When I first started my journey toward financial independence, one of the very first things I had to do was figure out how much I was earning and spending.
Basically, I had to develop a budget.
I knew I was broke. And I knew I wanted to be financially free before 40 years old.
But how would I go from broke to free? How could I go from where I was to where I wanted to be?
Well, that’s why a budget is so important. In order to go from Point A to Point B, you must first put together a road map. You can’t possibly go somewhere without first knowing where you’re at and where you’re going.
The budget is critical to the concept of reaching financial independence, as one’s savings rate largely determines just how quickly one’s able to quit their job and live off of their passive income (if they so desire). I knew that I had to save at least half of my net income if I wanted to go from broke at 27 to free by 40.
So a budget it was. I began to track all of my income and expenses, right down to the penny. (And I still track every penny to this day.)
What shouldn’t be a surprise to anyone is that I quickly realized I was spending much more money than I initially thought I was, and this was even after some thoughtful reduction in expenses to get things rolling. There was a lot of leakage. And my ship was thus barely staying afloat.
This is a situation that I imagine most people would find themselves in if they created a budget all of the sudden. It occurs to me that most people aren’t very good at managing money, which naturally manifests itself through one’s budget.
But if you can muster the courage to face that and then take the steps necessary to improve your relationship with money, amazing changes can and do result. I’m living proof of that.
However, when I first started budgeting, I wasn’t initially real sure what I was supposed to think of leakage – money that was frivolously spent on unnecessary luxuries without realization. Although I had the general awareness to recognize leakage when I saw it, I wasn’t particularly certain how bad this leakage was, or how much it was actually costing me.
Sure, it was easy for me to do the simple math early on, as my goal was to get my budget to a point where I was saving 50%+ of my net income. At that point, it’s just a matter of simply getting expenses down to 50% or less of my net income. So every extra dollar being spent (or every less dollar earned) was impeding me from reaching that goal.
If I were earning $3,000 and spending $2,000, I had to figure out how to cut at least $500 from my budget in order to get my savings rate to 50%+. As such, my initial attitude toward expenses were somewhat simplistic. I was only trying to get my savings rate as high as possible.
But by viewing my expenses only through the lens of either increasing or decreasing my savings rate, either speeding or slowing my journey to financial independence, I wasn’t realizing the true cost of expenses.
I now look at every expense through a lens of what I feel is the most accurate way to judge their true cost.
In my view, the true cost of expenses is how much capital would be required in order to generate the passive income necessary to cover the associated expense.
I’ll show you how that works.
Let’s say you have $200 worth of leakage in your budget. This is $200 per month of “fat” that you don’t need to really spend.
How much is $200 per month? Is it really that much money?
I’d argue it’s a hell of a lot more than “just” $200 per month.
If you really want to put yourself in a position to live off of your passive income, every expense has to be paid for by the passive income your portfolio is generating.
Well, I can tell you that my Full-Time Fund generates over $11,000 per year in passive income. It takes just over $335,000 of capital to generate this income. That’s thus a yield of 3.31%.
The yield on my portfolio has typically oscillated between about 3.5% and 3.6%; however, the recent dramatic rise in the price of stocks almost across the board has lowered their yields (price and yield for stocks are inversely correlated).
So in order for me to cover $200 worth of monthly expenses, I need to have ~$72,500 invested (at the current yield of my portfolio).
I arrived at that figure by multiplying that $200 by 12 – which is a year’s worth of that monthly expense. I then divided the resulting $2,400 by 3.31%, which is the yield I just noted for my own portfolio.
Sure, you could increase the yield up to 3.5% or 4%, but with the way stock prices are so high (and yields so low) right now, generating a portfolio-wide yield of 4% is anything but certain. That said, I’ve typically approached the math behind this idea with a 3.5% yield, as I’ve largely been able to attain/maintain that yield for many years now.
With all this in mind, and using the portfolio’s current yield as the base behind the math, the “true cost” of a $200 monthly expense for me right now is actually approximately $72,500.
