Building wealth is a pretty simple exercise. But retiring on that wealth is less simple.
Here’s what I mean…
First of all, consider a couple with their house paid-off, worth one million dollars. You could definitely consider them wealthy. This is a millionaire couple!
While it sounds good, it doesn’t do a whole lot for them with regards to financial independence.
Sure, they can probably just do some part-time work now and cruise along. But having a net worth of one million dollars didn’t make much difference. It was the fact that they’d paid off their house, reducing their future expenses that did the trick.
Unfortunately the couple still has to work, as they have no other sources of income.
You might know people in this situation. Since many Australian households are equity rich, cashflow poor, this scenario is pretty common.
As a nation, our obsession with owning residential property almost ensures this is the case.
Let’s compare two people.
One we will call High-Roller Harry. The other we will call Moderately-well-off Martin.
Harry has a net worth of $1.5 million. Martin has a net worth of $900,000.
Who is in a more financially independent position? Would you say Harry?
I’d say it depends. Since all we know about them is their net worth, we need more information.
What if I said they both have the same level of living expenses, at around $40,000 per year?
Then clearly Harry wins, right? I would say there’s still not enough details to draw a conclusion.
After all, Harry could have all his money tied up in a million-dollar home, a boat and a couple of cars. So really, he has no level of financial independence at all. He still needs to work to cover his living expenses.
He is fully reliant on his work income, because he has no other income streams.
Compare this with Martin, who has his entire $900,000 invested in shares. Since he’s renting, he has no money tied up in home ownership.
If he has a portfolio of diversified Aussie shares (for example) he is likely to be receiving dividend income of around $45,000-$50,000, once franking credits are included. Sure, he has to pay some tax, but this income will easily cover his living expenses.
Free Resource: I created a spreadsheet to keep a running estimate of my dividend income and wealth breakdown. I’ve used it for years as a way to help plan my finances and watch my progress over the years. You can get it below.
So to me, despite having a much lower net worth, Martin is in a much stronger financial position.
Because Martin’s entire net worth is put into income-earning assets, his living expenses are fully covered. He could declare himself financially independent.
Since he’s renting and doesn’t have any luxury cars in the driveway, people are likely to think he’s not doing anywhere near as well as Harry. Clearly another example of the Wealth Illusion.
But the truth is Martin is fully financially independent. And he can now spend his time as he pleases. In contrast to Harry, who has no level of freedom at all, despite being a lot wealthier on paper.
So it’s not all about equity. It’s about what that equity is producing for you. A million dollars can mean complete financial independence. Or it can mean not much at all. Maybe just a nice house and some cars… but little freedom.
My point is, don’t tie up your capital in assets that are not helping you gain more freedom. And clearly, all equity is not equal… make sure you park it in the right place!
Maybe you think it’s an unfair comparison, because Harry wasn’t an investor like Martin…
This time, let’s assume Harry is an investor too.
Since he loves owning property, we’ll give Harry a good-sized property portfolio worth $3 million, with $2 million of debt. So he has $1m of equity in his property portfolio.
We’ll also assume he still has his home worth $1 million.
So all up, Harry has properties worth $4 million, and $2 million of debt. Therefore his net worth is $2 million!
Pretty damn rich on paper. And arguably an enviable position to be in!
But is he financially independent? Let’s see…
His property portfolio is capital-city based and has a rental yield of around 4%. Since expenses tend to gobble up around 30-40% of the rental income (it’s often worse), the net yield will likely be around 2.6%.
Because of expenses, net rent received on his $3m investment property portfolio is around $80,000 per year. The interest on his $2m of debt, even at an interest rate of 4%, is $80,000 per year.
So all up, despite his large stable of assets, and multi-millionaire net worth, his total passive income is… zero dollars.
Therefore, with no investment income, his level of freedom is also zero!
He is still entirely reliant on his work income to cover his own expenses. And if interest rates go up from here, he’s footing the bill for that too.
