Personally, I want to live a life of financial independence, with the ability to make changes without fear of the financial consequences.
Two out of three American’s live paycheck to paycheck. It would be “Somewhat difficult” or “Very difficult” to meet current financial obligations if their next paycheck were delayed for a week, according to the latest National Payroll Week Survey. For me, such financial dependence would be unbearable. I want to meet my financial obligations no matter what short-term events disrupt my income or my expenses.
Let’s look at how you can gain financial independence in 4 (sometimes not so easy) steps:
- Become debt-free
- Build an emergency fund
- Invest excess savings for the long term
- Build smart passive income
Becoming debt-free is the first step to financial independence.
Many people worry about how to make debt payments if they would lose their job and income. Having loans and credit card debt is like living in a financial prison. You are not free to change your life as you please. You must keep your income, no matter what, to service the debt.
If you finance purchases you satisfy your needs now, but you pay extra for it by adding interest payments. It restricts your ability to buy things in the future. Realizing how you will make your future more miserable, gives you the courage to forego your urge to purchase now and to wait until you can afford to make the purchases you desire.
If you have debt, I encourage you to resolve to reduce it to zero. Start by paying outstanding loans and credit cards on time and not borrowing new money. It is not easy to do, but you got to make a plan for how you make these payments. You also need to stop adding to the debt you already have.
Build an Emergency Fund
Building an emergency fund is the second step to financial freedom.
Often people slide into debt because they lose their income. By living paycheck to paycheck, they need to borrow money to put food on the table and keep their housing. Building an emergency fund ahead of the crises will protect you from paying double when disaster strikes. It prevents you from having to pay interest on the loan or credit card when you can least afford it. Don’t let that happen to you by saving for an emergency fund.
If you have become debt-free, you have learned how to curb your urges to have things now. You learned how to make regular payments to pay down your debt. Reaching that moment of zero debt, you can make a decision: Spend the money you have been using to pay down debt on new consumption or you let that money accumulate for an emergency fund.
Why would you decide to build an emergency fund? Because you want to ensure you are not going back into this debt trap. Remember, often people get into debt because there was some emergency that needed money right now and they had non. The car might have broken down or I needed a wedding dress or whatever else comes up unexpectedly. If you don’t have some savings you’ll need to borrow money at a moment’s notice. You’ll go back to this debt prison and lose your financial independence.
When you start building your emergency fund of savings, you’ll ask yourself “How much money do I need to save for emergencies?” The rule of thumb is to stash away 3 months of net income. So if you take home $2,500 / mo, then you want to save $7,500. The good news is, by climbing out of debt you already have an amount of your budget that you can now put into savings. Just keep the same financial discipline and you’ll see that in 1, 2, or 3 years you have saved an emergency fund.
Of course, if you have to tap into your emergency fund, then you’ll have to start over again to rebuild it.
Invest excess savings for the long term
The third step towards financial independence is to invest money so it grows with compounding interest.
There is more to financial independence than not living in fear of inevitable emergencies. True financial independence pays off when we are no more able to achieve our working income. Remember independence is about the freedom to do what we want without being stopped by financial loss. For most of us, the job is our source of income. If we’d give it up for one that is paying less, we’d have consequences in our lifestyle. As history shows, most of us want to retire from that job at some point in time. For that, we need a passive income, that we don’t need to significantly work for.
Actually, if you have a job, government forces you to put aside money for your retirement in form of social security. However, it is a baseline of retirement income and it might not meet your needs in old age. You need to do extra savings if you aspire to more than basic needs.
In old age you need an income that you don’t have to work for, it needs to be passive income. The most passive income is the growth and the interest from investments into stocks and bonds.
The good news is that with the right investments into stocks, bonds, etc. we can achieve a substantial return on investment. The even better news is that over long periods of time, think multiple decades, the return on investment will be greater than the original savings you had to put aside.
Build smart passive income
Step four to financial independence is to maximize your return on investment in a smart way.
Match investment risk with the investment horizon
The return on investments depends on the risk of loss. The higher the risk to lose money, the higher the expected return.
Lending money to a well-run government (buy a government bond) almost guarantees my return in form of interest payments. I also do not have to fear much that this government will not return the money at the end of the contract term.
Buying a corporate bond (lending money to) of a well-run corporation is a tad riskier. Its fortunes could change and it could default on the bond. However, if the company goes bankrupt I have a higher chance of getting my money back, than if I buy stock in the company.
If I buy shares of that well-run company the risk is relatively highest. There is no contractual interest payment I can calculate with. The company may pay a dividend, but that can change according to how well the business goes.
However, if you don’t need the money, why not earn a higher average return in the long run. Learn more at “Smart Investment Portfolio Allocation“, based on your investment horizon.
Invest in baskets of stock
The smart way to achieve higher returns on investment is to invest in many different bonds/stocks at once.
Buying many bonds/stocks at once sounds difficult and a lot of labor, but it doesn’t have to be. You can buy investment funds that invest in many different products. However, that fund management comes at a price and you got to watch out for the fees. Because fees reduce your return on investment.
The other way of being smart with investment is to align the risks with the length of time you plan on not touching the money. The money you will not need in the next 3 – 7 years, you want to preserve the principle value. I’d hold it in cash accounts or maturing bonds or CDs. Any money you don’t need for the next 7 to 15 years or longer, you can invest into the stock market, where the returns are higher. You can watch the (book) value increase and contract, trusting in the fact, that averaged over long periods of time it will have a much higher return on investment than less volatile investments.
Many advisors on the Internet recommend investment into real estate or some side hustle to build passive income. If I’d be you, I would not consider this “passive” income. Because they all involve some really hard work at least in the beginning.
What is your path to financial independence?
Now it is up to you to chart your path to financial independence. First, make an honest assessment of where you are? Do you live paycheck to paycheck? Are you in debt? Do you have an emergency fund already in place, but have forgotten what your long-term money goals are?
Also, think about what financial independence means to you and your family? Do you really want it? Are you prepared to sacrifice things today to be less dependent on working a 9 – 5 job for income?
When you have a clear picture of where you are and where you want to go, then start with the next step that is right for you:
- Become debt-free
- Build an Emergency fund
- Invest Excess savings for the long term
- Build smart passive income
I’m sure you can do it like so many have done it before you.