When I first connected the dots and realized how seemingly small monthly expenses actually required massive amounts of capital invested in order to generate the passive income necessary to cover the expenses, it became very easy for me to start axing expenditures and significantly live below my means.
And it doesn’t even take that much to get to $200 worth of expenses for someone. I mean, I’ve heard of some people spending that much money on cable/internet.
So when I look at expenses through the “true cost” lens, I’m able to honestly ask myself whether or not the expense in question is actually worth the amount of capital that has to be tied up in order to cover it on an ongoing basis.
If I were to spend $200 on restaurant visits every month, I’d have to seriously ask myself whether or not these meals are worth $72,500.
After all, becoming financially free means one is able to live off of their passive income. Well, that passive income is generated from a capital base, generally. And that capital base requires a massive amount of work to accumulate in the first place.
Looking at expenses this way, I realized that every dollar of expense was not actually a dollar of expense at all. That dollar of expense was a small ball and chain that required a rather large underlying capital base in order for me to be able to one day freely move around with the added encumbrance.
Indeed, if we were to scale this example down, every added dollar of expense in my budget requires an underlying capital base of ~$363!
That’s basically how I now view expenses. The “true cost” of every dollar I add onto my monthly budget is actually $363, as that’s how much capital is required to be invested (at my current portfolio’s yield) in order to generate enough passive income to cover that extra ongoing dollar of expense.
I’d recommend you do a similar exercise for your portfolio and expenses, figuring out how much yield your portfolio is generating and then comparing that against your expenses. That should really put things into perspective, giving you extra motivation cut any unnecessary fat.
For added help, I recommend using Mint and Personal Capital. They both aid tremendously in regard to budgeting and managing one’s investments.
What do you think? Do you look at expenses this way? Why or why not?
Thanks for reading.
Image courtesy of: Sira Anamwong at FreeDigitalPhotos.net.
I really like this approach to give context to the small expenditures along the way. Earlier today Ty at Get Rich Quick’ish posted a similar approach, but based around the 4% rule: http://www.getrichquickish.net/2017/03/true-retirement-costs.html
Great minds, I suppose.
Thanks for the perspective!
Matt,
It definitely gives context. It’s sobering when you really look at these seemingly minor expenses through this lens. I haven’t run across that post you’re linking to, but this is a concept I talked a lot about over the years over at Dividend Mantra. It’s really a concept that’s been discussed by a lot of people many times, but I just don’t believe I ever actually went through the math all the way down to a single dollar before. Breaking it down like that makes even seemingly small expenses quite a heavy burden.
Cheers!
Hey @Matt – what a coincidence that these two similar posts would go up on the same day (with similar titles even).
I love looking at these different ways to quantify our financial decisions and then weigh the pros and cons using the new framework. Good stuff here Jason.
Ty,
Yeah, that’s kind of crazy that we posted this on the same day, even with similar titles. Although, I’ve really been talking about the relationship between expenses and the amount of underlying capital necessary to cover those expenses since I first started writing back in 2011: http://www.dividendmantra.com/2011/11/why-i-cancelled-my-gym-membership/
It’s just that I don’t think I’ve ever broken it down all the way to a single dollar before. When you see that even just one dollar of ongoing expenses can end up requiring hundreds of dollars of underlying capital generating the appropriate amount of passive income, it really gives some perspective to how quickly things can add up and how much work would be required to pay for an inflated budget indefinitely. 🙂
Thanks for dropping by!
Best wishes.
Hi Jason,
Excellent article , another way to calculate the cost of monthly expenses is the period of work it require to accumulate the capital require to generate the income match
Let focus on your example of the 200 monthly expenses it require 72,500 of Capital.
Next is to find How long it take you to accumulate 72,500 of Capital.
This vary base on the income level and the saving rate again.
It requires 35 months if the saving rate is 50% of 50,000 income.
& 58 months if the saving rate is 50% of 30,000 income.