He’s definitely a wealthy guy. But unfortunately, he still can’t escape his job in his current scenario. All his equity is tied up and providing him with no extra income whatsoever.
Now of course, he could sell-down some of his portfolio and start using his equity to create income. Although many folks wouldn’t do this, as it means paying Capital Gains Tax, and having a smaller portfolio of assets.
There’s nothing really wrong with this thinking, to be fair. But I think there are far too many people out there with oodles of equity, but absolutely no freedom.
Since property tends to be viewed as a sacred asset, that should never be sold, many people miss out on using their equity to achieve real freedom.
It probably also doesn’t help that the sharemarket is seen as some sort of crazy-casino, which it most certainly is not!
While Harry has plenty of options, I would say that our old mate Martin is still in a much stronger financial position at this point.
Remember Martin?
He has hit financial independence with a net worth of almost a million dollars.
In a real life scenario, he may have some cash as a buffer to cover drops in income at some point in the future.
Martin would be receiving somewhere close to $50,000 in income. Tax would eat a bit, but he’d be able to pay his expenses of $40,000 easy.
Of course, there are many variables here.
His dividends may be lower (or higher) than this. He’d also clear more after-tax if he had a split portfolio with a spouse. But to me, these are fair ballpark figures to go on.
Finally, with all his bills covered, we can be certain Martin has a much higher level of freedom and flexibility in his life than high-roller Harry. Because Martin focused on building income instead of equity, he’s now financially independent, despite a vastly lower net worth.
In this silly but point-proving example, our non-millionaire Martin is financially independent, and our multi-millionaire Harry still has to work. Since Martin and Harry chose different assets to park their money in, their outcomes are very different.
There’s even a good chance Harry makes a lot more equity over the years, since he’s using leverage to enhance his returns. But there’s a price to pay for this… his freedom.
He can only continue achieving (possibly) higher returns if he’s highly leveraged, which can only occur if he keeps working.
As I’ve mentioned before, with a strong savings rate, there is simply no need for leverage.
And in fact, even though we used leverage on our journey, by far most of our results came from saving.
And somehow I don’t think Martin cares too much how rich Harry is on paper. As Monday morning rolls around, Martin will be feeling truly rich, while Harry contemplates another week at the office.
In comparing these two scenarios, it becomes clear to me that it’s much more appealing to be income-rich, as opposed to just equity-rich.
Despite paying some tax, my new outlook is that it’s more useful, reliable, offers greater peace of mind on the road to, and during early retirement. In contrast to a strategy based solely on increasing asset values.
While the above examples may be too simplistic, I think the underlying message is important.
If we want to gain as much freedom as we can, as soon as we can, we do that by using all our available cash to create a strong income stream. And funnily enough, as the income stream from our investments grow, the value of those investments increase too.
So we aren’t missing out on capital growth by choosing stronger income producing investments like shares.
After all, as the dividend income increases from our shares over the years, it’s because the company has made more money, which in turn makes the company more valuable – hence the value increases.
But really, this is the icing on the cake. Most importantly, our focus is on generating passive income to live on.
The truth is, we’re retired today because we decided to bite the bullet and begin selling down our property portfolio, to convert our equity into a dividend income stream.
For some, this may look like bailing out, or not being fully committed to our initial plan. After all, some treat a property portfolio as a big shiny badge of honour.
But our plan was not to accumulate properties forever and build mammoth pools of equity. Since the very beginning, our plan was financial independence as soon as possible.
It just so happens, that along our journey we found a better way (for us) of doing things, to reach our ultimate goal faster. And if that meant accepting we needed to change our strategy and adapt to the new information we learned, then so be it.
Today, we’re much better off for swallowing our pride and changing our approach. Maybe not financially, but we live a much richer life now, measured in freedom and happiness.
And as you can see, it’s not so much about how much equity you have or even being a multi-millionaire. It’s all about what your equity is providing for you.
