Teach Compound Interest in High School Math Courses

According to a recent report, 66 million Americans have absolutely no savings available to cover a financial emergency.  This shocking figure is nearly one-third of the roughly 206 million Americans between the ages of 15 and 64 which makes up the age group most likely to lack a safety net to deal with emergencies.  A recent survey by Standard & Poor’s revealed that only 57 percent of Americans are financially literate.  Although it isn’t a good idea to unfairly stereotype individuals in large groups, it seems very likely that the Americans lacking savings also have a general lack of understanding of basic personal finance.

Why is this the case and what can be done about it?

One of the problems is that human beings do not seem to naturally understand non-linear systems, and this deficiency prevents us from automatically understanding what is perhaps the most important topic in personal finance:  compound interest.

Here is one of the questions asked in the financial literacy survey:

Suppose you had $100 in a savings account and the bank adds 10% per year to the account. How much money would you have in the account after five years if you did not remove any money from the account: more than $150, exactly $150 or less than $150?

It is likely that most people would understand that 10 percent of $100 is $10 which represents the first year of interest.  The account will be open for five years, so many people will be tempted to simply multiply the $10 by 5 and come up with $50 in total interest which is added to the initial $100 balance for a total of $150.  However, this ignores the fact that you earn interest on interest which is the essence of compounding.  Assuming annual compounding, the balance of the account would look like this over the five year span:

A simple formula can be used to determine the ending result of a sum invested at a certain rate over a certain period of time:

Ending Balance = Starting Balance * (1 + Periodic Interest Rate) ^ Number of Periods

The formula can be applied to this example as follows:

$161.05 = $100 * (1 + 0.1) ^ 5

Compound interest is an example of an exponential equation and the results do not neatly fit our natural intuitions.  It is much more intuitive to think that the $100 deposit will earn $50 over five years than to figure out the actual result which is significantly more than $50.  However, it is important to realize that this particular exponential function is very simple and should be understandable to the vast majority of people if explained clearly as part of a basic education.

Extending the Deposit to 50 Years

To make the effect of compound interest more clear, let’s extend the period of time that the $100 is kept on deposit at a rate of 10%.  Rather than assuming five years, let’s assume that the money is left alone for fifty years instead.  If we apply the same “gut instinct” (but incorrect) logic that would have led someone to believe that the $100 deposit would only earn $50 over five years to this longer example, the answer would be that the fifty year deposit should earn a total of $500, which is 50 years multiplied by $10 per year.

Let’s see what the correct result is:

Ending Balance = Starting Balance * (1 + Periodic Interest Rate) ^ Number of Periods

This formula can be applied to this example as follows:

$11,739.09= $100 * (1 + 0.1) ^ 50

Instead of earning the $500 that “gut instinct” might have led us to believe, the $100 deposit earns a shocking $11,639.09 in interest!

This unintuitive result is due to the exponential nature of compound interest, as we can see from the graph below:

We can see that progress is slow at first, which we already knew based on the first five years of the investment.  However, over time, earning interest on interest becomes the driving force behind the overall value of the account and we can really see the line start to explode upward over the second twenty-five year period.

What Applies to Savings Also Applies to Debt

How many people truly understand the horrible compounding effects of credit card debt?  Although paying 15 to 20 percent interest on a $1,000 sofa might seem like an annoyance over the first year, making minimum monthly payments while taking on additional debt will cause the problem to snowball over time in just the same way that savings multiplied like crazy in the previous example.  Actually, the snowball will be much worse. Compounding at 15 to 20 percent results in a much, much larger snowball than compounding at 10 percent.

Although credit card disclosure requirements have improved over the past several years and people are now clearly told how long it will take to retire debt based on minimum monthly payments, few people are going to pay much attention to the details on a credit card statement or stop using the credit card while paying it down.

Low Interest Rates Make Compounding Less Obvious

The example in the survey uses a rate of 10 percent for a savings account which is obviously unrealistic in today’s world of minuscule savings rates.  However, low interest rates are probably not going to be a permanent phenomenon over the long run.  The problem is that people have been trained to not appreciate the power of compound interest over the past several years because it is even less apparent than it otherwise would be.

Using a rate of 1 percent, which one would have been fortunate to get on a savings account over the past five years, the $100 deposit would have grown to only $105.10 over five years.  In this case, the “intuitive” answer of believing that the total interest would be only $5 is hardly different from the correct answer of $5.10.  In fact, it is so trivial that if we used the 1 percent rate in an example, people would laugh if we tried to claim that compound interest is actually important.

Multi-Disciplinary Education

Financial education is severely lacking in the United States and the fact that over half of Americans lack basic financial literacy is a national disgrace.  The place to remedy the problem has to be the public school system.  Ideally, parents would educate their children on personal finance but too many adults are financially illiterate and we do not want to have a society where this perpetuates through multiple generations.

It should not be difficult to incorporate an appreciation for compound interest into the public school system.  Basic exponential functions are routinely taught at the middle school level and, if not, certainly as part of a high school curriculum.  Rather than using esoteric examples that students might not relate to, teachers could incorporate compound interest directly into basic math education covering exponential functions.

But is it the job of math teachers to cover personal finance?  The better question is why not?

There need not be a special course in personal finance (although such an offering has obvious merits as well).  Disciplines like mathematics should incorporate subject matter from other disciplines, particularly when doing so reinforces the math that is being taught.  All young people are concerned with having enough money to spend.  They might be too impulsive to care about long term growth of savings, but if they are at least aware of the potential of compound interest, that might prevent the accumulation of unwise debt in college or when starting out in the workforce.

