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As-Salaam Alaykum dear readers,
Continuing on with our discussion about the principles of financial independence, I wanted to look at some investment strategies to get us on the path. Today, I wanted to explore two critical topics in financial planning and investing called the 25x rule and the 4% rule. If you need a refresher on the theory of financial independence, check out the basics (here) and savings rates (here).
So what exactly are these rules and how to they apply to becoming financially independent?
The 25x Rule
The 25x rule (multiply by 25 rule) estimates how much money you will need in your retirement by multiplying your desired annual income by 25. Here is the key, for this to really make sense, you need to look at this in terms of your annual expenses as well as inflation to get an accurate number. This aligns to the rule below in terms of what you can expect as returns when investing in the market indexes or diversified, large-company stocks.
If you remember my post on the basics, financial independence is not only about investing, but about reducing and eliminating the amount of debt you hold. For Muslims, eliminating all forms of bad debt carrying Riba (interest) as quickly as possible is a requirement. So when thinking about your expenses, you need to working on eliminating all of the various types of loans that you might have that is drawing monthly payments out of you. I believe that you need to eliminate the worst loans first (those with the highest interest) which are typically:
- Credit Cards
- Car loans
- Mortgages
- Lines of Credit
- Other Loans
The 4% Rule
The 4% rule refers to your withdrawal rate that can be safely taken out every year based on the investments you hold. The Trinity Study states that over the long term, the broader market index (large company stocks) will return 4% or better ever year. That means that if you take out 4% a year, there is a very high probability that you will not need to touch your base investments.
Now, I want to caution you that the 4% rule is really a guideline, because as we know there are no guarantees when it comes to economic uncertainty, global market crashes etc. This is just a tool for you to use to help guide what types of savings numbers you should be looking for to become financially independent.
Putting it all Together
So lets take a look at an example with some numbers:
Hiba works full-time and is divorced with no dependents and no large-loan debt in her mid-30’s. She is saving money every year, and is continually adding to her RRSP’s.
- Age: 36
- Existing RRSP’s: $83,000
- Net Income (after tax): $67,000 / year
- Expenses: $49,000 / year (All expenses including gas, insurance, bills, rent, utilities, phones, food, entertainment etc.)
- Savings Rate: $67,000 (Net Income) – $49,000 (Expenses) = $18,000 / year for a 27% savings rate
She believes that she will be able to live on $50,000 / year in expenses. Based on her current savings rate (27%) and the 4% rule withdrawal rate, she will be able to retire when she is 61 and would need $1,337,500 in investments to pull out $50,000 / year without touching them. If she earns more money or reduces her expenses this should increase her savings rate; which will allow her to get to retirement faster.
I hope this information was helpful as this really is the base of financial independence. Remember, it’s about reducing debt, increasing your savings and investing them in the market while not increasing your lifestyle expenses as times goes on. What are your thoughts on this idea?
Please feel free to leave any comments or questions! I would love to hear from you!
As-Salaam Alaykum