The concept of financial independence is now a big issue in the world of personal finance. Financial independence has become an important goal that many people are looking forward to achieve. We can identify several factors to this seeming renewed interest. One of those reasons is the increased dissatisfaction that people have with their jobs. Many Americans and many others all over the globe for one reason or the others hate their jobs. Therefore, many people look forward to a time when they won’t have to do jobs they hate. It is also one of the reasons for a growing interest in small and medium scale entrepreneurship.
Similar to this is the increasing desire for freedom and luxury. We live in a technologically saturated world where there are a lot of gadgets and resources that we could exhaust our time on. Years back, people did not have those luxuries. The workplace provided the major socializing factor. Work, therefore, was not just a financial endeavor but a major social endeavor. But in this day and age, there are a lot more activities that could engage our time and affection. Many people long for a time when they could be freed up to this endless leisure and freedom.
Also, many people look forward to some particular goals they want to accomplish in life that might not be financially rewarding. Therefore they look forward to a time when they can have enough money to leave what they are doing. This will free them to do what they love or what is so essential to their sense of fulfillment in life. For some, it may be going overseas to the mission fields. Others may have philanthropic or social welfare organizations they want to establish and run.
For these reasons and many more, the concept of financial independence is becoming a mainstay among the populace. But what exactly is financial independence?
Defining Financial Independence
Financial independence occurs when someone has enough money set aside (or enough sources of income) that they don’t need a salary or a particular stream of income to maintain their standard of living. For a business owner, it means having enough money set aside (or enough sources of income) to maintain your standard of living even if you make zero profit.Financial independence occurs when someone has enough money set aside (or enough sources of income) that they don’t need a salary or a particular stream of income to maintain their standard of living Click To Tweet
According to Wikipedia, “Financial independence is the status of having enough income to pay one’s living expenses for the rest of one’s life without having to be employed or dependent on others.”
The concept of financial independence must not be limited to retirement. For one thing, many people get financially independent before they reach the retirement age. Also, many of those who are financially independent might still be working because they love a particular job. The point is, they are not dependent on that job’s income. Conversely, many people retire but are not financially independent.
So financial independent must not be defined by or limited to retirement.
Some Basic Calculations
There is a Financial Independence calculation designed to help you estimate the longest possible time you can expect to reach financial independence. The calculation is based on your current spending and savings pattern.
The calculation is in two steps.
Step 1: Determine your Financial Independence No (FI No)
Your Financial Independence Number is your yearly spending divided by your safe withdrawal rate.
The yearly spending is how much you spend every financial year. This is a figure that every student of personal finance should know. The importance of budgeting cannot be over-emphasized at this juncture.
The Safe Withdrawal Rate is the percentage of your savings you can withdraw every year without running out of money for your lifetime. The safe withdrawal rate is often associated with retirement. So if a person retires at 6o for example with a nest egg of $500,000, the safe withdrawal rate measures what percentage of that $500,000 the person can withdraw every year without ever running out of cash.
The figure will be different for everyone depending on your annual spending, age of financial independence, nest egg, and number of years you live after attaining independence.
A general rate that applies to most people in most cases is 4%. The 4% rule existed before, but a study by PWC established its continued validity.
Step 2: Determine years to financial independence
The years to financial independence seeks to measure how long it will take for you to achieve financial independence based on current financial patterns.
It is your (Financial Independence Number – Total amount in savings) / Yearly Savings.
Suppose Mr. Caleb (fictional) who is 40 years old spends $50,000 every year and saves $50,000 every year. Suppose he has $200,000 in total savings as at January 2019. Assuming the safe withdrawal rate is 4%, the calculation will be as follows:
FI No= $50,000 / 4% = $1,250,000
Years to FI= ($1, 250,000 – $200,000) / $50,000
Years to FI= $1,050,000 / $50,000 = 21
By these calculations, Mr. Caleb will achieve Financial Independence by 61 years old.
However, some observations are in order at this point. This whole calculation rests on certain assumptions:
- You will not earn more than you currently do
- You will not save more than you currently do
- Your savings are not generating any compound interest
- You will not spend more or less than you currently do
As a result of these assumptions, financial experts advise that we see this figure as the longest possible time it would take to reach financial independence. It is not meant to be a perfect measurement but a basic calculation for planning.
By reducing your expenses, increasing your income, investing in compounding assets, and increasing your savings, you can significantly reduce the number of years. Also, the 4% rate might not work for everyone. Some might require a lower or a higher rate.
Achieving Financial Independence
How then can you begin the path to financial independence? More accurately, how can you reach that goal faster? Below are some suggestions:
Passive income is income you earn continuously into the future based on what you do now with little or no efforts going forward. According to Wikipedia, “Passive income is income resulting from cash flow received on a regular basis, requiring minimal to no effort by the recipient to maintain it”
The US Internal Revenue Service categorizes income into – passive, active, and portfolio. Passive income includes income from royalties on a book or work of art, property income from a piece of asset or from trade or businesses that don’t require your active participation. Investopedia defines it as “earnings derived from a rental property, limited partnership or other enterprise in which a person is not actively involved”
Some common sources of Passive Income include:
- Affiliate Marketing
- Dividend stocks
- Real Estate
- Savings Account
- Limited Partnerships, etc.