Here are some resources you may find useful on your wealth building journey:
Mortgage broker: My personal broker of 10 years is More Than Mortgages. Highly rated and award winning, Deanna and her team been super helpful over the years and can assist with anything home loan related, including refinancing and debt recycling.
Sharesight: A great portfolio tracking tool for share investors, and free for up to 10 holdings. It tracks all dividends, franking credits and capital gains, which is incredibly helpful at tax time. Saves me a lot of time and headache!
My book: After 5 years and hundreds of articles and podcasts, I decided to distill everything down into an easy to follow book. Designed as a complete roadmap to achieving financial independence and retiring early in Australia. Available in paperback, ebook, and audio.
Just so you know, if you choose to use these resources, this blog may receive a financial benefit at no extra cost to you. Thanks in advance if you do. And to be clear, I only ever recommend things I use myself and genuinely believe in.
Lizzie changed her career, moved location, sold her home and switched investment strategy. Now she’s looking to semi-retire in her 30s.
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What are your thoughts on leveraging for income? One fellow Australian blogger used their equity to earn income and pay off their mortgage quicker – borrowing against equity could be a way to fast track income levels if you can borrow at a low rate. Even if you’re earning 1% on $100,000 (when you take the difference between earnings and borrowings), it’s still better than a return on a conservative 5% on $10,000.
http://www.australiandividendinvestor.com/2016/11/17/debt-recycling-how-i-paid-down-a-mortgage-in-10-years/
Thanks for your comment DR.
I think debt recycling for shares can work great. In fact, I would use that exact approach if I was starting today!
I agree with your thoughts, at current interest rates borrowing is appealing, and it’s much more attractive to invest (for income), than it is to pay down debt. Everyone is different though, and it won’t suit many folks. It can also work out poorly if someone doesn’t know what they’re doing 🙂
Hey, thats me! I also went berserk paying down as much off as much as I could as well. I could definitely see a situation where people are uncomfortable with the debt.
For those in a hurry, its a pretty nice way to get ahead. You should definitely talk to someone about it before you do it though!
Thanks for stopping by ADI 🙂
I read your debt recycling story a while ago!
The leverage can definitely work (not always), but it’s not a sustainable end game. High leverage and a passive income stream are generally not compatible. There’s no real need to leverage if one can save, and some folks will always be shy of debt so there’s those things to consider also.
A great point to remember for anyone on the FI journey. This is why most of my investments are stocks rather than property – There are of course pros and cons for both, though the cash flow is what I want right now (well in the next 3-5 years especially).
Yeah exactly. My opinion has really changed over the last few years on this topic and I think it’s underappreciated.
Thanks for commenting Miss B
I think, as you suggest people get caught up in accumulating wealth for wealth’s sake without knowing really why they are doing it, just intuitively knowing it is probably a good idea. If you never turn your wealth into some sort of income stream whether through your path (LICs) or any other of multiple paths, then the wealth is useless in my eyes.
You played a winning strategy by leveraging to grow your wealth then switching to high income investments.
You’ve done what most can’t, detach yourself emotionally from the number that is your net worth. Congrats on making that choice, I’m sure at the time it was gut wrenching.
Thanks mate.
It was a little hard to start selling, but in truth, thinking about being free, made the choice a lot easier. It just became too hard to ignore. If we wanted to keep all the properties, we’d have to continue working. Not a great trade-off!
Exactly Pat. If the wealth is just sitting there, but providing no freedom, then what is the point. Especially true when it comes to property, as many people are emotionally attached to even their investment properties.
It’s true, it worked out fine. But it can be done with a good savings rate, without the debt, and in a simpler and hassle free way of investing. Sometimes there is an underlying assumption in Oz that leverage is the only way to grow wealth, and it can’t be done through saving. Sadly, that’s been my experience from talking to people. And that assumption really shits me 🙂
>With a strong savings rate, there is simply no need for leverage.
This is the key. You can only truly feel financially “independent” when you have no debt against your name. $4m property portfolio and $2m in loans? Better to sell it down and have the $2m cash to invest. No bank can touch you then.
