Programming, Investing and FI

How Financial Independence Indicator Is Calculated?

Let’s have a look at how the indicator is calculated (on the right of this post). I admit that it’s arguably accurate but we need measurement to have an idea of where we currently stand in our FI progress. Indeed, there are many ways to calculate this indication but I will show you mine and you can adjust if you don’t like it.

Calculations!

Expenses

I tend to use the easy way based on the 4% rule. Here is the simple calculation you have to do:

Your expenses per year X 25 = The amount you need in a (personal opinion) 90/10 portfolio.

Note: 90/10 means 90% stocks, 10% bonds.

To illustrate, let’s say I spend 20 000 $ per year time 25 = 500 000 $. That means I need 500 000 $ to cover all my expenses per year forever according to the 4 % rule. The 4 % rule simply says that, based on previous market returns, whatever the market returns in the next years you should be able to keep up with inflation and never touch your capital if you spend only 4 % of the total (including dividends, capital gains and all). Again, this is based on a pretty solid stock portfolio, that’s why you might have to gather a bit more than 500 000 $ just to stay on the safe side.

I have to mention that this rule is still controversial, some people believe it, some don’t. I do think it’s pretty accurate and it’s honestly not your biggest challenge on your journey to FI. Indeed, gathering and investing money is much more important for starters.

Gains

That tells us how much we need to stack up to be financially independent. But now we have to measure how much we make to know when we’re going to be FI. You need to know the amount you can save per year and that will give you the starting point.

Let’s say I bring home 50 000 $ a year (after income tax) and my cost is 20 000 $ (in expenses), then I am saving 30 000 $ per year.

I can then calculate how much time it will take to get to the amount found in the expenses section by running the numbers in the getsmarteraboutmoney calculator.

FI Target

Total

I always tend to go a bit over the amount because you will have to pay taxes on what’s not in tax differed or tax free accounts like RRSP and TFSA respectively. According to this calculation, it will take 16 years at 3.00 %, but if you do better, it might take less time!

Here is what 5 % would give you.

Better Interest Rate

You will notice, while playing with the calculator, that only the thinnest extra percentage makes big difference in the long run. That’s because in the market, time does not heal but rather amplifies! This is how the math of compounding works. In addition, that’s another great reason why you want to pay the less expensive fees possible. In other words, if you pay big fees for an investment like a mutual fund, it’s going to hurt your money big time as the time goes by.

In the end, let’s say you have 60 000 $ invested and need 500 000 $ to become FI, you can do 60 000$ X 100 / 500 000 $ and that will give you the percentage at which you are currently. In this case it would be 12 %.

Other Important Factors

Other important factors to consider are your saving rate and your dedication to create a budget in which you cut whatever is useless and keep what really matters for you. You can make more money but you can also cut on the spending as well! It’s true that we live only once but we live longer than we used to so it’s always good to keep a bit of that money for the future.

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