Four Basic Steps to Financial Independence

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, withdrawals from retirement accounts or other investments, etc.

Your current living expenses are just that, money to pay for rent or mortgage, food, utilities, travel, or entertainment etc.

The great thing about FI (Financial Independence) is that the 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 perhaps you‘d much rather have a more modest home but want to travel more, it’s entirely up to you.

Having FI means that 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 it took hard work, but it can be done…

“It really boils down to spending. Most people spend a lot more than they can afford while thinking they can afford it,”

Mr Money Mustache

Step 1 – Know the numbers

The first step to getting to where you are going is to know where you are now.  And in order to know where you’re starting from, you’ll 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 (see above).  This will help you in later steps to calculate you Financial Freedom (FF) number. As well as this, you’ll need to separate out your expenses so that you’ll know what expenses you can decrease or eliminate in the next step.

As soon as you know your passive income and your expenses, you can do a quick check.  Subtract your monthly expenses from your monthly passive income.

Passive Income – Monthly Expenses = FF number

If your number is greater than or equal to zero then congratulations! You are financially free!  You’re a member of the FF Club! Which is sort of like being a member of the Mile High Club, but with (hopefully) fewer arrests for indecent exposure.

You could stop here, if you wanted, and start enjoying the newfound pleasure of being free.  However, if you are like most of us and your FF number is less than zero, then there’s a bit more work to do.  If your FF number is zero, then congrats, you’re closer than most of us, but you’ll probably want to continue with the rest of the steps below to make sure you have a bit of a buffer for when Life Happens.

Your FF number can also tell 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 to meet somewhere in the middle.

Step 2 – Cut the fat

Now that you know your 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.  Unless you are extremely motivated or have a huge amount of willpower, you should start out cutting expenses slowly. Cutting expenses too quickly might make you frustrated, which in turn could cause you to fall off the wagon meaning that you’d have to start all over again.

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 Costa or Starbucks on your way into the office 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 hundreds, if not thousands of dollars a month. Get rid of debts, and you’ll be a whole lot closer to financial freedom.

The goal of cutting expenses is to ensure that you’ve got 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.  If you want financial independence then 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 covered expenses in the last step so it’s time for the income side of the equation now.  Cutting expenses is a great place to start,  but in real life it’s just not possible to eliminate all your expenses.  So – increasing your cash flow by cutting expenses is limited. But 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 also 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. Or have a look at our Free Course ‘How to start your own business’.

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 once you’ve got some, this is where we put that cash to use and start multiplying it.

Hopefully you already have an emergency fund setup, preferably in an online bank that’s paying higher than average interest.  If not, it’s important to start this journey by putting this leftover money into your online savings account until you have three to six months of funds saved away (six to 12 if you’re self-employed).

But as soon as you have your emergency funds stashed away, start squirrelling this cash away in an index fund.  There are tons of them out there.  We use VTSAX from Vanguard – they have 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 available to the new investor, and we’ll cover some of them in another post on our site.

Quick Start Guide

Looking for the quick start guide for Financial Independence?  Here it is:

  1. Know the 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.
  2. 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.
  3. 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!
  4. Multiply your passive income.  Once you have paid down your debt, use the extra cash to start saving and invest.  Use index funds and/or EFTs.  Your money will now (hopefully) be multiplied month after month and year after year.

Resources

Here are some tools and resources that we use.

Personal Capital – we use Personal Capital to track my Net Worth and they have a great Retirement Planner as well.

We use Vanguard for our index funds and ETFs

Summary

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 one 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, so 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.

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