Parents who are fully aware of the power of compound interest might try bypassing today’s low interest rate environment by setting up a family “bank” where their children can make “deposits” at rates that are far above market and possibly compound at a more frequent pace.  For example, parents could offer their children an “account” that compounds at a rate of 5 percent every quarter.  At that rate, a $100 deposit would grow to almost $150 over two years, well within the time frame that a teenager should appreciate.

Not a Panacea, But a Start

Even if every American left high school with a solid understanding of compound interest, we will still have people who fail to save because they lack self control or fall into really hard times through no fault of their own.  However, it is hard to believe that wide dissemination of this very basic principle would not dramatically reduce human misery.  Not being able to cover the cost of a broken refrigerator, a tire blow-out, or a traffic ticket should be preventable for almost everyone.

There are enough truly difficult problems in life that do not lend themselves to simple solutions, so we should adopt simple ideas that have little or no downside such as teaching students about compound interest as part of their existing math programs.  It might be wishful thinking to hope that all Americans will automatically think in terms of exponential functions rather than using their linear intuitions in everyday life.  But when faced with major life decisions, the default should be to think in terms of compound interest when it comes to spending and saving money.

Escaping the Ratcheting Lifestyle Trap

The Wall Street Journal published an interesting article recently regarding the sad financial future awaiting many NFL players.  The article cites a study that analyzed the financial data of more than 2,000 players who were drafted by the NFL from 1996 to 2003.  These players were followed until 2013 to see how their financial health would hold up after retirement.  After 12 years in retirement, more than 15 percent of the players who were followed had declared bankruptcy.  Were these players predominantly those who were drafted and only played a year or two at the lower end of the pay scale?  Apparently not.  Earning a higher income or having a longer playing career did not seem to offer much protection against bankruptcy after a player’s NFL career came to an end.

There is no shortage of statistics when it comes to professional sports, and this is as true for salary information as it is for measures of athletic performance.  The Spotrac website offers a wealth of information on current NFL salaries, including a ranked list of the top 1,000 cash salaries in the league.  In 2016, the top earning player was Drew Brees at $31.25 million.  Nearly 100 players earned over $10 million in cash compensation while 880 earned over $1 million. In 2015, the average NFL salary was $2.1 million while the median salary was $860,000.  The rookie minimum wage was $435,000.  1,696 players were employed by NFL teams.

So these guys are making very, very good money at a very young age and it is safe to assume that the vast majority of these players in their early 20s have never seen this kind of money before.  Here’s the problem:  The average length of an NFL career is only 3.3 years, although this figure varies widely based on the position played and the ranking of the player in the draft.  But how many new guys entering the NFL believe that their career will be just a few years?  Probably very few.  They see the money coming in, feel invincible, and believe that the good times will keep rolling indefinitely, or at least until their 30s, which for someone who is 22 seems a lifetime away.  How do you think they are going to choose to spend their newfound wealth?

Beware of the Ratcheting Lifestyle

The financial problems facing new NFL players are different than what most of us face in life, but only because the abrupt change of income experienced by players is far more noticeable than what the rest of us experience.  An NFL player goes from earning little or nothing to earning at least $435,000 per year as a rookie, and subsequently will earn much more if he performs well and remains healthy.  The rest of us earn little or nothing while in high school or college and then experience a significant jump in pay, but obviously nowhere near a half million dollars.  Then, if  all goes well, pay will rise gradually over time as we get more experience and take on more responsibility.

In some ways, the NFL player should have an easier time avoiding the temptation to ratchet his lifestyle significantly because it is obvious that playing careers do not last very long.  If it is very unlikely that a player will be in the NFL past age 30, it is obvious that plans need to be put in place to address that, whether it involves a second career or accumulating enough assets to be financially independent.  The rest of us do not have these obvious prompts to consider our level of spending.  Most people immediately ratchet up their lifestyle after graduating from college and save very little.  Then, annual raises are automatically spent as they are earned.

The Hedonic Treadmill

But wait a minute … what is wrong with increasing spending as one’s income increases?  Isn’t one of the major motivations for going out and getting an education (or making the NFL) the idea that we can then life a more comfortable lifestyle?  This is certainly true for most people and studies have shown that people do gain a significant amount of happiness as they increase consumption to meet basic needs.  Many people will experience happiness beyond that point as well, although obviously the degree to which happiness is correlated with increased consumption will vary based on personality and other factors.

However, one aspect of human nature that seems universal is that at some point, the degree of happiness one gets from spending an additional dollar declines.  Furthermore, human beings have a tendency to return to a stable level of happiness after a major life change.  This is referred to in psychology as the hedonic treadmill effect.  (As an aside, one of my favorite books on psychology, Thinking Fast and Slowby Daniel Kahneman touches on this subject along with many others.)

The temptation facing the NFL player is probably quite extreme.  Going from earning no money to earning, perhaps, half a million dollars in his first year, it would be difficult to avoid peer pressure to go out and buy a luxury car, a new home, better clothing, and to spend lavishly on entertainment for real and fake friends, as well as to try to help out family members.  Getting into the NFL is a very high publicity event.  Everyone the player has known for his whole life will probably become a new “friend” instantly and given that the player is now “rich”, he might seek to impress his new “friends” with money.

