Many people dream of retiring early and ultimately having more time and freedom to live their lives on their terms. One strategy that some people use to retire early is simply to save and invest enough money so that they can live off the interest from their investments and savings.
If you can do this, then you might be able to retire early as well. In fact, there are entire movements behind this idea such as FIRE or "financial independence, retire early."
Compound interest is what makes this strategy possible. In this article, we will break down the power of compound interest and go over some of the key information you will need to know if you would like to retire early and live off of interest.
FIRE is an acronym that stands for Financial Independence Retire Early. The FIRE movement is a movement that is becoming increasingly popular, especially amongst millennials. The basic philosophy of the movement is to save as much as possible every single year and to accumulate assets that generate passive income.
The end goal is to have enough passive income to live off of so that you can retire well before you reach the traditional retirement age.
Many people are extremely passionate about the FIRE Movement and work hard to succeed in their efforts to retire early. This movement was inspired by the 1992 book Your Money or Your Life by Vicki Robin and Joe Dominguez.
Today, there are thousands of bloggers, podcasters, and YouTubers focused on the FIRE movement and entire events dedicated to people pursuing FIRE.
The strategy aims for saving a large portion of your annual income each year. This can be a huge sacrifice in quality of life. But, those who can save enough money may be able to reach financial independence and retire early.
According to the ideas put forth in the book, people who want to live the FIRE lifestyle should practice saving up to 70% of their annual income every single year.
Once their savings reach roughly 30 times their annual expenses, they may be able to quit their day jobs and pay for their living expenses taking 3-4% withdrawals from their total savings and investment portfolio.
Investors aim for an investment portfolio that should be able to earn higher average returns than their withdrawal rate.
Considering that the S&P 500 yields an average of around 8% per year, people who use this strategy may still be able to grow their investment portfolios while taking out 3-4% per year for living expenses.
People who live the FIRE lifestyle are searching for total financial freedom and usually trying to escape the typical 9 to 5 career. The main incentive is to have more flexibility and to not have to trade time for money. It is actually a very enticing retirement strategy for many people.
This strategy does require living well within your means and to save huge percentages of your annual income every single year.
It can be difficult for people who live on tight budgets and who do not have large incomes. However, any amount that you can decrease your expenses and increase your savings can help you get closer to financial independence and early retirement.
As mentioned above, proponents of the FIRE Movement suggest that you need about 30 times your annual expenses in order to be able to live off your portfolio and its compound interest.
So, the lower that your annual expenses are, the easier it will be to save 30 times your annual expenses, and vice versa. Depending on your lifestyle, you may be easily able to do this especially if you have a higher annual income.
According to this theory, if your annual living expenses are $25,000, you will need to have $750,000 saved to be financially free and to retire early. If your living expenses are $50,000, you will need to have $1.5 million saved. If your annual expenses are $100,000, you will need to have $3 million saved.
The FIRE movement suggests saving 50% to 70% of your annual income.
This figure really depends on how much you spend as a percent of your annual income. If you want to retire early, the higher your annual income and the lower your annual expenses, and the more you will be able to save.
Say, for example, you are 25 years old and spend $35,000 per year and you would like to retire by age 40. You must save approximately $1,050,000 in 15 years. This means you must save $38,671 per year and invest it into the stock market and earn on average an 8% return. As you can tell, this is much more difficult than it sounds.
The best shot at the FIRE approach would be to save as much as possible and assume a lower annual return. This way you have a more conservative estimate of how much money and how long it will take you to accumulate.
The risk of overestimating how much money you need is much lower than underestimating that amount.
If you overestimate and end up working an extra year you'll likely end up with more to spend each year in retirement and the ability to leave more to loved ones or causes you care about. If you underestimate and don't work long enough, you run the risk of running out of money in retirement.
Compound interest is interest that is paid on as a percentage of the principal plus all of the other interest that has already accumulated. This is opposed to simple interest which is interest that is only paid on the original principal amount. Compounding can have a tremendous effect on your wealth, especially over longer periods of time.
Thanks to compound interest, you can have your savings account grow every single year even if you stop adding money to it.
So, for example, if you deposit $100,000 into a savings account, and your bank offers an interest rate of 2%, after one year, you would have $102,000. After two years, your account would be worth $104,040. You have earned $40 from compound interest.
Banks and financial institutions offer interest as an incentive for customers to keep their money in the bank account. Banks then lend out this money to people and companies who are looking for loans.
Many of these banks compete to offer the best interest rates, encouraging more deposits to their institution. For example, online brokerage Betterment currently offers a savings account with an above-average interest rate.
Dividend stocks have a similar compounding effect to savings accounts. Dividend stocks pay dividends on a monthly or quarterly basis to shareholders.
So, if you own dividend stocks, you can watch the value of your investments grow over time as you receive more and more dividends. You can reinvest the dividends each time you receive them to keep growing your account.
