I created this blog almost two years ago and I’ve posted a grand total of, wait for it, two times. And one of those was the ‘About’ section. That’s pretty poor really. I think of interesting things to post about but somewhere between me having an idea and writing it down there seem to be obstacles, be they internal (doubts, laziness, overthinking) or external (workload, social life, other priorities). And nothing gets written. I need to change that.
A couple of weeks ago I had a brief conversation in the comments section of a Firestarter post (link) and realised maybe it is time for me to start contributing. I had been rambling on about mortgages and savings rates and thought I was just talking to myself when Mr Firestarter himself replied. He ended by saying:
“You sir/madam are a Genius! Thanks and yet again I will incorporate this into a new spreadsheet and post on the subject ASAP!”
Maybe I’m a sucker for flattery but I was taken aback. Here’s a guy I really respect calling me a genius, and while I’m sure he is exaggerating, it has boosted my confidence somewhat. So here you go (anyone who’s reading this), here are my thoughts on savings rates, your mortgage, and passive income.
The Savings Rate
A few years ago I came across a Mr Money Mustache (MMM) article called ‘The Shockingly Simple Maths Behind Early Retirement’ (link). Those in the FIRE community are probably all too aware of it. In the article MMM explains how there is a link between your savings rate and the number of years until you can retire. If for example you’re saving 10% of your income each month then it will take 51 years until you’ll be able to retire. Increase that to 50% and the number of years drops to 17. Increase it to 66% and it drops to 10.
What I like most about MMM’s article is that it gives you a FIRE date. Currently I’m 32 and I know if I want to retire by the time I’m 40 then I need to be saving just over 70% of my income. There are lots of assumptions involved, your return on investments is predicted at 4% per year after inflation, your cost of living wont change (planning children anyone?), and so on, but it is still a powerful motivator. And it’s for that reason that I have a spreadsheet where I input all my income and expenditure, my savings and my net worth. This is quite common among the FIRE community.
So far, so good. The problem comes when you try and work out your savings rate. When you look at your income do you take pre-tax or post-tax income? What about your mortgage, is that a saving or an expense? What about income from investments, should that be added in?
There is a more fundamental problem as well. Unless you are somehow living completely off-grid, making your own food and energy and not relying on society for anything, then you are always going to have some expenses. But in that case, even if your income is really high and your expenses really low, you’ll never reach a 100% savings rate. How can that be?
I think I’ve figured it out. I have many doubts of course, but I’m going to lay out my theory and invite discussion and then you can make up your own mind. Here we go.
Do you take your pre-tax or post-tax income figure?
In my humble opinion you’ve got to take post-tax income when you’re calculating your savings rate, because once you retire you won’t be paying income tax. This doesn’t sound controversial but it is, as I will explain. You should add on automatically deducted items like your pension (including your company’s pension match if you’re lucky enough to have that) because it’s all savings towards your retirement pot.
The problem is, if you take post-tax income then you’re not necessarily going to be motivated to make the most of beneficial tax arrangements such as your company pension. RIT talks about this in his blog Retirement Investing Today and for this reason he uses pre-tax (or gross) income as his basis for the savings rate. I agree with his reasoning but his method does mess up the savings rate somewhat. Ultimately I want to know how many years until I can retire and to work that out I need to use the post-tax income figure. But I take his point and I do put the maximum amount into my company pension scheme each month.
Where does your mortgage fit in?
Some bloggers out there treat their mortgage as an expense. Personally I object to this, and this is the reason I first posted on The Firestarter’s (TFS’s) article. As I pointed out there, your mortgage, assuming it is a repayment mortgage, will one day be paid off and you’ll have a house to show for it. Put it another way, you’re investing in an asset which will one day pay your rent for you. RIT on the other hand doesn’t own his house and pays rent each month, so while his investment fund looks great (and it is, don’t get me wrong), he will still have to pay rent in the future unless he uses some of that investment fund to buy a house.
Of course, a mortgage isn’t free (if only), although they are reasonably cheap at the moment. Personally I have 2 mortgages, one on my house and one on a rental property and the interest rate averages just under 3%. I’m currently paying around £1500 overall each month of which about £700 is interest. So I’m only paying down my mortgage balance about £800 each month. Many FIRE bloggers treat the interest part of the mortgage as an expense and the repayment part of the mortgage as a saving. Which seems reasonable but the hope is that once I retire I will have paid off the mortgage. So should the interest still be considered an expense? It’s a little like the income tax question above, on the one hand we should consider mortgage interest an expense and we should try and reduce it as far as possible (by moving to a better deal for example). On the other hand there is, hopefully, a time limit on the mortgage and eventually the expense will cease to exist.
Furthermore, what if all of my net worth is tied up in an overly expensive house? If I have a half-million pound property and no other savings then am I really able to retire? If nothing else a larger property usually carries other costs with it, higher property tax, cleaning costs, maintenance and so on. If I’m ‘saving’ to buy this ‘asset’, but it is only going to house me, would it not be better to buy a smaller house and put the rest of my money in investment funds that will actually pay me an income? Perhaps, but do I want to sacrifice that standard of living? It could be that, in choosing the more expensive house you extend your working life and perhaps that’s a valid trade-off, but it does mean your savings rate will look better than it actually is.
Where does that leave our savings rate? Well I’m seriously confused, and I get the impression most people just throw their hands up in the air at this point and say ‘well it doesn’t really matter, the main thing is that we should be saving as much as possible.’ I get that but I still want to know how long until I can retire, and the savings rate is supposed to help me work that out. So what can we do?
Treating your house as a rental property
It was at this point that I thought, hey, why not treat my house as though it were a rental property and see how that affects the figures? If I consider my house an asset that will one day pay my rent for me, why not treat it that way now? I already own one rental property and I have a spreadsheet for that. With a bit of guesswork I can use that model and ascribe a theoretical rent to pay myself.