A new college graduate who is entering a more prosaic field, such as accounting, faces some of the same psychological impulses, although at a less extreme level.  With a new job paying $50,000 per year, she might move into a recently built apartment in the city, spend more on personal services, go out to eat and drink with friends, purchase new clothes, and make a down payment on a more modest car.  But she is facing similar temptations to spend up to her newly found income limit.  And in some ways, her problem is worse than the NFL player’s because there is no real upper bound on how long an accountant can work.  You can have a 50 year career in accounting, assuming that you want to have one and jobs are available.  So why not go out with friends and drink $15 cocktails?

So, We Should Save Everything? 

The point isn’t to suggest that people who have suddenly experienced an increase in income should take no actions whatsoever to fund a better lifestyle.  It would be ridiculous to suggest that an NFL player, or our accountant for that matter, should be subjected to poverty and save almost everything.  That isn’t the point.  The goal is to be mindful regarding spending and to understand the trade-offs that inherently exist.  Also, it is important to know yourself and how your personality will deal with the diminishing returns from additional spending.  You don’t want to be a hamster on the hedonic treadmill.

The question of how quickly to increase spending when income suddenly increases depends on many factors, some of which include:

  • How long will the increase in income last?
  • What is the starting level of spending that you are accustomed to?
  • How much do you enjoy the work involved in earning the income?
  • How likely is it that employment in your chosen field will continue to exist in the future?
  • How important is financial independence to you, irrespective of whether you like your work?

For the NFL player, it is pretty obvious that the income will not last for very long no matter how much the player enjoys playing football.  So a good question to ask is whether the player wants to work in some other field after his playing career is over.  The stereotype of the academically challenged jock is just that, a stereotype, and there is no reason why a former NFL player in his late 20s or 30s cannot have a full career in some other field.  Even if so, financial independence after the NFL, or at least some assured minimum level of income for life, seems to be a worthy goal.

Financial Independence After the NFL

Assume that a player is drafted and earns a first year salary of $500,000 followed by an increase to $750,000 in the second year, and $1 million in the third and fourth year.  On the final game of the fourth season, the player suffers a career ending injury and has to retire.  In aggregate, the player will have earned $3.25 million in gross pay over four years.  For purposes of this brief analysis, assume that the player lives in Texas and does not incur state income taxes (although this is unlikely since many states will tax players on games played in-state).

H&R Block provides a free tax estimator that I will use for this example.  Assuming that the player is single with no dependents and takes the standard deduction, he will earn the following on an after tax basis:

  • Year 1:  $500,000 gross income – $154,375 tax = $345,625 net income.
  • Year 2:  $750,000 gross income – $255,625 tax = $494,375 net income.
  • Year 3 and 4:  $1 million gross income – $356,875 tax = $643,125 net income.

We can see that the $3.25 million in gross pay has already shrunk to a little over $2.1 million after paying federal income taxes.  How much should the player spend and save each year?

Here, the situation becomes even more interesting.  First of all, the player does not know that he will be forced to retire after four years.  He only finds out at the end of the fourth season when he suffers a career ending injury.  Therefore, from the perspective of the player at the start of his career, it is not apparent that his lifetime earnings from the NFL will be around $2.1 million in terms of cash in his pocket.

But for the sake of argument, assume that the player knows that the average NFL career is under four years and intelligently assumes that he won’t beat the average by that much.  Also, assume that he can predict his salary increases after his first year.  So, now we have a 21 year old newly minted NFL player with almost $350,000 of income in year one.  How much should be spend and save?

To answer this question, let’s assume that the player wants to ensure that he has at least some minimum level of financial security after retirement from the NFL, for life.  Median household income in the United States in 2015 was slightly over $56,000.  Let’s say that we define financial security as the ability to withdraw $56,000 from a portfolio on an inflation adjusted basis in perpetuity.  Using the 3 percent withdrawal rule that I prefer, the portfolio needs to be 33 times the withdrawal level, or 33 x $56,000 = $1.85 million.

$1.85 million!  On an after tax basis, our NFL player is only collecting $2.1 million in cash over his four year playing career!  Ignoring investment returns, this means that the player only really has about $250,000 to spend over his four year career in the NFL, or approximately $62,500 per year, on average.  In reality, the situation is probably a little bit better because he will be earning investment returns on funds saved during the course of his playing years, so let’s say that he can spend about $70,000 per year while playing.  If he spends $70,000 per year during his playing career, it seems likely that he will have a large enough investment portfolio to be financially secure for life, if we define financial security as the ability to withdraw, on an inflation adjusted basis, the median U.S. household income in perpetuity.

Is This Realistic? 

The honest answer is probably not, at  least for the average NFL player.  There are very, very few men in their early 20s who are going to have the self discipline to earn enormous salaries in the NFL but spend only $70,000 per year on an after tax basis.

Yet is clearly possible.

Plenty of people get by on far less than that.  Furthermore, $70,000 is well above the typical gross income in the NFL player’s age cohort.  In other words, his friends from high school and college who are not playing in the NFL but working in other jobs are likely to earn far less.  So, we are not talking about any major deprivation here, only exercising a very unusual level of self restraint.

What does seem to make a great deal of sense is for an NFL player to be very, very conservative in his early years while stockpiling an initial sum that can guarantee financial independence for life.  After that point, if he is still playing, it is very likely that he will be earning a much higher salary.  Staying in the NFL for a decade or longer is not just a matter of staying healthy.  You have to perform.  Veteran players in their late 20s and 30s are going to earn several million dollars per year.  Younger players should attempt to defer big ticket items until later in their career once basic financial freedom has been assured.

But What’s the Alternative?

