海角大神

How to achieve total financial independence

Shrewd, secure investments in the form of bank CD ladders or treasury bonds are great ways to set yourself up for long-term living

Monica writes in with a great question:

I read in 2002 and it changed my life. My dream has always been to be able to focus all of my energies on painting and I realized that if I didn鈥檛 actually make that my goal it would never happen. So I started drastically changing my life so that I could do that.

Over the last few months, I鈥檝e begun to realize that I鈥檓 on the home stretch. I have $600,000 in my savings account that came from spending very little over the last decade. I own my home and have no debts of any kind. When I got my statement from the bank last month, I saw that I had made about $8,000 in interest over the last year on that money and so I started investigating how to set things up so that I could live in perpetuity on this money I saved.

Right now, I make about $1,000 a month on my paintings in profit after the expenses are paid. I have four or five slots at a local gallery, where I sell on average two paintings a month, which is about the same as my painting output as I do it in my spare time.

My living expenses are about $1,400 a month, meaning I need to consistently come up with a $400 shortfall each month beyond my paintings. The interest on that money in savings would provide that, so it would appear that I鈥檓 financially ready for this leap.

My question to you is how would you organize all of this so that it鈥檚 easy for me to step away? What鈥檚 the best way of moving from where I am right now to walking away from my job in six months or a year? I want to do this right, not just rush into something.

Right off the bat, I鈥檇 say that your current savings account is probably the best deal out there. My back-of-the-envelope math says that your savings account is earning you 1.2% or 1.25% interest or so, which is better than almost any other rock solid investment with a relatively short term out there on the market right now.

There are usually two options that people follow when it comes to setting things up for such long-term living. One, they buy certificates of deposit from a bank and set up a 鈥渓adder鈥� or two, they buy long term treasuries from the government and live off of the payments. Let鈥檚 look at these two options.

CD 鈥淟adder鈥�
聽A certificate of deposit (often called a CD) is something you can buy from a bank. CDs are usually sold at a particular length of time and at a particular interest rate.

Typically, people will go to the bank, buy a CD with a particular interest rate and length, and wait for that length of time. At the end of that length of time, the buyer gets their money back plus the interest earned on the money during that period. If you try to get your money early, though, you usually have to pay a stiff penalty.

So, let鈥檚 say you find a 1 year CD at your local bank with an APY of 2%. You put $10,000 into it. At the end of the year, you get your $10,000 back and get another $200 back in interest. You can set this up to happen automatically so that the $200 gets rolled into your checking account and the $10,000 goes to buy another CD. All you see is the $200 in your checking account each year.

So, what鈥檚 a 鈥渓adder鈥�? Let鈥檚 say you buy one of these CDs at the start of each month for a year. This means you鈥檝e spent $120,000 on CDs over a year.

At the start of each month, one $10,000 CD matures, paying you $200 (assuming they鈥檙e always at 2% interest). That $10,000 then automatically buys another one year CD. That way, when that month rolls around next year, the same exact thing happens again.

The problem with this approach right now is that the interest rates on CDs are so incredibly low that you鈥檙e not really getting much of a boost at all beyond what interest rate you can get for an ordinary savings account. As the economy rebounds, these rates will go up and, eventually, CD rates will exceed savings account rates by enough to make it worthwhile.

If you鈥檙e thinking of this option, I offer a couple points of advice.

One, don鈥檛 put all of your money into this CD 鈥渓adder.鈥� Keep at least a month鈥檚 worth of living expenses outside of this in savings as an emergency fund so that you don鈥檛 have to sell a CD early.

Two, wait to start this until there鈥檚 at least half a percent between a one year CD rate and what you can get in your savings account. Since you have to lock away your money for a year, you shouldn鈥檛 do it unless you鈥檙e getting some reasonable compensation for it.

Treasuries
聽Treasuries are sold by the United States government under several different names (treasury notes, treasury bonds, etc.), but they all function in more or less the same way.

In essence, when you buy a treasury from the government, it has a maturity date, a face value and a coupon value. Let鈥檚 say that the face value is $10,000 and the coupon value is 2% and the maturity date is 30 years down the road.

For the next thirty years, you鈥檒l receive a payment every six months. That payment is equal to half of the face value times the coupon value. So, you鈥檇 receive a payment of $100 every six months for the next thirty years, at which point you鈥檇 get your original $10,000 back.

Most of the time, when you buy a treasury, you pay either a bit more or a bit less than the face value of the treasury, depending on the market at the time. The federal government makes buying them pretty easy using , but you can also buy them through brokerages.

A couple of thoughts:

Even if you own several treasuries, you鈥檒l usually just get a single lump payment every six months. With good money management, this isn鈥檛 a problem. Of course, without good money management, you wouldn鈥檛 ever find yourself in this situation.

Treasuries are really really low right now. Just like CDs, I would be hesitant to lock down my money for such a long term with rates this low. I would wait for a while.

What Should Monica Do?
聽If I were her, I would jump on board with this sooner rather than later. She has more than enough money saved up to make this work and she already has her foot in the door with her painting.

I would live out of my savings account for a while until rates begin to rebound, then I would choose one of the above paths and set it up. Which one? I鈥檇 probably choose the CD ladder unless 30 year treasuries begin to have rates above 6 or 7%.

After that, the only worry is great painting.