calculations is something I've looked at from several different angles.

1. The conventional way for free and clear homeowners to calculate SWR seems to be to leave the home equity out of your retirement assets number, and since it's paid off you don't have a mortgage or rent in your withdrawal number. The advantage to this approach is simplicity... no need to try and guess how the home value will change over time; you just stay there for the rest of your life and pass it on to your kids. If the real estate market is heading up or down you don't have to lose any sleep over how that might affect your withdrawls.

But the problem with this approach is that it doesn't recognize that the home is an appreciating asset (historically) whose value can provide money for withdrawls, and therefore it ends up giving a lower SWR number than is probably realistic. Some folks like that extra measure of conservatism.

2. Another way is to do a cashflow analysis... in my case I have a mortgage so I would include the mortgage payment in my WR number, and include the full equity of the home in my assets. This is problematic in that the SWR studies do not include real estate, so deriving an SWR number from real estate is not going to be historically accurate. It is also problematic in that it is overly sensitive to the mortgage payment... a 95% LTV mortgage payment would be the same as my total 4% SWR per month, leaving me nothing for living expenses. But a 5% LTV would leave me thousands per month to spend. That doesn't pass the common sense test... paying off a mortgage with your retirement assets as the original poster did does not free up that much cashflow. It's just an artificact of this incomplete accounting method that it appears to do so.

3. As wab suggested, using imputed rents is actually a pretty reasonable idea. The thinking goes like this: If I didn't own my home and instead rented it from someone else, then I would have the full equity as an asset, and have the rent taken out of my 4% SWR. Then we assume that it's financially better long term to own than to rent (otherwise we are stupid for not selling and renting). So the amount you can spend per month on non-housing expenses is as much as if you were renting. I use that number as the amount I can spend on non-housing expenses as an owner. This method ends up allowing you to spend more, so it is less conservative than the other methods. It ignores the way that a required mortgage payment can suck your balance down in bear markets, which is a disadvantage. But I would also argue that it's still overly conservative since buying is presumably better financially than renting long term, and this accounting does predict that.

I'm actually leaning towards the imputed rent accounting myself, because I believe it's closest to the financial reality of the situation.

But what is really frustrating is that none of these accountings help me to answer the question of whether it would be financially better for me to sell and rent; they all predict that renting would be financially better (or the same for the imputed rent accounting). That conclusion is I think more an artifact of the incompleteness of these models than a true financial reality. Everyone would rent in retirement if these models were correct.

 

[mathjak107]

my feeling about counting a house in net worth or calculations is i dont..reason is until the day comes that a house is moved from the personal consumption side of living in it,to the im ready to liquidate it ,it was an investment side it serves no purpose in my net worth...i wouldnt count my origional art works i own as i enjoy them and im not selling them at this point, my prized road bike collection either.they are personal consumption items at this point...the only time a million dollar house and a 500,000 house differ in value if your living in it is for tax purposes,loans,or death......yeah i know you can reverse mortgage it but a reverse mortgage is really nothing more than just taking a loan with a balloon payment due either when you die or move no big deal...you can get a balloon payment on loans with special terms even if you dont have a house

 

[ladelfina]

Poor Rich! (oxymoron?) His enthusiasm seems misunderstood. All the talk of 'investment' leaves out the issue of his previously paying interest to service this investment. Now he is free and clear. We don't know what his mortgage rate was.. maybe he had an ARM (brrrrr!).. anyway, he is well clear of it. I don't think many of you would advocate margin trading, so why the disdain over paying off the mortgage?

While with a low mortgage interest and higher expected returns, you could be making something off the spread, for a conservative investor this is not going to be a huge difference, while the relief of not worrying about writing an extra check every month and worrying about whether your withdrawals will need to stay high in a year when the market is low.. well, I think that may be worth the difference. As free4now said, Simplicity!

Rich (an MD, IIRC) may also be in an AMT tax territory that doesn't give him the full benefit of the interest deduction, so in his case it may be a no-brainer. (disclosure: I know almost nothing about the AMT, so feel free to correct me on this).

Anyway, it seems to me like a bird in the hand being worth two in the bush. His $170k has brought him a guaranteed positive return w/r/t his previous position, so I say "WELL DONE!"

[Wab is right to consider 'imputed' rent; as I mentioned elsewhere, in Italy on your personal income tax there is an item to calculate this virtual income, on which you are required to pay tax (!). Sick, indeed!]

 

[Rich_by_the_Bay]

Anyone that eliminates their house equity from any net worth analysis is an idiot. Or an idiot with respect to finance 101.

Az,

Easy big guy. In your view is everyone who values FIRECALC an "idiot," as you so graciously put it? No home equity there that I recall...

We are talking about retirement planning, not net worth analysis (I used and clarfied that way back at the beginning). No argument with the former.

 

[Rich_by_the_Bay]

Poor Rich! (oxymoron?) His enthusiasm seems misunderstood.

Oooh.. an online hug. That felt good, thanks Ladelfina  .

Yes, truth be told the decision was actually a fairly complicated one and it was an ARM which is now rising fast on its way past 7%.

Of course the point of my post was that for all the angst of saving 25 bucks pre-FIRE for every dollar in anticipated expenses, it is kinda nice to know that you can reverse that reality a bit by reducing your saving goals by 25 bucks for every dollar by which you reduce your long-term expenses POST-FIRE.

 

[audreyh1]

Of course the point of my post was that for all the angst of saving 25 bucks pre-FIRE for every dollar in anticipated expenses, it is kinda nice to know that you can reverse that reality a bit by reducing your saving goals by 25 bucks for every dollar by which you reduce your long-term expenses POST-FIRE.

Rich - reducing expenses is definitely a major part of the FIRE equation. This is also why moving to an area with a lower cost of living can make such a huge difference.

Audrey

 

[astromeria]

Another hug for Rich here from a fellow lover of the mortgage-free life. In fact, the absence of mortgage helps this nervous nellie cope with stock market gyrations. I enjoy FIRE more when I avoid stress.

Although we already downsized our real estate, it was downsized in value, not size (SanFrancisco condo to South Carolina house). And we live once again in a much appreciated asset, and this time wihout a mortgage. But I don't count the value as a FIRE asset. I figure on eventually trading this place for a small condo and/or spiffy fifth wheeler--and much later, assisted living (especially if DH goes to the great beyond first), and a good place/trailer costs to buy and costs more by the month than my current housing expenses, so any cash I take out will be needed to help pay that increased housing expense. If I'm lucky, it'll be a wash. Even if we stay in the house and make use of a reverse mortgage some day, we'll likely need that money in our dotage to pay for additional services (like weekly house cleaning instead of the current less than monthly) and other expenses (like more heat and A/C when we're weak & cranky). If I really mismanage our investments, we could tap the value, but I just keep that data point as a footnote on one of my lists--along with the other emergency backup ideas.