Taking a more common path, the player will probably spend the vast majority of the $350,000 in cash received during the first year.  Spending on a luxury car, better clothing, vacations, and entertainment can easily soak up a couple hundred thousand dollars, and perhaps he will also make a down payment on a house.  With an increase in income in the second year, spending will ratchet accordingly and probably include even more entertainment, perhaps a second car, and much else.  After reaching a salary of $1 million in year three, all sorts of additional spending options come into play, perhaps even including a small share of a private plane.  After all, many veteran players are earning $10 million per year, so why not?

The tragic consequences of a career ending injury at the end of year four becomes glaringly obvious for someone who has adopted that kind of lifestyle.  Not only are his playing days over, with the associated loss of prestige and popularity, but there is suddenly much less income, even if there is some element of insurance that comes into play.  And the lifestyle that he has become accustomed to is suddenly out of reach.  With no plan for a second career, it’s easy to see how the player will have little or no net worth along with high fixed expenses.  It isn’t surprising that 15 percent or more will eventually suffer bankruptcy.

There are lessons for the rest of us here as well.  We should all strive to understand the hedonic treadmill and the fact that we are not going to make ourselves happier on a sustained basis merely by increasing our spending.  We should be aware of the risk of making choices that do not increase happiness but do reduce financial flexibility in the future (such as purchasing an expensive car on credit, living in a large home in a suburb 30 miles from work, etc).  If we consider financial freedom at a relatively young age to be intrinsically valuable regardless of whether we wish to continue working, then some thought needs to be given to having restraint in the early years, and that is especially well illustrated by the choices facing a new NFL player.

When Can You Consider Yourself Financially Independent?

When can you give up the security of a regular paycheck?

This is a fundamental question that everyone must eventually answer in the context of their own “retirement”.  I put “retirement” in quotes because what we are really talking about here is not necessarily retirement in the conventional sense of the word but rather attaining the level of financial independence that is needed to make a regular paycheck optional.  You might like your job and have great relations with your boss today, but that could always change tomorrow or next month.  A recession could result in layoffs and you might find yourself involuntarily out of work.  Illness has been the cause of many premature exists from the workforce.  At what point are you immune from having to worry about drawing a paycheck to fund your lifestyle?

The following Dilbert cartoon humorously illustrates what I am referring to:

Nassim Nicholas Taleb should properly be credited with the concept of “F*** You Money” that he developed in The Black Swan and has elaborated on numerous times since the book was published, such as in this Facebook post from 2015.  Now, not everyone works for a pointy-headed boss and hates their job as much as Dilbert and Wally, and plenty of people actually love their job and enjoy the people they work with.  Whether or not you like the kind of language used by Scott Adams or Nassim Taleb, the point is obvious:  When can you declare independence from paid employment if you choose to do so?

At the risk of stating the obvious, there are two major factors that we need to look at:

  1. How much money is needed to fund your lifestyle every year?  The answer is not as simple as looking at what you are currently spending every year.  There will probably be expenses related to work that will entirely disappear from your budget if you choose to leave paid employment.  You will no longer have to commute to work so the cost of driving or public transit will disappear.  Maybe you can even give up your car entirely.  It will be unnecessary to purchase clothing specifically for work (I can count the number of times I’ve worn a tie over the past eight years on two hands).  If you aren’t packing a lunch for work almost every day, you are probably spending a lot of money on eating out and that could be eliminated as well.  This list isn’t exhaustive.  On the other side of the equation, you will incur new expenses in “retirement” such as the cost of health insurance, which is probably going to be the largest new big ticket item.  Also, you will have more time to travel and pursue recreational activities.  You could very well end up spending more money in “retirement”!
  2. How much money have you saved?  This is obviously simpler to answer but, unlike many personal finance articles, I don’t think that it can be distilled to a single number.  Most importantly, it is critical to differentiate between assets that are accessible and assets that are locked up for an extended period of time.  If you are 40 years old and contemplating giving up your paycheck, what matters for the foreseeable future is the amount of liquid assets that you have in non-retirement accounts.  You do not, I repeat do not, want to even contemplate touching retirement funds in a 401(k) or IRA because early withdrawal penalties are significant for anyone who is younger than 59 1/2 years of age.  You also do not want to consider any form of home equity unless you are planning to downsize to a smaller home in retirement.

If you read enough personal finance articles, you probably have already come across discussions of “safe withdrawal levels”.  The idea of a safe withdrawal level is to calculate the amount of money that can be withdrawn from an investment portfolio on an inflation adjusted basis over a specific period of time without running a significant risk of depleting all of your assets.  There are usually a number of embedded assumptions that are made in studies of safe withdrawal levels, such as the percentage of assets invested in stocks versus bonds, whether the stocks are invested in an index fund, and so forth.  Typically, safe withdrawal levels are contingent upon a certain stock/bond mix and broad diversification of a portfolio.

The Four Percent Rule

Over the past two decades, the idea of the “Four Percent Rule” has spread quite widely.  The idea is that one can withdraw four percent of an investment portfolio in the first year of retirement and subsequently withdraw the same amount adjusted for inflation every year.  The inverse of the four percent rule is that one needs to have savings equivalent to 25 times annual spending requirements in order to safely retire.  So, if you have calculated that you need to have $50,000 available for spending in the first year of retirement, you would need to have an investment portfolio of $1,250,000 to support that level of withdrawal in a “safe” manner.

