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Are you seeking financial freedom or financial independence? Many dream for the day where working becomes optional. Having so much money where one can quit their job and live their life completely the way they wish sounds nice. The good news is that financial freedom is possible. It generally takes many years of work, but you, too, have a solid chance to walk away from your job and pursue your dreams with the right mindset and good money habits.
But it won't be easy. The earlier you want to retire, the more work you'll generally have to do. Raising more income and cutting back expenses requires effort, and the reward for the effort is being able to wake up when you want, work when you want, and do things like traveling the world with your family.
In this article, we'll go over what financial freedom is and the ten steps you can take to achieve it.
Let's jump right in.
Table of Contents
What is Financial Freedom?
Financial freedom can be defined in a few ways, however, one common theme is that when you're able to live your life the way you want and work becomes optional due to the amount of income you have coming in, then you are generally considered financially free. Generally speaking, having more passive income than you do expenses means that you can live the rest of your life without earning money through work.
When you've reached financial freedom, you have the option to take an early retirement. This is called FIRE, or Financial Independence, Retire Early. You have peace of mind knowing that any additional work you do simply supplements your income so that you have more fun money or a bigger cushion in case you wish to have one.
To reach financial freedom, you'll typically go through 10 steps as outlined below. These main methods will take you from where you are today to a place where you're financially independent in the future.
Step 1: Determine Your Starting Point
The first step you'll want to do is figure out where you are currently. This can be accomplished by writing down all of your assets and liabilities. In simpler terms, this means determining how much money you have in all of your bank accounts, investment accounts, and the value of everything you own. Then, draft up how much you owe, including auto loans, mortgage, personal loans, student loans, credit card debt, and so on.
Use an app like Personal Capital to do all of this for you. With Personal Capital, you can connect all of your accounts in one place and see what you have and what you owe. In addition, you’ll see your net worth and all of your transactions, which can be used later to create a budget and track your spending.
Of significant note are your total debt and your current income. Your current income will help you determine your financial freedom number, and your total debt will help you figure out how much time you'll need to pay it off, based on your leftover money each month.
Step 2: Come Up With Your Financial Freedom Number
Your financial freedom number is the amount of money you need to have invested so that the money you remove from your investment accounts sustains you for life. How does this work?
Assume that your investments grow each year enough so that you can safely withdraw 4% of your money each year to live off of. 4% is a commonly used number in the financial world, though some will use a smaller number.
Because your investments are predicted to grow at 4% or higher each year, then you can remove 4% from your account annually and never run out of money. So, if you require $60,000 per year to live off of comfortably, you would enter $60,000 divided by 0.04, or 4%, into a calculator. This would leave you with $1.5 million. This means that you need $1.5 million invested to safely pull $60,000 per year from your account and not risk running out of money in the future.
- Figure out how much income you expect to need to live off of comfortable
- Divide that number by 4%, or 0.04. Alternatively, if you're more conservative about the future, consider using 2.5% (0.025) or 3% (0.03).
- The answer is your financial freedom number.
Figuring out your financial freedom is one of the most important financial goals you can make when planning out your path to FIRE.
Step 3: Set Up Your Accounts and Automate Your Finances
The next step in reaching financial freedom is to set up your bank and investment accounts. Recommended accounts include:
- A checking account to store money for immediate expenses and to be the primary destination for all of your incoming money.
- An emergency fund in a high-interest savings account.
- One or more retirement accounts, such as a 401(k), Roth IRA, or Traditional IRA.
- If you plan on using your investment money before you're 59½, a taxable brokerage account will allow you to invest and withdraw money at any age without penalty.
Next, set up an automated process to ensure you won't miss a payment or forget to save money. Essentially, you'll want to pay, at minimum, the minimum payments on all of your credit cards and other debts. You'll also want to transfer money each paycheck or each month to your savings account and your investment accounts, depending on your financial situation. By automating this process with automatic transfers, you'll treat yourself as an expense and always save money.
Even if you start off with a tiny amount of money, it's essential that you save and/or invest money each month if you're to reach your financial freedom number eventually.
Step 4: Create a Budget and Track Your Spending
The next important step to take on your journey to financial freedom is to create a budget and track your spending. There are several ways you can accomplish this.
- You can create a budget on paper, writing down all of your income and all of your expenses. Then, using another piece of paper, track your expenses throughout each month.
- You can use a spreadsheet to create your budget and use formulas to calculate your total income and expenses automatically. Check out Clean Cut Finance's FREE home budget spreadsheet template to get started.
- You can use an app like You Need A Budget (YNAB) for a more detailed approach, though this app has a small monthly fee. Alternatively, you can use Personal Capital, a free app, to track your transactions.
Tracking your spending and creating a budget will help you identify where you might be spending too much. For example, you might eat out too frequently and determine that you can save money by eating out one less time per month or per week. Likewise, you may realize you can save money by switching auto insurance providers or mobile phone providers.
