No matter what your current financial situation, you can take control of your financial future. With a few simple steps, you can improve your financial situation, build and grow wealth, and ultimately become financially independent.
Becoming financially independent is a journey. You won’t read about any get rich quick schemes here. I won’t say that no one ever gets rich quickly. It does happen to a select few but I attribute that to luck and fortune.
Instead I am going to give you a guaranteed path to becoming financially independent. These three steps will ensure your net worth increases, your financial situation improves, and you become financially independent.
Step 1: Take control of your money
The journey to financial independence begins with understanding how you are using your money.
Begin by creating a personal budget that lists your income and all expenses. It may be helpful to look at your past few months of expenses to see how you have been spending.
Once you have listed all income sources and all expenses, subtract the expenses from the income. The difference between your income and expenses is the amount of money you can save. In step 3 I’ll discuss more about how to put this money to work for you. To build wealth, your income must exceed your expenses.
If your expenses are more than your income then you are building debt, not wealth. This means your net worth is decreasing, not increasing. If you are in this situation, you should immediately reduce your spending and/or increase your income so that you are earning more money than you are spending.
Step 2: Increase savings (make more and spend less)
To build wealth you must start putting your money to work for you. The more money you save, the more money you put to work for you, and the faster you will achieve financial independence. There are two ways to increase your savings: increase income, reduce expenses (or both).
Finding ways to reduce your expenses can be a quick way to save more money. You can begin by reviewing your budget and looking for areas to reduce spending. Some ideas include eating out less often, replacing cable TV with streaming services, and paying off debt.
There is a limit to how much you can reduce spending because some expenses are necessary. I believe that finding ways to increase your income is also necessary and even more impactful than reducing expenses. The potential to increase your income is unlimited. Whereas the ability to reduce your expenses is limited by how much money you currently earn. The maximum you could ever save (if you had no expenses) is your entire paycheck. But if you increase your income you can save much more.
You can increase your income in a variety of ways. Some examples include getting a raise, getting a new job, getting a second job, getting a side hustle, or creating passive income (more on this later).
Although you might not be able to increase your income as quickly as you might be able to reduce your expenses, increasing your income can be more impactful to your finances over time.
Investing in yourself and gaining new skills to get a new job or developing a side business will take time. But it can provide large income increases that will go a long way towards increasing your savings.
Active income vs. passive income
Active income is income that you have to directly work to earn. This includes both hourly and salaried employment as well as many self employed businesses when owners actively work. Basically income is considered active if you must continue putting in effort to continue earning the income.
Passive income is different in that you earn passive income whether or not you actively work. Examples of passive income include rental real estate income, stock dividends, and small business income (when active participation is not required). Note, we’ll get into this more in step #3.
Because there are only so many hours in the workweek to earn money, the amount of active income you can earn is limited by how much you are able (or willing) to work. Passive income enables you to earn additional income without putting additional demands on your time.
Whether you reduce your expenses or find ways to increase your income, the first steps towards financial independence begins with spending less than you bring in so that you can save the difference. This savings, the difference between your income and expenses, is what you can put to work for you as you move toward financial independence.
A quick note before getting into step #3: if you don’t have one already, you should create an emergency savings fund of about 3 to 6 months of your typical monthly expenses. This fund should only be used for emergencies such as major home repairs or loss of a job. This money should be liquid, meaning that it should be held in an account that you can access immediately (not stocks, bonds, or CDs). I recommend a high-yield savings account so that you can earn some interest on this as well.
Step 3: Invest and put your money to work
Once you have created some savings you need to put that money to work for you by investing. You must invest to become financially independent! There are two primary reasons why:
- Investing will enable you to use compound growth to help you reach your goals faster
- If you don’t invest, inflation will reduce the purchasing power of your cash savings
It is extremely hard to simply save enough cash in a bank account or “under a mattress” to ever become financially independent for the rest of your life because inflation is working against you and compound growth is not working for you.
Let compound growth work for you
Investing enables you to use compound growth to your advantage. Earlier we discussed creating passive income. Basically the concept of compound growth is creating passive and taking that and re-investing it so that your passive income starts creating it’s own passive income. As this continues to happen over and over, your investments grow exponentially.
Inflation and the risks of holding cash long-term
Many people feel that investing is risky and cash is safer than investing. Over short time periods this is absolutely true which is why you should hold your emergency fund in cash (in a high yield savings account). However over longer periods of time, investing is actually less risky than holding cash.
Inflation is a measure of how much prices increase over a period of time. As prices rise, the value of your cash loses it’s purchasing power. Investments (including holding cash) can be measured by their “real return” which is the return after subtracting inflation. For example, if an investment increases by 8% in a year, but inflation is 3%, then the real return is 5%. Note, the nominal return is 8%.
Cash is also an investment as it’s a choice to invest in the U.S. dollar (or other currencies). Using the same example with 3% inflation, if your cash generates a 2% return in a high-yield savings account then your real return is -1%. If your savings rate is 0%, then your real return is -3%.
Holding cash over a long period of time will ensure that your real returns are negative and your wealth will erode over time. Between 1990 and 2018 the purchasing power of cash declined by 49%.
How to invest
There are countless available assets that you can invest such as stocks, bonds, mutual funds, ETFs, derivatives, real estate, small businesses, currencies (including crypto currencies), and even collectibles. With so many options I recommend only investing in proven types of long-term investments that have a history of returns. These investments are lower risk than other more speculative investments.
Investing in a diversified portfolio of multiple types of assets (stocks, bonds, real estate) using low-cost ETFs is one of the simplest and best approaches to investing for financial independence. This will both enable your savings to grow as well as reduce the risk of large losses from being invested too heavily in any given investment. Here’s my guide on How to build a diversified investment portfolio
The amount of investment risk you take will depend upon your risk tolerance as well as how much longer you have until your expected retirement age at which you will need to begin using the money. As your investment portfolio value grows and you approach financial independence risk management become more important.
Even if you’re not close to financial independence or retirement yet, you’ll need to start thinking about the types of investment accounts you should use. Different types of accounts will affect the taxes you pay now and in retirement differently. Using employer retirement plans (401k, 403b type plans), traditional IRAs, or Roth IRAs are some of the most popular options and generally better than a regular brokerage account. However there are a number of eligibility requirement and other considerations. You can read more about how to get started investing here: How to start investing (4-step beginner’s guide)
Reaching financial independence
There are various approaches to estimating how much money you will need to retire or become financially independent. Likewise there are countless retirement calculators in the internet. But one of the common approaches to quickly estimate how much money you will need is the “4% rule.”
This rule says that you should have enough wealth so that in retirement you withdraw about 4% of your wealth every year for expenses. The concept is that your investments will (usually) generate more than 4% so if you withdraw 4% annually you will never deplete your savings no matter how long you live.
To estimate how much wealth you need, divide your estimated retirement expenses (or your current annual income) by 4% (or just multiply by 25). For example, if your expected expenses are $60,000 in retirement, then you would need $1,500,000 in assets.
Once your wealth reaches this figure you have achieved financial independence. This will afford you more freedom in how you spend your time, whether you choose to continue to work, volunteer, or simply enjoy retirement.
If you follow these three steps you will become financially independent.
Remember, it is a journey. The amount of time it takes to become financially independent will depend upon how much you are able to save and invest. The more you can save and invest, the faster you will achieve financial independence. Best of luck on the journey ahead!The more you can save and invest, the faster you will achieve financial independence. Click To Tweet