When I first started thinking about the concept of early “retirement”, I spent quite a bit of time researching the topic of safe withdrawal rates and came upon a study that went quite a bit deeper than the four percent rule.  I am not going to link to the study because it has not been updated since 2001 and actually generated some subsequent controversy regarding the methodology that was used.  However, at the time it was the most comprehensive look at safe withdrawal levels that I had come across.  The study looked at financial market returns from 1871 to 2000 and projected the safe withdrawal level for various payout periods based on past history.  A reader could pick their projected payout period and find the optimal mix of stocks versus bonds that would generate a “100% safe” withdrawal level.

The payout periods ranged from ten years, which would only be appropriate for someone who is either already very old or in poor health, to sixty years which was more appropriate in my situation since I was in my early 30s a the time.  I found that the safe withdrawal rate for a sixty year payout was 3.24 percent with a 85%/15% split between stocks and bonds.

The study examined 70 periods from 1871 to 2000 in order to come to the conclusion that a 3.24 percent withdrawal level could be safely sustained for sixty years, with withdrawals rising each year with inflation.  In the vast majority of cases, there would be a very substantial portfolio left at the end of the sixty years. In fact, the median result was that every $1,000 of value in the initial portfolio would end up being worth nearly $43,000 after 60 years assuming a yearly withdrawal of 3.24 percent of the initial portfolio rising each year with inflation.  The worst possible result was that the portfolio would be effectively depleted.

But the main problem with safe withdrawal level studies is that they are backward looking.

It is a major logical fallacy to assume that the next sixty years will look like the period that spanned 1871 to 2000, or anything like it at all!  This is obvious, but it is tempting to look at an overly precise number like “3.24 percent” and assign it with more certainty than it deserves.

No one has any idea what the future will bring or what investment returns will look like, but if we want to make any kind of estimate regarding financial independence, we have no choice but to at least try.  In my mind, this exercise calls for a great deal of conservatism.  I am not comfortable with the four percent rule, and not really comfortable with the 3.24 percent figure that came out of the study.  Part of this is because of the fact that interest rates have been at an unusually depressed level in recent years.  In addition, the level of the stock market implies an “earnings yield” that is far below average.  In a world of savings deposits earning next to nothing, a ten year treasury note yielding just 2.5 percent, and stocks offering an earnings yield under 5 percent, is it really conservative to look at a four percent withdrawal rate as a sure thing?  Would you bet your financial future on it?

The Three Percent Rule

I am not going to propose any specific rule for readers to follow, but I will say that I am comfortable with a three percent withdrawal rate and that is the rate that I used when considering my own financial independence.  This rule implies that you would need to save a little bit over 33 years of annual expenses in order to consider yourself financially independent.  That’s obviously more than the 25 years that is implied by the four percent rule, but it is much more conservative.

Many people would criticize this approach as way too conservative, but is that such a bad thing?  Sure, you might have to save for a longer period of time to achieve independence, but once you do, the level of stress over withdrawal rates will be much lower.  Also, I’ve read criticism of low withdrawal rates along the lines of ending up with “too much” savings at the end of the withdrawal period.  This line of criticism is based on the idea that something big is being given up by under-spending for many years and that ending up with a fat account balance in old age is a negative.  I think this is somewhat absurd for a number of reasons.  First, old age involves facing vicissitudes that younger people might not think of, especially when it comes to nursing care.  Having a pile of cash available to make life comfortable would hardly be unwelcome.  Second, most people want to leave some kind of legacy to family members and providing financial security to others in old age is hardly a negative.  Finally, you can always give away money.  There’s value in generosity and the knowledge that one’s savings can generate benefits beyond personal consumption.

The Bottom Line

The subject of safe withdrawal levels has not been a personal concern for quite some time as the level of my annual spending has declined well below any plausible “danger zone” as a percentage of my available investment assets.  However, I am planning to look at the current research for the purpose of writing about it here and will share any notable information that I manage to uncover.  For now, I would suggest that using a three percent initial withdrawal level is far more reasonable than the much more commonly advocated four percent level and this would imply setting a target of about 33 times annual expenses as a goal for financial independence.

The other factor that should be noted here is that the lower your annual spending requirements, the sooner you can reach financial independence.  Perhaps that is obvious, but it might not be widely understood.  Too many people think about financial independence in terms of replicating their current income in retirement.  This is the wrong way to look at it.  For example, let’s say that you earn $150,000 per year but are only consuming $40,000 per year, which you expect to remain relatively constant in retirement.  You do not need to replicate a $150,000 income in retirement.  You only need to ensure that you can safely withdraw $40,000 per year from your portfolio, and that you can increase this figure each year at the rate of inflation.  Using a three percent rule, this would imply a required portfolio of a little over $1.3 million, which is less than nine times your current $150,000 annual income.

Obviously, no one want to live some horribly restrictive lifestyle either while employed or in retirement, but what is “horribly restrictive” for one person might represent luxurious living for another.  Mr. Money Mustache manages to provide for his family on a little over $25,000 per year!  That figure is going to seem incredible to most readers (it is impressive to me as well) but if you read his blog for any length of time, you will see that it is actually quite possible given his lifestyle and location.  If you only need $25,000 per year, financial freedom using a three percent rule would be around $825,000 in savings.  To be sure, that is still a very sizable sum of money, but as we will see in future articles, the miracle of compound interest makes that kind of savings possible to achieve for many people.

How I Escaped the Car Clown Habit

Many personal finance articles try to get people to believe that very minor changes, such as skipping the morning latte at Starbucks, will lead to financial freedom.  While small steps do indeed help, the fact is that many of us should be looking at the big ticket items in life first because that is where smart changes can have the most significant impact.  A small number of good decisions on the big expenses in life, such as housing and transportation, will outweigh the effect of a hundred minor decisions.  If your boat is sinking, you want to find the source of the big leaks immediately.