With everything laid out in front of you, you may find more than one way to save, meaning more money in your pocket each month. An added plus to tracking your spending is to identify your spending habits and how you can improve them. Remember, the more positive cash flow you have, the more you can apply towards debt, save, or invest.
Step 5: Open an Emergency Fund
If you don't already have an emergency fund, open up a bank account, preferably a high-interest savings account, and start saving up $1,000. Fewer than 4 in 10 Americans can cover a $1,000 emergency, and common emergencies will run up to $1,000.
Common emergencies include:
- Your car breaking down
- A trip to the emergency room
- Replacing a broken refrigerator or washing machine
Financial experts generally agree that you should have up to six months of living expenses saved up, and we'll get there, however, having at least $1,000 banked will protect you from rainy days.
Remember, having money in an emergency fund will cushion you from having to swipe your credit card when unexpected expenses come up.
Step 6: Pay Off Credit Card Debt and Other Debt
Having too much credit card debt leads to financial problems and can also hurt your credit score, which will impact obtaining loans and may even increase how much you pay for insurance.
There are two ways that you can aggressively tackle debt.
- The debt avalanche method: With this method, you pay each debts' minimum payments first and then apply all of your remaining monthly income towards the debt with the highest interest rate. Once that debt is paid off, you move to the next debt with the second-highest interest rate and repeat until all of your debts are paid off. The advantage to the debt avalanche method is that mathematically, you save the most money by tackling higher interest debts first.
- The debt snowball method: Similar to the debt avalanche method, first pay all of your debts' minimum payments. However, this time, you'll apply all of your remaining income to the debt with the lowest balance. Once that debt is paid off, you'll apply your money to the next lowest balance, and so on until all debts are paid off. The advantage to the debt snowball method is that you'll get quicker wins as smaller balances are paid off quicker. This also increases cash flow faster at the expense of potentially not quite paying less money in interest.
Determine which is the best strategy for you and stick to it until you're out of debt. You may consider leaving your mortgage as your one debt before moving to the next step. This is particularly true if your mortgage balance is very high and your interest rate is very low.
Step 7: Save Three to Six Months Expenses
Now that most or all of your debt is paid off, it's time to revisit the emergency fund. To help prevent future money problems and sinking into debt, it's recommended that you save three to six months' worth of living expenses. By saving several months' worth of expenses, you'll be at less risk for financial distress if you lose your primary source of income, such as if you get laid off from work.
You can save money by increasing your income, cutting your spending, or doing both. Check out this article on how to save up to $10,000 in a year. Saving up a three-to-six-month emergency fund may take time, but the financial security is well worth it.
Step 8: Invest For Your Future
You've paid off your debt, and you've saved up for an emergency. Now it's time to invest for your future. The stock market is a popular place to invest money and if you feel overwhelmed by all of the investment options, then enlisting a financial planner might be best. Through investing, you'll grow your money in a variety of ways.
Some options include:
- Stocks and bonds
- High-yield Dividend ETFs and index funds
- Real Estate
- Peer-to-Peer lending
Smart investing is a great way to reach financial success. Many investment banks have learning centers to teach you about investing if you want to do it yourself. Charles Schwab Bank is one such bank with comprehensive resources for beginners and experts alike. Open an account with Schwab Bank through this link to get started.
Step 9: Increase Your Income
At this point, you're on your way to reaching your financial freedom number, but perhaps you want to get there sooner. In comes the plan for more income. More income can be obtained through a side hustle or operating one or more small businesses. To further increase earnings, invest the money you earn from your side business into passive income paying assets, such as high-yield dividend ETFs and real estate crowdfunding, to name two.
The more extra money that you generate, the more you can invest and the faster you can reach your number. Hustling early on leads to more years of financial freedom later.
Step 10: Build Wealth and Reach Your Financial Freedom Number
The last step of financial freedom requires patience. Wealth takes time to build, but the longer you invest, the more wealth you'll obtain, thanks to compound interest. Once you have enough money, you'll have officially reached financial independence, and you can consider whether or not you want to continue working.
You've reached the point where you can start withdrawing money every month to pay for all of your expenses while preserving the capital you've invested; an amazing feeling.
You've come a long way, and now you can focus on the things in life that are important to you.
What To Do When You Reach Financial Freedom
The sky's the limit once you reach financial freedom. Here are some ideas for what you can do once you no longer need to work:
- Spend more time with family members
- Donate to a charitable cause
- Help your children with a major purchase or their student loans
- Buy a new car
- Move to your dream town, city, or country.
Really, there's no right or wrong answer for what to do once you've reached financial independence. Simply ensure that you don't spend more than you withdraw each month and don't withdraw more than your capital appreciates. Keeping this in mind, and your money will support you indefinitely.
Wrapping It Up
In this article, we discussed financial freedom and the 10 steps for reaching it. Everyone's path to financial independence is different, so make sure to work out a plan that works for you and your family best.