As it turns out, I recently moved into a terraced house with 4 bedrooms. It’s a 3 storey house and on the top floor there are 2 spare bedrooms and a bathroom. I currently rent these rooms out to 3 lodgers (a couple and a single) which brings in about enough money to pay my mortgage. All part of the FIRE plan. I have 1 bedroom with an en-suite which I use myself and a spare bedroom for guests.
But let’s keep things simple. Let’s say I have a house which only I live in, and I pay £800 a month for my mortgage. Let’s also assume that I’d get £800 a month if I rented it out, and let’s assume my income is £2000 a month (it’s not, just to be clear, this is just an example) and my expenses are £600 a month on top of the mortgage. Let’s also assume the mortgage is split, £500 repayment and £300 interest.
Method One: If we simply treat the mortgage as an expense then my savings rate is 30% (income = 2000, expenses = 1400, so savings = 600). This method doesn’t seem right – as I say, one day we’ll own the house so we won’t have to pay rent eventually and so we should think of it as an asset we’re saving towards.
Method Two: If we treat the repayment part of the mortgage as a saving and the interest part of the mortgage as an expense then the savings rate is 55%. This is the method most FIRE bloggers use it seems. The problem is, if one has bought a house that is far more expensive than what they need then their savings rate will look fantastic, but FIRE will be far away (unless they’re planning to downsize eventually).
Method Three: What happens if I treat the house as though it were a rental property that I pay rent to? Then my income is increased by £800 a month but my expenses are also increased by £800 (because I’m paying myself rent). That makes sense – if I buy a bigger house that I don’t need then my savings rate will suffer and it will take longer to FIRE. In this scenario the interest part of the mortgage reduces my income, as it would do with a rental property and so my income is actually £2500 a month (2000 + 800 – 300). My expenditure is £600 + £800 rent, so £1400 a month. Therefore my savings rate now is 44%. Sounds about right? Well, it seems closer though I’m still not sure, as I will explain.
Passive vs Active Income
My problem with all this, as I alluded to earlier, is that increasing my income is all well and good but I will always have expenses and so there is no way I can ever get to a 100% savings rate. I kept this thought at the back of my mind for a while because it always confused me, but recently I revisited this and had something of an epiphany. I think it was after reading this post from Weenie at Quietly Saving, in which she stated she wanted to get to £3000 investment income each year because:
“£3000 a year currently covers the following expenses for me – electricity, gas, internet/broadband, mobile phone, water, boiler cover, TV licence and dental/optical cover. That’s a lot of bills to not have to worry about!”
I had a bit of a light bulb moment after reading this.
Of course! If investment income covers all my expenses, then any income from work will all be saved and so I’ll have a 100% savings rate! I began to reformulate my spreadsheet, putting income into two different brackets, active and passive. Fairly self-explanatory really, my income from work is active because I have to do something for it, whereas things like dividends and rental income are passive because they will continue to come in even with me doing nothing (rental properties are probably more ‘semi-passive’ as I still need to do things every now and then but let’s leave that topic to one side).
So, if I now consider my passive income as an expense reducer (rather than an income increaser), how does this affect my savings rate and how does it affect my ‘pay myself rent’ theory?
Method Four: According to the ‘pay myself rent’ theory I have two lots of income – the active part is £2000 and the passive part is £500 (£800 rent minus £300 mortgage interest). My expenses are increased as well (because I’m paying rent) to £1400. Using the new approach however (where passive income is an expense reducer), my expenses drop to £900 against £2000 active income and my savings rate is 55%.
All those mental hurdles basically leaves me back where I was before with method two – the interest part of the mortgage is an expense, the repayment part of the mortgage is a saving.
So why not buy a bigger house?
Let’s say I bought a bigger house and my mortgage is £1000 a month, split with a £500 repayment and a £500 interest charge. Let’s also assume the rent for such a property would be £1000 a month. According to method two my new savings rate would be 45%. According to method four my new savings rate would also be 45%. It seems whichever way I cut the data method two and method four produce the same result.
I believe my calculations for methods two and four above are correct, though I’m welcome to hear other thoughts. But in that case, why not buy a bigger house? Well, the deposit you’re able to put down will be the same – so you’ll either increase the loan-to-value and so pay a higher interest rate, and/or you can lengthen the time of the mortgage, thereby paying a higher interest rate anyway. The question as well is whether you can afford that extra saving month to month or whether you need a bit of a buffer. You’ll effectively be paying a higher interest rate for the privilege of owning a bigger house. In my example above, when I increased the mortgage from £800 to £1000 it did reduce the savings rate from 55% to 45% so FIRE is further away.
There is also the extra costs of having a larger house as mentioned before – property tax, maintenance costs, cleaning costs and so on. You’ll probably end up filling the house with stuff you don’t need too.
A better option I think is to use half your deposit for your own house and half for a rental property, (or one third for your house and two thirds for two rental properties etc. If you get 5 then you can knock them down and build a hotel apparently) but that is a subject for another day I feel.
I feel a lot more comfortable about how I treat my mortgage in my savings rate now. It all makes more sense once you work it through. Plus I know how to include income from share dividends and rental properties as well. I actually think method four above is better than method two even though they produce the same outcome, if only because I can see logically how it all fits together.
One unexpected side effect of treating passive income as an expense reducer (as opposed to an income increaser) is that my savings rate fluctuates far more from month to month as my passive income fluctuates. In terms of working out how long until I can FIRE this does make things interesting – perhaps it’s best to take a yearly average say and not worry too much about the savings rate month to month? I’m not sure, but something to consider.