One of the most popular websites devoted to personal finance is Mr. Money Mustache, and if you aren’t familiar with the site already, you should probably click on the link and spend a few hours reading it before spending much more time here.  One of the recurring themes over the years has been MMM’s focus on making smart choices when it comes to transportation.  He advocates using human powered modes of transportation (walking and cycling) when possible, resorting to motor vehicles only rarely and efficiently.

MMM’s concept of the “car clown” culture in the United States may seem judgmental, but if you think about it, people do some crazy things with their cars.  Probably one of the most ridiculous examples involves how people take their children to school.  When I was a kid in the 1980s, it was common to walk or bike to school, but these days, the number of people queuing up in long lines to drop their kids off and pick them up has reached epic proportions in many places. People will get in their cars and drive a mile or two, and then sit in a long line with their engines running to drop off or pick up their kids, who are no doubt learning that cars are preferable to using any form of human power to get anywhere, to say nothing of the hypocrisy of people who claim to worry about climate change but do nothing to lower their personal carbon footprint.  Driving a mile to the grocery store, using drive thru lanes instead of walking into a restaurant, and voluntarily choosing to spend an hour or more of one’s life every single day in a soul crushing commute defies logic.

If we had to construct our perfect existence from scratch, how many of us would choose to adopt this type of behavior?  Aren’t many of us trapped in this car culture based mostly on habit and because “that’s the way everyone else does it”?

Why Go Car-Free? 

Like many other people who grew up in the suburbs in the late 20th century, I never gave any thought to these questions.  Everyone waited eagerly for their 16th birthday and the idea that buying a car was a necessity was obvious.  Although walking and biking to school was normal, kids who did so after turning sixteen were not admired. A car was a sign of personal freedom.  I purchased my first car before I turned sixteen and have owned five different vehicles since that point, including one absurdly ridiculous vehicle that I’ll probably discuss at some point in the future.  But in late 2014, I sold my car and have been happily car free for well over two years enjoying the financial and health benefits associated with freedom from the car clown culture.

Why did I do it?

Not really for the money, at least not out of necessity or due to financial duress.  I could easily afford to go out and purchase a $30,000 or even $50,000 vehicle this afternoon for cash and it wouldn’t materially change my financial life.  However, I am an advocate of efficiency and simplicity in life – that’s the Spartan mindset.  I don’t like clutter and I’m annoyed by the idea of having possessions that do not provide sufficient enjoyment to justify their cost.  So I sold my 2008 Ford Mustang GT for $13,850 to a neighbor in my building in December 2014.

I paid $27,239 in cash for the car in November 2007, so the car depreciated by almost exactly 50 percent over seven years, which actually isn’t as bad as it could have been, at least at a surface level, although the opportunity cost of not investing the money in 2007 really means that my net worth is probably $50,000 to $60,000 smaller today than it would have been had I gone car-free sooner.

How Did I Do It?  

I have lived near the center of a major metropolitan area for the past thirteen years with no conceivable need for having access to a car on a 24/7 basis.  I live about three blocks from a major subway station that has three lines serving the entire region.  In addition, cabs are everywhere on streets in my neighborhood and, recently, the density of Uber drivers on the road has reduced wait times to well under five minutes.  As if that isn’t enough, there is a bike sharing system that allows anyone to rent a bike for $2 for a ride of up to thirty minutes which can get me almost anywhere I need to go in the area.  I also have my own personal bike.  And I have my two feet that can be used to walk nearly anywhere I need to go.

Now, I can tell that many readers will be thinking, “this guy doesn’t even have a regular job and he doesn’t have to commute”, and this is true, but prior to 2009, I did have a regular job and my commute was just five minutes and two stops away on the subway.  I made a conscious decision to locate myself in a place where I would have a short commute because I’ve always valued my time more highly than having a large amount of square footage in my home.  You necessarily get less square footage close to the city than in suburbs, but benefit from lack of a soul crushing commute.

Although I made the right decision to live close to work, I always kept my car.  Why?  A force of habit more than anything else.  I always had a car, and assumed I’d always need a car.  There would be road trips I’d want to take.  The subway may shut down at some point.  The weather might be bad and I wouldn’t want to walk.  The list is endless, but unpersuasive.

So, specifically, how did I go car-free?  Here are the specific steps I took:

