What is Financial Independence? Can Anybody Reach It?
Very few people can honestly say they don’t need to earn a regular income to pay the bills. If this is you, you know what financial independence is all about.
A common myth is that financial independence (FI) is only for the upper class. You know, “the 1%.” While it’s easier for them to be independently wealthy, it’s possible to reach financial independence in the middle class too.
Maybe, you’re tired of living paycheck to paycheck. Or, you want to set the ultimate money goal. Whatever the reason, you can draft a plan to reach financial independence.
Is Financial Independence Legit?
Here’s a simple definition of financial independence:
You don’t have to earn a regular paycheck to pay the bills. In most cases, your monthly passive income exceeds your monthly expenses.
For example, your monthly expenses are $1,500 and you earn at least that much from these passive income streams:
- Bank account interest
- Stock market dividends
- Rental property income
- Peer-to-Peer investments
You also have enough savings that you can quit full-time work and not have to replace your lost wages with another job (active income).
In the financial world, several acronyms are thrown around:
- FI (Financial Independence)
- RE (Retire Early)
- FIRE (Financial Independence Retire Early)
Just because you achieve financial independence doesn’t mean you have to stop working. If you don’t like your job you can finally afford to change employers. Or, switch to a less stressful career field. But if you enjoy your job or are too young to retire full-time, you can keep your job.
Once you retire early, you’re technically in the FIRE category.
8 Habits to Reach Financial Independence
Making work optional doesn’t happen overnight. It takes years, maybe decades. While every person takes a different route to financial independence. There are several common habits you must adopt.
Remember, you can adopt several of these habits at once. You don’t have to follow them in linear order.
Stop Living Paycheck to Paycheck
If you’re still living paycheck to paycheck, this is the first thing you need to change. Maybe it’s a quick fix. Or, perhaps you have to repay those high-interest credit cards.
When this is you, accomplish these two goals first:
- Use last month’s income to pay this month’s bills
- Build an emergency fund for at least 3 months of living expenses
Once you accomplish these two goals, your savings balance grows. Eventually, you use your income from two months ago to pay the bills for this month. Then, it becomes three months, then four…
Track Your Finances
Almost anything good in life doesn’t happen by accident. It takes planning and work. On the bright side, you have a better chance of reaching financial independence than winning the lottery.
The first step is knowing how much money you spend and save. Your important money metrics include:
- Disposable Income
- Savings Rate
- Retirement Savings Rate
- Net Worth
Many people are pursuing FI with Personal Capital. It’s a free app that tracks your net worth and other vital metrics you need to know.
What’s Your FI Number?
Another question you must ask yourself is, “What’s your financial independence (FI) number?”
There are two answers to this question:
- The total amount of money you need to be financially independent.
- Your projected monthly expenses once you retire.
If you plan on living on $1500 a month for the next 20 years, you may decide you need at least $360,000 in cash and investments. Of course, these assets earn passive income that you use to pay your bills with first. Remember, you don’t want to use these reserves unless you have to. If you use them up early, you may have to re-enter the workforce. And, you reduce your passive income potential in the process.
So, you may choose an FI number closer to the $1 million mark in liquid assets. This is a common target for people who retire at the normal retirement age. And, it’s the same for people on the FI and FIRE bandwagons.
Minimize Your Monthly Expenses
There are three ways to reach financial independence sooner:
- Reduce monthly expenses
- Increase your active income
- Earn more passive income
This section focuses on reducing your monthly expenses. There are many ways to spend less money. But, these actions can help you save lots of money:
- Don’t borrow money
- Pay off your high-interest debt to eliminate monthly payments
- Move to a smaller house or a cheaper city (unless your high-income job is location-locked)
- Cook meals at home
Relocating from a high cost of living area to less expensive city can be the easiest way to save money. The money you save by paying less in rent, insurance, and taxes can build your net worth.
Also, you should use some of your extra income to repay high-interest “bad debt.” This might be any debt that has an interest rate above 10%. So, even though you want to have as few monthly payments as possible, you probably won’t pay off your mortgage early.
The reason why is that you can earn more income investing than you save with extra loan payments. Depending on how soon you want to retire, you may wish to repay your mortgage early to be debt-free.
Avoid Variable Monthly Expenses
You also need to avoid variable monthly expenses. These expenses alter your FI number. And, a large expense can delay your financial independence date.
For this reason, some people sell their home and choose to rent instead. While rents can rise, owning a home has plenty of expensive surprises. For example, you may have to replace the roof or air conditioner several years early. Or, home values drop when you get ready to retire and you were counting on that extra profit to retire early.
You can’t eliminate every variable expense. But, it’s good practice for living on a fixed income.
Increase Your Active Income
Hopefully, you have a job that earns at least $100,000 a year. If not, you can still make more money in your free time with a side hustle. You will make the most money freelancing with your current skills. Maybe that’s graphic design, tutoring, or building websites.
Put this cash toward paying off high-interest debt or investing. Whatever puts you closer to reaching financial independence sooner.
Whether you only do a side hustle for a few months or have long-term ambitions, you don’t have to rely on your day job to earn active income. Eventually, this side hustle can provide part-time income when you quit your day job. And, it gives you something to do when you retire early.
Invest Your Extra Income
The key to reaching financial independence is earning more in passive income than your monthly expenses. And, you can only do this by investing your money.
This doesn’t mean you have to put all your money in the stock market. You should diversify your holdings to limit downside risk. And, to have different dividend yields.
You should consider these investment options:
- Index Funds
- Real Estate (Rental Property and/or Private Real Estate)
- Peer Lending
- Bank CDs and Money Market Accounts
When it comes to investing in the market, most people who achieve financial independence primarily invest in index funds. Overall, they are the easiest way to capture the total income potential of the market. And, they perform better than most active investors.
Index funds also have the lowest investing expenses. This means more money remains invested in the market. That means more money that can earn compound interest.
If you choose, you can also invest a portion of your money in individual stocks with a strong dividend history. But, so you can focus on the other aspects of reaching FI, stick with index funds.
Always remind yourself it doesn’t take a genius to reach financial independence or to be a successful investor. The real secret is investing early and investing often. The more time your money is in the market, the more potential income you can earn.
Learn the Tax Code
As you earn more active and passive income, you might pay more in taxes. So, you need to learn how to maximize your tax-advantaged accounts.
Here are a few places to start:
- Employer 401k (Traditional and Roth)
- Traditional IRA
- Roth IRA
- Health Savings Accounts (HSAs)
- 529 College Savings Plans
Since you’ll probably need access to some of your cash before you reach the “normal” retirement age of 59 ½ years, keep some of your money in taxable accounts. But, you should also try to maximize these tax-advantaged accounts too. This way, you pay less in income tax and capital gains tax.
If you need help finding the best mix for your tax situation, don’t be afraid to talk to your financial advisor and tax accountant. These can be some of the most valuable conversations you have as you optimize your finances.
Financial independence doesn’t require you to be rich or win the lottery. It’s simply living within your means and being diligent about saving for the future. Everybody has different money goals and target retirement dates. But, you have a freedom that most people think is impossible.
Are you chasing financial independence? If so, what’s your FI number?