For those of you who either own or plan to own a home in the future, your current or future mortgage payment will allow you to increase your safe withdrawal rate without increasing your risk of portfolio failure. We know that financial independence is achieved when your investment balances represents 25x your annual expenses. So if your annual expenses are $30,000, you’d need to save $750,000 to be considered financially independent. This data comes directly from the Trinity Study which shows a success rate of 98% if you withdraw 4% of your investment balance each year. But there’s another line in the Trinity Study we should look at. The vast majority of people in the FIRE community use this inflation-adjusted 4% rule to calculate their number. But what does the data show when we look at withdrawal rates that aren’t adjusted for inflation?
The same portfolio that grants a 98% success rate at a 4% inflation adjusted rate grants a 96% success rate at a 6% rate that isn’t adjusted for inflation. Let’s stop and restate these two facts:
1) Success rates for inflation adjusted withdrawals of 4% are 98%
2) Success rates for non-adjusted withdrawals of 6% are 96%
As we can see, if all of your expenses didn’t rise with inflation, you’d be able to maintain a 6% safe withdrawal rate. But as we know, overall living costs do increase over time. But this is when your mortgage payment comes in. Assuming you have a fixed mortgage, your principal+interest payments will never change. This means as a homeowner with a mortgage, you can effectively raise your safe withdrawal rate without raising your risk!
To find out how much you can raise your SWR, add up all your projected post-retirement expenses. Here’s an example:
Sample Monthly Expenses for a Family of 4:
Mortgage: $1,200 ($300 goes to property tax/insurance, $900 goes to principal and interest)
Cell Phone: $80
Groceries and Personal Care: $460
Gas & Auto Maintenance: $100
Home Maintenance: $100
Kids’ Programs: $100
Total Expenses: $2,700
In this scenario, total expenses are $2,700/month or $32,400/year. Based on a conventional SWR calculation, this family must save up 25x these expenses or $810,000 before they’d be considered financially independent.
But let’s throw the norm on its head.
Of the $2,700 in monthly expenses, the $900 that goes towards principal and interest isn’t impacted by inflation and that’s 33% of their monthly expenses. Because of this, they can increase their SWR and lower their FIRE number while still keeping their portfolio success rate above 95%. This is what that calculation would look like:
Inflation-Protected Expenses (aka principal and interest payment): 33% of total expenses
Inflation-Impacted Expenses: 67% of total expenses
Adjusted SWR calculation:
SWR for Inflation-Protected Expenses: 6%33% of overall expenses = 1.98%SWR for Inflation-Impacted Expenses: 4%67% of overall expenses = 2.68%
Adjusted overall Safe Withdrawal Rate: 1.98%+2.68%=4.66%
With this new calculation, this family now needs to save $695,000 instead of $810,000, a $115,000 difference!
The best part about this calculation is that it holds true regardless of if you’re a believer in the 4% rule or a more conservative 3.25% safe withdrawal rate. Since both figures factor in inflation, having a mortgage will allow you to increase your SWR without increasing your risk for both camps.
To calculate this yourself, follow these three easy steps:
1) Project your post retirement expenses
2) Find how much your principal+interest payment will be, as a percentage of your overall expenses
3) Subtract this percentage from 1 to find out how much your inflation-impacted expenses will be, as a percentage of your overall expenses
4) Take the percentage you calculated in step 2 and multiply it by 6%.
5) Take the percentage your calculated in step 3 and multiply it by 4%.
6) Add the figures calculated in step 4 and 5 together to find your new SWR!
7) Divide your projected annual expenses in FIRE by this new SWR to find your new number
Astute readers will notice that this calculation has one problem: as inflation increases your non-principal+interest expenses year and year, your principal+interest payment represents less and less of your annual expenses, as a percentage. For example, if during year 1, your fixed interest+principal payment represents $1,000 of your $4,000 expenses or 25% and five years later, your $3,000 of inflation-impacted expenses have risen to total $3,500, your fixed principal+interest payments now only represent 22% of your total annual expenses. While you can update the adjusted SWR each year to account for this, I’d hold that your eventual mortgage payoff and subsequent drastic drop in expenses cancels out this impact.
So what do you think? Will you stick with convention and work longer to save more than you actually need or buck the trend and follow the math? What does your new SWR or number look like? Let me know in the comments!