Agree with your sentiments ETF bloke!
While the person with the higher assets might make more money… the guy with no debt is in a stronger, more flexible and more financially free position!
Great analysis!
Cheers 🙂
Enjoying reading your blog and really like this post. At the moment, we are certainly in the Harry situation with a home we own outright after aggressively paying down and eliminating our mortgage within 5 years but have only just started to invest in index funds since getting rid of the mortgage. I’m not going to discount the amazing sense of peace we have in owning our home but it does mean we still have a few years left of working while we save like crazy and invest to generate sufficient passive income to commence an early retirement.
As is so often the case with hindsight, we would have done things differently when starting out with our wealth building strategy from day dot but with no mortgage payments anymore, our savings rate is shooting up as we also continue to optimise our spending.
I’m interested to know if you plan on starting to allocate to international stocks/funds in the future and whether you see being invested almost completely in the Australian market as potentially limiting growth of your portfolio. That whole “Australian market represents only about 2% of the world’s markets” argument. Sounds like your current strategy is solid and is working well, just curious on your thoughts.
Thanks a lot SOL Guy!
Don’t worry, we’re still mostly in the Harry situation too. In fact, most of Australia is! But excellent work for getting yourself mortgage-free!
And kudos for optimising your spending even without a mortgage – that’s when most people get (even more) sloppy with their finances.
If you keep reading, you’ll find out 😉 (my latest post mentions this) Yes, we do plan on adding international shares. But only after we’ve fully built our Oz focused portfolio giving us the income we need. We see international as some extra diversification and more of a long-term goal to further reduce risk.
As for limiting growth – well that depends. Only if international shares have higher returns for the foreseeable future, but nobody knows that. Capital growth will likely be lower here, because we’re receiving a higher income. So returns may be 5% income 2% growth, instead of 2% income 5% growth. A different return, but not necessarily a lower return.
I prefer more of our return to come from income at this stage, due to our low tax rate and desire for cashflow. Hope that makes sense!
To add to this thread, I find that most people are obsessed with balance sheet valuations – what is my real estate worth today? What is the value of my share portfolio today? My wife and I attained FIRE status some years ago on the back of rejecting the net worth proposition. Our balance sheet is nothing more than a historical record of what we paid for the assets we purchased. This way, we remove all the emotion associated with valuation swings that result in most people doing the wrong thing at the wrong time. Instead, we chose to focus our financial attention on the monthly cashflow movements and comparing budgets to actual. Sounds boring but it is the more meaningful and empowering. The wealth effect is simply fools gold.
Thanks Stephen – very well said, and congratulations on your Financial Independence!
It’s a strange line of thinking, especially for home-owners who will never sell to invest the ‘profits’…
Sure your house/investment property is worth $x, how much freedom is it giving you? If none then what’s the point? There becomes a trade-off that those with large portfolios need to make – do I want to keep working to support my expenses/portfolio, or do I want to sell up and invest in assets that support me? Most people continue to choose the first one because they’re seduced by owning/keeping a larger asset base, and/or scared of the alternatives. Luckily I learned to change my mind as I saw the clear trade-off, rather than hold onto old beliefs.
Given the comments I have read in response to this article, it seems to me that the good old aussie dream of owning a home has a new rival, the new aussie dream of achieving FIRE status. Seems a worthy ambition! And it makes for a refreshing topic of conversation at dinner parties, etc.
Haha yes let’s hope so. It’s a great goal to have – to support ones-self indefinitely from sensible living, saving and investment. Then free to work on more enjoyable things, help others or simply enjoy the freedom of time, which is the most valuable asset of all.
Let’s hope it continues to gain traction 🙂
I really wish I had found FIRE 10 or 20 years ago!
