Personal finance is hot. One need only have a look at the number of books, podcasts and websites dedicated to this topic to see that we have a keen interest in learning or perfecting our money skills. And that’s not so surprising: who wouldn’t want to have some extra cash, a more secure financial future and a more satisfying financial life?
Luckily, personal finance doesn’t have to be complicated. Whether you want to achieve financial independence or simply learn how to better manage your money, in this new series of “10 common questions…” you will learn all the essentials about personal finance and money issues.
In this first article, we’ll start off with the concept of Financial Independence (FI)- what it is, why you might want to pursue it and how you can achieve FI.
1. What is FI?
FI stands for Financial Independence, which can mean one of the following three things, depending on who you’re speaking to:
- In the past, Financial Independence was often used to describe women who were financially independent of their husbands: they made their own money and didn’t need to rely on getting an allowance from their husbands.
- Financial Independence can also refer to the process of growing up and becoming an adult and no longer needing to rely on your parents for money and / or financial help or advice.
- Lastly, Financial Independence can mean you generate enough passive income that you gain independence from your job and essentially no longer need to work for money.
In this article I will mainly focus on that last meaning of Financial Independence: removing the need to work in your life and being able to pay for your expenses through passive income streams.
2. What is passive income?
There are 3 different types of income: active income, passive income and semi-passive income.
An active income is money you generate by selling your time for money: most of us with a job get paid for showing up to work every day and working on specific during during the time we spend at work.
Then there is passive income: money you get by doing nearly nothing. Think about the interest you receive on your savings account.
A semi passive income is income that you don’t need to work for every day, but does now and again require some work: a landlord receiving rent from its tenants or a musician who sells records 24/7 in any country without physically being there.
3. Why would I want to achieve FI?
One of the main reasons you might want to pursue FI is to free up time and be able to fill your life with more of the things you love doing: be that spending time with your (grand)children, hiking with your pets, pursuing a new hobby, traveling, keep working, working part time only, volunteer, doing absolutely nothing, starting your own business, writing a book, doing up the house or becoming a philanthropist to name just a few ideas. There are many options, just think about some of the things you love spending time on!
The problem with time is that you can only spend it once, after that it will be gone for ever. You can’t rewind a moment and live it again or do something different with it.
Time is our most valuable asset and by achieving FI and no longer needing to work to pay your bills, you can be much more intentional with your time.
4. But I like my job! I don’t want to stop working!
Great if you enjoy the job, the projects you do, the results you achieve, the contact with other people or the daily structure that it provides you.
Luckily for you, becoming financially independent doesn’t mean you have to give up these things. Once you reach FI you need longer NEED to work for money, that doesn’t mean you’re not ALLOWED to! If your job gives you happiness, satisfaction and a sense of purpose or belonging, then by all means don’t walk away from it! In fact, many people pursuing FI like work and aren’t necessarily thinking about quitting their jobs.
What it does mean that if for whatever reason they no longer want to work (due to a change in family situation, a company structure change or for any other reason), they can just decide to stop whenever they want!
5. How can I reach FI?
If you’re keen to start working towards Financial Independence, your main objective should be to build passive income streams to replace your income.
Some common ways to do this include investing in the stock market, crowdfunding or investment property.
You can also create a semi-passive income stream that, although not fully passive, still only needs a much smaller amount of time to set up or manage. This can include blogging, online courses, selling craft on Etsy or really anything else that you are good at and enjoy doing and you believe people might pay for.
6. How do I know I’ve reached FI?
You reach Financial Independence when your passive income can pay for your expenses.
There can however be some variation in this: do you want all your expenses covered (including those that are “savings expenses” to build up savings or investments?, do you want just the essentials covered or do you want to be able to spend even more than you currently are?
The road to FI has 8 different stages, so depending on which one you are pursuing, you are the only one who can decide whether you’ve reached FI!
7. What are these 8 stages of Financial Independence?
Becoming familiar with the 8 stages of Financial Independence can help you determine where you are on your journey to FI and what your goal is, i.e. where you want to get to. They are:
- 1 – Financial dependence – when you rely on others to provide for you. This is how we all start off in life!
- 2 – Financial solvency – when you can pay your own bills and financial commitments, but likely have debt.
- 3 – Financial stability – when you have some savings / emergency money set aside in case of adverse financial situations.
- 4 – Debt freedom – when you no longer have any debt.
- 5 – Financial security – when you have passive income that can pay your essential expenses, such as utilities, food, insurance, transport and housing costs.
- 6 – Financial independence – when your passive income can pay for all of your expenses, including the discretionary (fun) ones.
- 7 – Financial freedom – when your passive income allows you to splurge on some luxuries now and again: a fancy holiday, a second house or a more lavish lifestyle.
- 8 – Financial abundance – when money isn’t a problem anymore you really have no limits in terms of what you can pay and do.
8. How long does it take to reach FI?
One of the main factors determining how long it takes to become Financially Independent is your Savings Rate, i.e. how much you save in proportion to your income.
You can calculate your savings rate by dividing the amount of money you save each month by your net income. Say you set aside $300 each dollar a month (putting this into savings, investments, crowdfunding projects etc.) and that your total net monthly pay is $1,500 then your savings rate is $300 / $1,500 * 100% = 20%.
The higher your savings rate, the faster you’ll reach FI. There is as excellent post by Mr. Money Mustache where you can find out how different savings rates affect your time til FI. In the case of 20% this would be 37 years. If you manage to save 30% then you can retire after just 28 years.
9. Do I have to earn a huge salary to reach FI?
As we saw in the previous question, your main most important factor to reach FI is your savings rate. Regardless of how much you earn you can reach FI. If you don’t make a lot of money, you likely spend a lot less too compared to somebody who earns a lot more.
The more we earn, the more we also spend, meaning we also need more money coming in from passive income to cover all those expenses! As long as you don’t plan on spending more than you currently are, there is no need for you to have a 6 figure salary!
But of course, if you are looking to get rich instead of reaching Financial Independence (or better said: if you are looking to reach stages 7 or 8 of the 8 stages to FI), then earning a lot of money will definitely be necessary.
And having a bigger income CAN also speed up your path to Financial Independence, but doesn’t necessarily have to: there are many big earners who don’t have any savings, simply because they are used to spending everything that comes in.
10. Where do I start?
If you are ready to start working towards Financial Independence, here are a few things you can do to get started:
- Start living off less: make small tweaks in your current expense patterns to save money.
- Save or invest your money wisely, and automate this process.
- Find ways to make more money (pick up extra hours at work, begin a side hustle).
- Treat your finances wisely: pay off debt, invest in your social security provision and learn about other ways to become financially literate.
- Keep on reading these next few blog posts, where I’ll be discussing more practical tips on many ways to work towards FI, including how to get your money to work for you and create those passive income streams!
This article is part of the “10 Common Question series”, where I address issues about some key financial areas, including Financial Independence, paying off debt, increasing your income, retirement provisions, saving, investing, financial protection and much more. If you want to find out more about Financial Independence, you can sign up to my newsletter to stay up to date or get a free sample of my book 100 Steps to Financial Independence.