  1. Sold the car.  I guess that’s obvious, but how you go about this step matters.  I sold the car privately to someone who lives in my building after advertising on the building’s bulletin board and website.  I also advertised on craigslist, but received mostly fake inquiries, including several scams.  If you want to maximize what you get for your car, try to sell it privately within your community.  Although I did not know the person who purchased my car, living in the same building or neighborhood builds trust.  People aren’t likely to sell a lemon to a neighbor they might see in the hall.  I was able to sell the car for very close to its Edmunds True Market Value.
  2. Fixed up my old bike.  Although it still isn’t my primary transportation (I use the subway and walk far more often), I made a point to spend about $50 to fix up my old bike which was gathering dust in the storage unit that came with my condominium.  I ordered new tires and tubes from Amazon and spent about an hour fixing up the few things that needed fixing on the bike itself.  I also purchased a decent lock for about $20.
  3. Started using Uber when necessary.  I gave myself the permission to use Uber freely when it makes sense to do so, and mentally that is a big step toward reducing the insecurity of not having 24/7 transportation at your disposal.  I previously viewed taxis to be a waste of money and psychologically I had an aversion to it, but I simply decided that doing so is now acceptable when using the subway, walking, or biking isn’t an attractive choice.
  4. Signed up for car rental loyalty programs.  The main benefit of signing up for car rental loyalty programs is more related to convenience than the money saved from the small discounts that most companies offer.  In most cases, you can avoid filling out paperwork each time you rent and greatly expedite the process if you are a member of a loyalty program.  I signed up for all of the major rental programs,  but I have ended up using Budget the most.  I rent a car once a week, on average, and the local Budget neighborhood location is nearby and the staff knows me and expedites my rentals.  I’m usually driving a rental car within five minutes of showing up and never have to sign anything.
  5. Verify insurance coverage.  You will need to ensure that you have coverage for times when you drive a rental car or borrow a car from a friend or family member.  My Visa and Discover cards offer protection for the value of the rental car and I have an auto insurance policy for a classic car (I’ll write more about this car, which I don’t use regularly, at another time) which covers my liability for rental cars.  Avoid using the insurance provided by car rental agencies since that coverage comes at an egregiously high cost.

And that’s about it.  The obstacle to going car-free was more mental than practical.

How Much Can You Actually Save? 

Obviously, the savings will vary, but in my case it was quite substantial for a number of reasons.  Before considering the savings from recurring expenses, I was able to take the $13,850 proceeds from selling my car and add it to my liquid assets.  This means that, effectively, I had almost $14,000 more working for me in my investment portfolio than I otherwise would have.  My investment portfolio has returned about 11.7 percent per year, on average, since 2000.  If I can generate 10 percent per year going forward, this $14,000 should grow to over $94,000 over the next 20 years.  That is a substantial amount of money, and probably the most important immediate impact.

In addition to the savings generated by having access to the cash from selling the car, I benefited from the following expense reductions:

  1. Depreciation.  The car was depreciating by about $1,500 per year and the absence of this is very real savings, even if many people prefer to ignore the fact that cars are constantly losing value.
  2. Maintenance.  I like to work on cars myself and handled tasks like oil changes, but I did take the car into the shop periodically for more complicated service and obviously consumable items like tires, windshield wipers, etc had to be replaced from time to time.  On average, I was spending around $500 per year to maintain the car.  However, the car was getting older and annual maintenance expenses would probably have increased substantially over the next several years, especially as the car’s mileage crept up toward 100,000 miles.
  3. Insurance.  I have a great driving record, but my insurance for the car was still running about $500 per year. This cost was obviously eliminated when the car was sold, and I received a full refund of the amount of time remaining on my policy.
  4. Property Tax and Registration.  My county charges property tax for all personal vehicles.  The tax was running at about $350 per year.
  5. Fuel.  From 2011 to 2014, my average annual cost to purchase fuel for the car was around $800.  Of course, gasoline was more expensive back then compared to the current price due to the crash in oil prices, so I’d probably be spending only $600 to $650 for fuel today if I still owned the car.

So the total in expense savings amounts to about $3,500 per year.

Of course, I now have some new expenses that I did not have when I kept a car at my disposal on a 24/7 basis, and I have to account for that as well to figure out my net savings:

  1. Car Rentals.  I rent a car about once per week, on average, for a trip into the suburbs.  The nice thing about doing this is that my expense is now variable.  If I’m traveling, I don’t spend any money on car rentals.  When I owned a car, it would depreciate every day even when not in use.  I spent about $1,430 on car rentals in 2016, and an additional $230 on fuel.  Obviously, I am driving less than when I owned a car – about half as many miles or even less, with a commensurate benefit in terms of carbon emissions.
  2. Subway Fares.  I use the subway a lot more now that I don’t have a car.  I spent $380 on subway fares in 2016, although this was higher than expected for a few reasons that probably won’t recur this year.  I typically ride the subway several times per week.
  3. Taxi/Uber Fares.  I spent $120 on Ubers in 2016.
  4. Bicycle Costs.  I used the local bike sharing service four times in 2016 at a cost of $8.  The use of my personal bicycle is pretty low and probably less than $50 per year, on average.

So I spent a total of $2,168 on transportation in 2016, with the vast majority spent on car rentals.  Obviously, someone who doesn’t need a weekly car rental is going to experience far more in savings, but even with renting a car nearly every week, the savings compared to owning a vehicle are substantial.

But Wait, There’s More … 

I own a unit in a condominium and the unit came with a parking spot.  When I owned a car, it spent almost all of its time just sitting in that spot.  Now that I do not own a car, I rent out the spot for $120 per month to one of my neighbors which generates $1,440 per year in income.  And not all of that is taxable because the building allocates about $50 per month, or $600 per year, of my condominium fee to maintenance of the garage.  As a result, I’m only paying tax on about $800 and my net cash flow from renting the spot is probably around $1,200 per year, on average  (more precision would require looking at my tax return and isn’t worth the time for this exercise).

So What’s the Bottom Line? 

Based on the numbers above, I am saving $3,500 per year by not owning car plus I am receiving about $1,200 in income from renting my parking spot for a total gross benefit of $4,700 per year.  However, in 2016, I spent $2,168 that I would have avoided if I owned a car.  So the net benefit is $2,532 per year – or let’s just round that to $2,500 per year.