Regards
atm,
Absolutely. That’s really the underlying point of the article. If you’re spending $200 per month and don’t think it’s a lot, you really have to think to yourself about the $72,500 that it takes to sustain that level of expenditure and how much work is required to accumulate that $72,500. Because everyone’s situation is different, I didn’t touch on it as much, as this is really a high-level article designed to get you think about what things actually cost.
Thanks for dropping by!
Best wishes.
hey Jason just stumbled across your blog. Man this is the first time i’ve seen it written like that. Sure we know to carry those expenses we need the passive income. I like it, think I’m going to list my monthly expenses and compare to the dollar carry cost. Thanks man
CPI,
Hey, I’m so glad I was able to help. It really gives one a whole new perspective to look at every expense through this lens. Makes even seemingly small expenses quite a bit larger when you realize the amount of underlying capital (which itself requires a lot of work to accumulate) that’s necessary to sustain those expenses indefinitely.
Cheers!
Jason,
A great article so thank you for that. While this triggers immediate action to cut the fat, it also triggers questions what can bring joy as a lot of fun things actually do cost money. Guess it is a question of finding the right balance but quite a diifficult one I must say.
Bodyrock,
Yeah, that’s a tough call. Really depends on the individual. I’m an INTJ, an introvert. So I’ve found that it takes very little money for me to have fun and be happy, which is what my “Happiness Is” series of articles is all about. But what’s fun for me and what’s fun for others will naturally vary. Nonetheless, I think the ultimate luxury is really ownership of one’s time, which actually doesn’t cost that much once you get a handle on the concepts of happiness, hedonic adaptation, the hierarchy of needs, etc. 🙂
Best regards.
Excellent post Jason. A few years ago when I decided to get serious about being able to retire early, I asked myself where I can get the extra dollars every month to invest. I thought I was doing reasonably well in my budget; I knew I had leaks, but I didn’t really think they were that big.
A friend of mine along with suggestions from FI blogs said to keep track of every expense via a notebook or receipt. I did this for a month, and I could not believe my eyes!! It was an equivalent of a small fortune being frittered away every month!! I was spending over $250 just on eating out!! That’s $3000 per year!! Yikes!!
It’s kind of like that boiling frog analogy, where you don’t really notice the little things.. i.e. $12 for a meal here, and there which was equivalent to increasingly warming water to the point of boiling (for the frog). You’re right. You have to ask yourself if that $150 monthly cable bill or equivalent is actually worth it. When I finished this seemingly simple exercise, I was humbled, but also empowered at the new knowledge I now knew into where my money was going.
Hence, the fat trimming. I won’t go into the details too much.. some of it is actually embarrassing (like a $600 a month car payment which I thought was a great deal because of the interest rate!! I’ve since sold the car and couldn’t be happier ). But I now know better. Thanks for this timely reminder of a post.
j
j,
Hey, that’s great that you took the time to record every penny. If you don’t know where you’re at, you can’t possibly determine how to get to where you want to go. Budgeting is absolutely critical. I would say achieving financial independence for regular people cannot happen without it.
We all have leakage. I certainly had leakage back when I first started tracking everything, and that was even after trying to cut down on things. There’s just a lot of waste in this world, so it shouldn’t be surprising that a lot of us are spending too much money. Once you realize that happiness and money spent do not correlate at a constant 1:1 ratio, it makes it pretty easy to start really cutting down on the fat, which allows you to reach your goals that much faster.
Great job!!
Cheers.
I love the dollar breakdown and I think it’s something that your/my generation (millennials) lose sight of. I was just reading an article about their coffee consumption habits and dropping $10-$20 a day on take out coffee chains. I am with you where I bet most of these individuals don’t even realize that they are spending that much money on something they could get at a fraction of the cost. Heck we have free coffee here at work and people still go out to spend additional money on the Starbuck’s across the street.
