In a nutshell, Financial Independence is defined as the point where you are earning more money with your passive income than you need for current living expenses. Your passive income can be any income that involves little to no effort on your part to generate that money. It can include interest from savings, investment dividends, royalties, businesses you own but don’t manage, websites, withdraws from retirement accounts or other investments, etc. Your current living expenses are just that, money to pay for rent or mortgage, food, utilities, travel, entertainment.
The great thing about FI is that number can be different for everyone. It’s up to you, because you get to decide what your monthly expenses are and therefore what your monthly income requirement is. Maybe you want a large home for entertaining friends and family, or you ‘d prefer to have a more modest home but want to travel more, it’s up to you.
The great thing about FI is you get to choose what you want out of life. You also get to choose how long it will take to get there. Mr Money Mustache, Peter Adeney, retired comfortably at the age of 30. It was simple but not easy – and took hard work, but it can be done!,
Step 1 - Know thy numbers
The first step to getting to where you are going, is to know where you are. And to do the you need to know your current income and expenses. You don’t need a budget yet, you just need to calculate your total income and total expenses.
For your income separate out your active income, the money you get for trading time for money, and your passive income. This will help you in later steps to calculate you Financial Freedom (FF) number. Also, separate out your expenses so you will know what expenses you can decrease or eliminate in the next step.
Now that you know your passive income and your expenses, you can do a quick check. Subtract your monthly expenses from your monthly passive income.
FF number = Passive Income – Monthly Expenses
If your number is greater than or equal to zero then congratulations – you are financially free! Welcome to the club. You can stop here and start enjoying the new found pleasure of being free. However, if you are like most of us and your FF number is less than zero then we have some more work to do. If your FF number is zero, then you will want to continue with the rest of the steps to make sure you have a bit of a buffer when those unexpected things in life come your way.
Your FF number also tells you how far away from financial freedom you are. For example, if you have $1,000 a month in passive income and your monthly expenses are $2,000, then you FF number is -$1,000. Meaning you need to do one of three things, increase your passive income by $1,000/month, decrease your expenses by $1,000/month, or a combination of both.
Step 2 - Cut the fat
Now that we know our expenses, it’s time to start cutting them. Again this is up to you. Some people want to achieve financial independence as quickly as possible, while others don’t want to sacrifice those things that are important to them. Most people should start out cutting expenses slowly. Unless you are extremely motivated or have a huge amount of willpower, cutting expenses too quickly will cause you to fall off the wagon and you’ll have to start all over.
Try bringing your lunch to work instead of going out to eat. It’s a small thing that adds up quickly. Instead of stopping at one of those fancy coffee places try one of those fancy creamers in your work coffee. You get the idea.
One of the biggest expenses most people carry is Debt. This expense can be a large percentage of your monthly outgoings. The average American owes nearly $16,000 on credit cards and $28,000 in auto loans. That’s costing you hundreds, if not thousands of dollars a month.
The goal of cutting is to ensure you have extra money left over at the end of the month so that you can put it to use in the later steps of this plan. Yes, if you want financial independence you are going to have to save and build up your net worth.
Step 3 - Show me the money
The FF number is made of two parts: income and expenses. We’ve covered off the expenses in the last step so it’s time for the income portions. While cutting expenses is a great place to start, you can’t eliminate all your expenses. You still got to eat! So increasing your cash flow by cutting expenses is limited, earning more income is not.
The fastest way to get to financial independence is to save more, and the easiest way to save more is to make more. Increasing your income is also a quick way to make a large impact on any debt you carry month to month.
One of the easiest ways to increase your income is to simply ask for a raise at your current job. I know it can be stressful, but that one simple question to your boss may get you further along the path to financial freedom. Side gigs are a great way to get some extra cash. Most likely someone, somewhere, needs some help and your current skill sets could be just what they are looking for. Try looking on Fiverr, Upwork, or the dozen of other freelance/gig websites out there.
Step 4 - Multiply your passive income
Remember back in step 2 when I said you were going to need some cash leftover each month? Well here is where we put that cash to use and start multiplying it.
Now hopefully you already have an emergency fund setup, preferably in an online bank that’s paying higher than average interest. If not, please start by putting this leftover money into your online savings account until you have three to six months of funds saved away (6 to 12 if you’re self-employed).
Now that you have your emergency funds stashed away, start squirrelling this cash away in an index fund. There are tons of them out there. I use VTSAX from Vanguard due to the low fees and easy investment options. This fund does require an initial investment of $10,000 so you may need to use one of the other versions like VTI the EFT. There are plenty of options and strategies we will cover in another post on our site.
Quick Start Guide
Looking for the quick start guide for Financial Independence? Here they are:
- Know thy numbers. List all your income and expenses. Subtract your monthly expenses from your monthly passive income. These is how far away from Financial Independence you are.
- Cut the fat. Lower monthly expenses. If you have credit card or auto loans use this money to make additional payments to your debt. It’s called a debt snowball
- Show me the money. In addition to decreasing your expenses, increase your income. This makes the whole process quicker. Again if you have debts use this extra money to pay those down, this includes using any bonuses or tax refunds! See the link above.
- Multiply your passive income. Once you have paid down your debt you can now use this extra cash to start saving and invest. Use index funds and/or EFTs. This money will now be multiplied month after month and year after year.
As you grow your monthly investments and they start compounding over and over, and you lower your expenses, the FF number you calculated in step 1 will go from a negative number to a positive number. Once that happens you are technically financially free. However you can’t just stop there, as life and situations change you need to always be watchful. If your expenses increase or your passive income decrease you may find your FF number has turned negative again.