What is Financial Independence?
Financial independence is when you have enough wealth and income to cover your living expenses for the rest of your life while not being required to have a job or rely on income from another person.
This means you’ll need a combination of passive and semi-passive income sources to cover your lifestyle indefinitely.
When you reach financial independence, you have the ability to retire. Those who retire at a young age are said to reach FIRE, or Financial Independence Retire Early.
There are many ways that you can become financially independent, including living well below your means while significantly increasing your income for some time, and using your extra money to invest in assets that pay you passively indefinitely.
How Do You Get To Financial Independence?
To reach a state of financial independence, you’ll first have to reach financial security. Financial security is broken down into a few steps, as mentioned below.
Many Americans who are first starting out live paycheck to paycheck, meaning that losing their income for even a day or two, or having a sudden expense, means that they will sink into debt.
You first need to get out of the paycheck to paycheck grind to reach financial security. You’ll have to save money and pay down your consumer debt.
Financial security means that if you lose your job, you can cover day-to-day expenses for some time without needing to go into debt or take out a loan. This gives you time to find a new job while having cash on hand to pay your bills.
Reaching financial security is easier reached by living well below your means and not spending money on things that you don’t need while maximizing the income you earn between things such as:
- Your full-time job
- A side job or side hustle
- Getting raises and promotions by going the extra mile at work
- Locking away money in investments that pay you regularly, such as dividend-paying stocks and ETFs.
Once you’ve gotten to a place of financial security, the next step is to reach financial independence.
Going from financial security to financial independence can take considerable time and effort. To reach financial independence, you need enough passive income built up where your job is optional, and your passive income covers your living expenses for life.
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There are stages of financial independence, such as what’s called Barista FIRE, which is when you have enough passive income that you’re only required to work part-time.
There’s also Coast FIRE, which means your investments cover all of your long-term goals while you work part-time for day-to-day expenses.
To speed up getting to a state of financial independence, you can take steps such as:
- Lower your living expenses drastically: When you remind yourself that every dollar you lock away puts you one step closer to financial independence, you’ll be less likely to spend money on frivolous things like online shopping. You’ll also seek to cut common expenses like how much you spend on groceries, rent, what cars you buy, how often you go out to eat, what types of clothes you buy, and so on.
- Invest every dollar you can: When you educate yourself on investing, you’ll make smarter moves to grow your money quicker. You may consider investing in stocks that pay dividends, in real estate for rental money, in P2P lending for interest payments, or similar.
Not everyone wants to seek financial independence at a young age as you will have to make sacrifices. That said, the freedom you’ll obtain may be worth it to you later.
Taking it a Step Further: Financial Freedom
Financial freedom is the step beyond financial independence. When you reach financial freedom, you have enough passive income to cover not only your living expenses but also enough passive income to cover any lifestyle you could ever dream of.
That means you can travel whenever you want, buy whatever you want, and do anything you desire while never worrying about money again.
Reaching financial freedom is similar to reaching financial independence, however, you’ll need to take your wealth building to the next level.
You’ll want to consider doing things such as:
- Build a business that can run without you one day
- Invest in the stock market in stocks and ETFs that pay dividends
- Get involved in real estate
- Invest in fixed-income assets
- Avoid acquiring liabilities
- Avoid sinking into credit card debt
- Creating other income streams, such as royalties from books written
As you reach financial freedom, you can consider adding to your passive income further, as there’s no limit to the income you can generate when you’re free to do what you want.
What’s the Difference Between Financial Independence and Financial Freedom?
Simply put, the main difference between financial independence and financial freedom is that financial independence is not relying on a job to pay your living expenses. In contrast, financial freedom is having enough passive income to live any lifestyle you could ever desire.
How Much Money Do I Need To Become Financially Independent?
An effective way to determine your financial independence number is first to decide how much money you need to live off of every year. You can calculate your living expenses for a year and then increase that number by up to 20% to allow for a buffer.
You can consider using the 4% rule from there, which states:
- Take the amount of income you need to get by.
- Divide by 4%
- The result is how much you need to invest in a relatively stable portfolio that provides 4% of its income annually. An example is if your money is diversified over stock ETFs that average a 4% dividend yield.
Here’s an example:
- You decide you need $80,000 per year to live off of.
- $80,000 divided by 4% is $2,000,000
- Your estimated financial independence number is $2,000,000 if you estimate that you can pull 4% of that money every year and that your investments grow at 4% or more on average each year.
Dave is a Certified Educator in Personal Finance (CEPF®) and is passionate about spreading financial literacy. He founded Clean Cut Finance in 2021 and has been featured on websites like Yahoo! Finance, MoneyGeeks, and GoBankingRates. In his spare time, Dave enjoys experimenting in the kitchen, racing simulation, and reading.