If you are thinking that $2,500 per year isn’t a lot of money, consider looking at it another way.  If you take that $2,500 savings and invest it at a 10% annual rate of return over the next twenty years, you’ll wind up with over $143,000 in additional savings.  And taking the $14,000 I sold my car for and investing that at 10% over the next twenty years would result in an additional $94,000.

That’s a total of $237,000 – almost a quarter million dollars.

That is substantial any way you look at it.  And it is another example of the miracle of compound interest, which I’ll be coming back to again and again in the future.

But why did I really do it?  Having an additional quarter million dollars in twenty years will be nice but I do not think that it will change my life.  The real reason I made this change is to live a life of efficiency and minimize complexity and the number of possessions I have.  I’m also in better health that I’ve ever been in, not necessarily directly due to the additional exercise from biking and walking, but that was certainly a contributing factor.

I am often struck by how people who claim to care about the environment seem to care only in theory but not in practice.  As I can tell from my consumption of fuel, the amount of driving that I’ve done in recent years has been much less than when I had the option, at a second’s notice, to jump in my car and take the lazy way out.  Having that 24/7 option to succumb to laziness was not a good thing for me.  It detracted value instead.  I’m not saying that doing this was based on environmentalism because it was much more related to personal interests.  But having less of an impact is also a net positive any way you look at it.

There’s a whole litany of reasons for why a reader may say, “Hey this worked for you, but it is unrealistic for me.”  Maybe that’s true and maybe it isn’t and I’m not interested in preaching to anyone, only laying out the case as I see it.  If someone lives in the suburbs and has a soul crushing commute to the city that can only be done with a car, then that’s the product of a choice that was made, not an inevitable outcome.  And while in the short run, there may be nothing that can be done about the need for a car, maybe that car can be smaller and more efficient.  Maybe the household doesn’t really need multiple cars.  Maybe a move closer to work nearer to public transit would be a net positive.  Maybe living close to schools would give children a better mindset and curb the obesity epidemic.  Everything involves choices and we should make those choices consciously, not by default or out of mindless habit.

Welcome to The Spartan Spendthrift!

Money is not the most important thing in life, and probably isn’t even on the top ten list.  

Time is the true currency of life.

But money has the power to control how we spend the majority of our waking hours during the best years of our lives.  No one wants to be stuck on a forty year treadmill and then end up with nothing to show for it at the end.

But there is another way, a better way, that can lead to financial independence at an early enough age to devote your time toward what really matters.  This might mean continuing in your current occupation if you love it, although liberated from the necessity of doing so.  Or it could mean spending more time with your family, devoting time toward volunteer activities, or simply opting for more recreation.

No matter what the motivation, there is always intrinsic value in financial independence! 

There’s an unfortunate negative connotation associated with people who carefully monitor their personal finances:  We can be perceived as “stingy”, “cheap”, or “tightwads” by people who, themselves, probably have no savings.

There are ways to be Spartan with money without being a cheap, stingy tightwad!

This means spending money on what matters.

And it means avoiding waste on things that add no value or actually detract from our overall well being.

Above all, the Spartan mindset requires acting honorably, ethically, and generously in the situations we choose to place ourselves in.

The Spartan mindset is not cheap, but intelligent and mindful regarding life choices, and this goes far beyond money to encompass our lifestyle as a whole.

Financial independence provides the ability to control our time.

A person who has no control of his or her time is not truly free.  And time is the currency of life.  But a strange thing happens at a certain point:  we reach financial escape velocity.  This is the magical point at which our assets begin to generate more income than we require for our day-to-day lives.

It is nearly inevitable that the Spartan will eventually have the ability to become a Spendthrift.  

Wealth grows at an exponential rate, not a linear rate.  In simple terms, this means that saving money has momentum that appears to start painfully slowly at first but soon gains speed.  Pretty soon, you have a snowball growing rapidly as it coasts downhill.  Those with a Spartan mentality toward life will, more likely than not, soon have far more financial resources than they are accustomed to spending.

Being a Spartan Spendthrift doesn’t have to imply selfishness!

The Spartan Spendthrift can choose to spend money on himself, but more likely than not will choose to spend money on others, whether than means something as simple as picking up the check at dinner with a friend or giving generously to charity.  The point is that financial freedom allows us to become a spendthrift where it matters most:  with the currency of time.  And we can become spendthrifts with our money as well, if we choose to, once the miracle of compound interest manifests itself.

It Can Be Done! 

I reached “financial escape velocity” in 2008 at the age of 35 and “retired” from regular employment soon after that point.  Although I had a well paid job in the software industry, at no point did I earn anywhere near the kind of money that is par for the course in Silicon Valley today, nor did I have any decisively large financial windfalls.

What I did throughout my time in traditional employment was act as if I earned about half of my actual salary, saving and investing the rest.

I have made my share of serious mistakes with spending and that probably delayed my financial independence for a few years beyond where escape velocity should have come into force.  Nevertheless, financial freedom 30 years prior to traditional retirement age was achievable without being cheap, stingy, or a miserable tightwad.

This website attempts to provide timely and timeless content on personal finance and early retirement topics that goes beyond the tired cliché of avoiding the daily latte at Starbucks as a route to financial freedom.  There are steps that can be taken relatively easily to allow for substantial savings without sacrificing much, if anything, in terms of quality of life.  In some cases, adopting a Spartan mindset can save money while also improving your life!

Admittedly, much of the content will not apply to the very poor.  The core idea here is to dramatically underspend income.  If someone is earning a very small income, there are still ways to save but the focus should be on increasing the income side of the equation.  But I am not targeting only the well off.  The vast middle class is the group I hope will benefit the most.