DD,
It’s so easy to lose track of the minor expenses that really add up over the course of a month. And while they may not seem like a big deal in the short term – since $200 isn’t really a lot of money in the grand scheme of things – they’re actually a tremendous problem over the long haul if it becomes a recurring theme for your budget. It takes a substantial amount of work and capital to support a rather small amount of regular expenses, so I always try to think hard about what exactly drives value and happiness in my life.
Cheers!
Brutal. I’ve been looking at life this way for a while now.
I also multiply the price of things by ten, as that is roughly how much I could make by investing the money for thirty years instead. Makes you think before you pull out your wallet!
sendaiben,
Brutal, indeed.
I’ve received so many emails and comments over the years questioning how I can be so frugal. When I look at expenses through this lens, I question how people can spend so much money. I guess it just comes down to whether you ever truly plan to be free. To each their own. 🙂
Best wishes!
Excellent article, Jason. It is an excellent way to change how people think about budgets. Each additional $1 in expenses you add to you budget requires an additional $33 be added to a 3% yield portfolio to balance out. Want that $5 mocha berry whipped cream chocolate chip frappe? If you are disciplined, you better find an additional $150 to make up the balance. Thanks again for a great article!
Holden,
Actually, that’s incorrect. Every additional $1 in ongoing expenses in your budget requires over $300 (not $33) to be added to your portfolio. So if you have that $5/month mocha berry super whipped frappe special coffee habit, it would require over $1,800 (not $150) in underlying investments (yielding 3.31%) in order to cover that habit. Really shines a light on what things are actually costing you, especially considering the amount of work required to accumulate that much capital in the first place.
Thanks for dropping by!
Best regards.
Jason, this is a very important article. In 2001 a friend introduced me to the book, ‘Your Money or Your Life’ Several commentators already highlight the value and time required to earn the money we spend.
With your math showing the capital required to earn a dollar, just keeps driving the message home.
It took my wife and I from 2001 – 2010 to reach the point our capital produced more income than we spend. The past couple of years we’ve gotten a little sloppy with our spending, as we have 2 children, costs add up quickly.
Thanks for the reminder of the costs behind a $1.
D.
D.,
YMOYL is one of the greatest books I’ve ever read. It really changed my life (by changing how I look at money). Can’t recommend it enough. 🙂
It’s pretty crazy to realize what it takes to be able to afford just $1 in ongoing expenses. When you see how all of this works, it makes saving money that much easier and that much more important. Once I did the math (which happened many years ago), I knew right away that I had to really buckle down. What followed was ramen noodles, bus trips, and moving to a cheaper apartment. No regrets here.
Great job getting to that level in just nine years. That’s fantastic. Many people never reach that kind of success. To have that flexibility and freedom is truly priceless, making most other “luxuries” pale in comparison.
Thanks for sharing!
Best wishes.
‘Your Money or Your Life’ was introduced to me at a very opportune time. All the math, and ideas are very simple and straight forward, implementation is what is difficult for many.
My wife and I found tracking our bills for one year, made a huge difference. By the end of the year our expenses had changed. When you see where the money goes, making changes is easier.
The flexibility as you stated is incredible. For our two kids, we can provide things that on our salaries would not have been the case. Talent helps open doors, so does money. Our eldest has been to National level competitions and that takes both, talent and money.
D.
Jason,
It’s great how you sold your other website and now are creating another one basically just like it (but even better, of course!). You are one badass dude!
I swear I probably spend $10-15 per day some weeks on food while I’m at work….let’s extrapolate that…keeping the numbers simple I’m probably looking at an average of $400/month spent on meals “at work” which could equate to $130,000 of capital to maintain this habit on a passive income! YIKES!!!! I know I can seriously cut this expense, but I can never seem to muster up the motivation to put in the time to meal prep or take simple lunches/dinners with me. Of course I think my habits would change if I knew I was relying only on passive income. Part of me tries to justify my actions by saying, “well, I’m only doing this during tax season when I’m working 60-80 hours per week, and I don’t really have the time or energy to be doing that stuff anyways (first-world, single guy problems here, lol) but outside of that I have time to cook at home, make simple snacks/meals, etc.”