Establishing or increasing passive income sources can help to attain financial independence faster by:
- Reducing your dependence on your primary source of income
- Increasing your savings
- Reducing your FI no and Years to FI
Side hustles are jobs you can do on the side that will not affect your primary job. In the gig economy, such jobs are sprouting up now and then. You can work as a freelancer on various freelancing platforms like Fiverr and Upwork. If you can write, design graphics, build websites, analyze data, handle social media marketing, you can increase your income on the side.
Alternatively, you can become an online tutor on tutoring platforms (Tutor.com is a popular one) and earn some extra bucks. Offline, you can monetize some of your hobbies or do any number of simple jobs that can increase your income.
By incorporating these side hustles, you can reduce dependence on your primary income, and increase your savings. This will reduce your FI no and Years to Independence.
Investing in Growth Stocks and Real Estate
Investing in stocks individually or through mutual funds is another way to achieve financial independence. These are growth stocks that grow in value over several years. People like Warren Buffett have built significant asset value from growth stocks.
When you invest in growth stocks that multiply in value over the years, you can build a significant nest egg. Such a nest egg will be enough to last you for the remainder of your lifetime at a particular point in time.
You can achieve financial independence by investing in growth stocks that will give you sufficient asset value at a future time enough to achieve financial independence. Value Investing is still very important in a world of day and swing trading.
Just like stocks, real estate properties can also grow in value over time. Just as you analyze stocks to determine the fundamental health and prospect of a company, you can analyze the prospects of a real estate investment.
Investing in communities with much potential for future growth can multiply your investments over a significant number of years. Just like growth stocks, you can have a significant nest egg at a particular time that you gain financial independence.
Yearly Spending is another important factor in the Financial Independence number calculations. By reducing your spending, you can reduce your FI no and consequently reduce the years to FI.
Many sites have written a lot of methods and strategies to reduce your expenses across many subcategories (housing, transportation, food, etc.). It is too long a list to highlight here.
Sales of idle assets
Selling off some assets that are unimportant or have become liabilities can be another way to increase your savings. If you have three cars but only need two, you can send the third one. If you have household appliances that are idle and useless but still has some resale value, put them up for sale.
Taking this step once in a while can be a helpful way to de-clutter the house and increase your savings. By increasing your savings, you reduce your Years to FI.
Financial independence and the life you have always wanted
Why do all these matter? Why go through all the stress. Why can’t I focus on working my ass off and waiting till retirement when I can use my nest egg to maintain my current lifestyle (or a toned-down lifestyle)?
As we said in the beginning, there are many significant reasons why it is important to achieve financial independence earlier rather than waiting for retirement.
Financial independence helps you to do the things you love doing rather than the things you have to do. Why wait until you are 60 or 65? Why can’t you have more years doing what you love and enjoy? Why can’t you start that charity earlier, travel around the world while you are still strong, spend more years in the mission fields?Financial independence helps you to do the things you love doing rather than the things you have to do. Why wait until you are 60 or 65? Why can’t you have more years doing what you love and enjoy? Why can’t you start that charity… Click To Tweet
Also, Financial Independence is the ultimate “bulletproof” against unemployment. Achieving financial independence as soon as possible means you are protecting yourself from the possibility of a job loss. In some cases, your emergency reserves (you should have one) might not be enough for the time between a job loss and a new job. Getting to the point where you don’t need a job to maintain your standard of living protects you from possible loss of job and unemployment.
It also provides you an opportunity to pursue goals that are important to you. You can engage in what you want irrespective of how much it pays. If you love teaching kids, you can finally do it without caring about the salary. You can finally start the business you have always dreamed about without killing yourself over how to replace your full-time income.
The preceding section does not imply that you cannot enjoy life before attaining financial independence. It does not mean that living with a dependence on your primary source of income will take all the fun and happiness away from life. It does not mean that financially independent people are happier since there are many other factors (social, emotional, psychological) involved.
However, a life of financial independence is key to our ability to achieve our ultimate goals in life and become all we want to be. Financial independence might not be all you need, but it is an important part of what you need. You may be happy without it, but you will be happier with it. Why settle with happy when you can be happier? Why settle for the good when the better is available?However, a life of financial independence is key to our ability to achieve our ultimate goals in life and become all we want to be. Financial independence might not be all you need, but it is an important part of what you need. You may… Click To Tweet
Also, it is not only about the “Now.” As Aristotle reminds us, “Money is a guarantee that we may have what we want in the future. Though we need nothing at the moment, it ensures the possibility of satisfying a new desire when it arises”
Financial Independence is a goal that everyone should seek. But like every goal, it takes efforts. It does not just happen. It involves lots of financial planning and adherence to proven personal finance wisdom.
But like every difficult thing, the real question is, “Is it worth it?” When we face goals that require difficult steps and actions, the focus should not be on the difficulty, but what lies on the other side.
It must be the same here. What will you give to be financially free at 40? How will the trajectory of your life change? How will it affect your happiness, your sense of fulfillment, and self-actualization? It is when you have contemplated those questions that you will realize that this is a goal that is worth all the efforts.
Ultimately, it is never about money in itself. It is about how it can be an effective tool to get us to where we want to be.