In this way, you can benefit from the compounding effect of reinvested dividends. Certain investment platforms and brokerages will allow you to reinvest your dividends. By reinvesting your dividends, you ensure that the amount of idle cash in your account is minimal and compound interest is kicking in.
Capital appreciation within stocks can also have a compounding effect. Growth in the equity of companies has the ability to compound returns over time. As companies retain earnings and reinvest into the company itself, rather than pay out earnings to shareholders, they are attempting to generate even more return with that capital.
If you are trying to figure out how much money you can make with compound interest, there are tools on the internet available for free called compound interest calculators.
With these calculators, you enter in the relevant information such as current principal, contribution amount and frequency, years to grow and the interest rate. You can see exactly how much money you will end up with after a set amount of time.
This can be extremely beneficial for planning your retirement, especially if you are trying to use the FIRE Movement strategy. Here is a compound interest calculator that you can use for free. You can test out different amounts for the interest, principal, etc. to see how much you would need in order to live off of the money that you have.
If you have never used a compound interest calculator before, the experience can be highly educational. Your two primary inputs are time and money and it can be eye-opening to see how saving for an extra year or two or chipping in an extra couple dollars each day can really add up over time.
The FIRE Movement focuses on saving as much money as possible and benefiting either through compound interest from savings accounts or investment portfolios. However, that is not the only option when it comes to creating passive income. In fact, there are many different ways to earn passive income.
Investing in real estate is one of the top ways to earn passive income. There are many different types of ways to invest in real estate. For example, you can buy a duplex, rent out half and live in the other half.
You can buy a single-family home with an in-law apartment or basement apartment and rent out any extra space.
An investor with more capital may buy a single-family home and rent out the entire house.
You can also buy commercial properties and rent them out.
There does tend to be maintenance and property management responsibilities if you own property through any of these methods. These can be outsourced but doing so will cut into your potential profits.
On the other hand, if you are looking for a more passive way to invest in real estate, you can invest in REITs (real estate investment trusts), which are securities that represent real estate and pay out dividends. You could also invest in crowdfunded real estate platforms such as Fundrise or Realty Mogul.
Investing in stocks can be risky, but investors have the ability to build long term wealth by choosing smart investments. You can take advantage of compounding your returns by investing in stocks.
The S&P 500 which is an index of the 500 largest companies in the United States, has returned roughly 8% since its inception in 1957.
When investing in the stock market, you choose whether you want to pursue a passive or active investing strategy. Passive investors will typically try to track a market index like the S&P 500 by buying and holding index funds. Active investors on the other hand will take a more dynamic approach and attempt to outperform the market.
Stock market investing isn't for everyone, but if you are looking for a passive way to grow your wealth then it can't be overlooked.
We've put together a fully comprehensive article on investing in the stock market for beginners which is a good place to start if you have little-to-no experience in the stock market or just need a refresher.
The bond or the agreement to lend money for interest has been around for hundreds of years. Bonds are a source of indebtedness which offer a fixed-income investment to the lender and a liability to the borrower.
In return for lending the borrower a principal amount, the lender typically repays a percentage of interest. There are many different types of bonds with various levels of risk. Investors can build a portfolio of bonds to generate passive income.
In reality, the deposits into your bank are a form of a bond as the bank pays you interest to lend out your deposit in the form of loans. The bank makes money on the "spread" or the difference between the interest rate they pay you and the interest rate they receive on their loans.
Bonds come with different maturities, liquidity, and risk. Certain online investment platforms such as Betterment offer online savings accounts that invest in short term bonds and money markets. The Betterment Cash Reserve savings currently offers one of the highest interest rates on the market.
Another strategy for creating passive income is to create Youtube videos and get paid for the ads that run on your videos. If you take this approach, you can also earn affiliate commissions by selling products with your videos either in the section beneath your video or directly in the video itself.
Creating an e-commerce store through a platform like Shopify is another way to generate passive income. Shopify can help you sell products from suppliers around the world. This passive income strategy can be very lucrative when it works. Maintaining an online store is a lot of work so it may be considered slightly more active than other strategies.
Creating a work of art and receiving royalties on it is yet another great way to make passive income. For example, you can write a book, a movie script, a piece of music, etc. then publish it and collect the royalties. This is how many celebrities create passive income.
Retiring early is all about replacing your active income through passive investments. If you are trying to retire early and live off of the interest, then it is vital to save as much money as you can each year. The FIRE retirement strategy suggests saving 70% of your pretax income.
Investing your savings in stocks, bonds, ETFs and other vehicles will help you build wealth and earn income over time. Other methods for generating a passive income will help you in your early retirement journey. Eventually, you will be able to replace your annual income each year and have more flexibility with your time.
When you stop having to trade your time for money, you have more freedom over what you do with your time and how you live your life.
What would you do with your time if you didn't need to work?