It’s an on-going balancing act of value vs. cost that I think is only solved by one’s own internal self. The key thing is to be intentional with actions and plans. I do make up for large food category expenses by keeping my rent super cheap by having roommates, my boss pays for my phone and health insurance, etc., and I have some side income that brings in $800/month which I look at as my “living expenses” income. Probably 80+% of my “full-time-job” take-home income goes towards paying down debt or funding retirement accounts/investments, which I think is pretty damn sweet. Within the next couple years, accounting for raises and no debt, I should be socking away an estimated $3,000-$3,500 per month into retirement and investment accounts. Looking forward to it!
Take care,
Mike
Mike,
Definitely a balancing act. And that balancing act will look differently for each individual. I don’t really mind living “extremely” for years on end, and I think there’s real value to being quite extreme for the first couple years or so (in order to get the snowball rolling). Others require more luxuries in their life, for whatever reason(s). To each their own. However, once you realize the true cost of just one dollar, it really puts things into perspective. At that point, I think it’s easier to tilt the balance toward saving/investing, especially if you’re not terribly close to your long-term goals. Obviously, the balancing act becomes a lot easier once you’re much further along and no longer have to be so extreme about things, but I still track every penny to this day and continue to find that it just doesn’t require much money to make me happy. 🙂
Thanks for dropping by!
Best regards.
Hi Jason. In reading your article you discuss the true cost of expenidures and the yield of your portfolio. Since you purchased most of your holdings at a lower price than todays market, wouldn’t it be more persuasive to present the real yield of the portfolio against the cost basis. With the length of time of ownership and increase in yearly distribution I would assume that the portfolio is throwing off in excess of 4.5%. Are you willing to share that number with us?
Bid in Cleveland
Bid,
What you’re talking about is yield-on-cost (YOC). I don’t track that metric. And I don’t find it at all useful. Just because your YOC on some stock might be super high, it really doesn’t have anything to do with the present. All that matters is what your capital is currently doing. If I have a YOC of, say, 6% on a stock that only yields 3% presently, I could sell that stock and buy a stock with a present yield of 4%, which would actually increase my income. My YOC goes down, but my income goes up. I can’t buy anything with YOC. I don’t go down to the YOC store to buy goods. All that matters is income. But to each their own. If someone else finds value in tracking YOC, more power to them.
Nonetheless, the numbers still stand. It takes more than $330k of present capital at a present yield of ~3.3% in order to presently provide for the income listed.
Hope that helps!
Cheers.
I’ve often done a similar exercise. I multiply the cost of an item or service by my portfolio yield, and see what I’m losing in forward income by making the purchase, rather than investing. $100 on new shoes or an extra $4.00 in perpetual, growing, dividend income from Realty Income? Makes me think through all my purchases more carefully. Great article sir
dbpowr,
Absolutely. I go through this exercise before I add anything to my budget. It’s just a matter of deciding what’s worth what to you. Once you realize the actual cost of things over the long term, it really promotes value and thoughtfulness. For me, the ultimate luxury is owning my time, so it’s not difficult to spend less than most people.
Thanks for dropping by!
Cheers.
There is a flipside to that coin. What if you had invested that 200 dollar with growing dividend and compounding interest? Then it would be even more expensive that leakage. On a 40 year investment with 20% profit per year you would get 60k on your 200 dollar investment. Let stand that you invest that 200 dollar each month. The numbers are outragious.
Amro,
That’s another way to look at expenses. However, it’s hard to always do that calculation because a lot of expenses are necessary in modern-day life. If you’re wasting money on stuff, then it’s definitely wise to consider what that money could otherwise turn into. However, I certainly wouldn’t use 20%, as that’s Buffett-like returns. Something closer to 9% or 10% is probably more reasonable. Nonetheless, frivolous spending can be seen for what it is when you consider the opportunity cost.
Cheers!