I’ve only just come by it in the past few months and recently found your blog this month. I’ve always considered myself to be money wise. As I learned form a child after watching my mum struggle to raise me by herself on a single parents pension, I vowed to never allow myself to have to live off a pension. I’ve always been a good saver. But I had never heard of ETFs or LICs! So, consequently, I had ‘dabbled’ in shares lost thousands of $$ and stayed well away. I now have over $100k in precious metals bullion, $207k in home equity (with $58k of that in redraw), $60k in IP equity and then super $170k. The IP costs me $50 a week. I thought that was good! lol. Oh boy. I’d love an outsiders perspective/opinion as to what options I have from here.
Since finding FIRE, I’ve been putting a bit of money into Spaceship Universe Portfolio each week as my cashflow doesn’t seem to be enough to paying high brokerage fees at the moment for small parcels of ETFs. Eventually I want start investing in IOZ through Commsec Pocket and IWLD through Commsec. How could I make that happen sooner? I only just purchased the IP in March this year hence why the equity is so low, probably not worth selling that so soon and I admit I am attached the the bullion. I started buying that back in the peak of 2012. So I’m still down around 22% on silver while the gold has gone up only 17%.
BTW I just turned 40 (a week ago), I’m single/divorced with 2 kids with shared custody and only have part time work so my income fluctuates. So feel a bit limited there. I’d love to be FI in 8 years.
Thanks for sharing your story Beth. You’ve made some progress to date which is great. But on the other hand, the approach seems a little bit scattered if I’m being honest. Reaching FI means really taking a focused approach and making sure your finances and investments are all working towards the same goal.
I’ll send you some thoughts by email.
I wish I’d heard of FI 20 years ago too!
I have always been a saver, and very conservative with money having grown up with very little money. I bought a house to live in when I was 22 simply because the repayments were cheaper than renting. I’d rented for a year with friends and decided I didn’t want the hassle of flatmates anymore. I got a new job and moved to the city 3 years later and rented alone while renting out my house. Looking back, I should have bought in the city but I was always a little concerned about whether I could pay 2 mortgages if my first place was ever vacant (which it never was) but hindsight is always 20/20!
I have always been sensible with expenses, only ever bought 2nd hand cars with cash, didn’t bother with the latest fancy gadgets most others seemed to need (iPods, iPhones, iPads, etc). In 10 years paying rent living alone in the city, I managed to save 250k in online savings accounts (thanks to much higher interest rates than we can get today). I did splurge once and spent 3 months travelling around Europe which cost me $20k all up, but the experience was totally worth the money (and all from cash savings).
After I got married we bought a house (comfortably thanks to my salary, $250k cash savings and equity in my investment property). After 5 years, we sold our house and my IP and bought our forever house which is now essentially paid off. I feel like that money could have been put to a much better use earlier if I knew about FI, but it has given us a lot of options and security in terms of house purchases over the years, so it has been beneficial even if not optimal.
We are not FI by any stretch (we have just begun our investing journey with 2 small LIC purchases, and reviewed our expenses and saw just how much we wasted on groceries and takeaway last year!) but a fully paid off home and moderate living expenses gives us both the flexibility to work part time while our munchkins are little, still with an expected savings rate of around 50% (based on this year’s budget now we’ve eliminated our wastage). We realise we could both work full time now and ramp up our savings and be FI right around the time the kids leave high school, but we have chosen to spend the time with our kids while they are little and we think it’s worth it. No childcare fees for one!
We hope to both continue working part time, as it gives great work life balance, eventually having the flexibility to only have one of us in the workforce (hopefully still part the or even casual).
We don’t know how to calculate our FI number as we don’t know how much our expenses will be when the kids grow up. But we’re just looking forward to growing our passive income year after year and seeing where we end up. And so begins our FI journey, thanks to resources like your blog!
Hi there,
I have only recently come across your blog.
I wanted to reach out to you to let you know how useful this article was for me.
Not to mention it was the final straw that convinced him to transition from IP to ETF index funds.
I realise this article is 5 years old, but its still as relevant today as ever.
oh, I also love your latest post on early retirement being “immoral”
Anyway, I just wanted to say thanks and share some appreciation
Chriss
Another great article!!