Yup, I could talk about the subject for hours! FI or Financial Independence occurs when your passive income becomes higher than your expenses. That would mean that you could live forever and never need to make money anymore! An easy example, let’s say I spend 30000$ per year. Then following the 4% rule, I would need 750000$ invested to cover all my expenses in passive income only. Let me explain a few things first!
Anything that creates money without you doing anything but taking risk. People refer to this as Assets. Assets have value and will grow, expenses will only go down in value. For example, a car is not an asset because it’s constantly going down in value. It’s a money pit. An house is arguably an asset, in the way that it goes up in value but it’s really a costly asset and can become an expense. A painting can be an asset, a stock, a bond or money in a small business are all assets. An asset is most of the time taxed at a different level than normal income. By the way, a lottery ticket IS NOT an asset because the chances for it to go up in value are statistically negligible.
The income is what the government is charging you big bucks to earn, especially in Canada. You want to limit that kind of income as soon as your passive income is above your total expense or else you will pay a lot of taxes.
The 4% Rule?
This is more of a guideline than anything really scientific because we cannot predict the future. But it’s said that if you only remove 4% of your investments per year, you can technically live forever without affecting your principal.
This is an easy one, yet, really hard to master for some reason. The cash flow is a simple calculation of income minus expenses. If the number is negative, you’re in big trouble. If the number is positive, then that’s what you want, you’re making money! Here is an example: Joe makes 50000$ per year, he lives in Quebec so he gives a whooping 11000$ (or something around that number) to the government. Joe also has expenses of 30000$ per year that he calculated using his nice budget. Here is Joe’s cash flow:
Easy isn’t it? That’s our basis to financial independence.
The control of the cash flow is essential to FI, the column on the right must be the lowest and the column on the left must be as high as possible (after taxes). But to lower the column on the right can be really difficult. You need to make a budget and reduce your expenses to a bare minimum. Why? Because that minimum is going to dictate how much you need to save if you never want to have to work for money again. It’s a lot more difficult to cover 30000$ expenses with passive income than it is for 20000$!
Ok so how long does this takes? 30 years?
Depends on your motivation, your cash flow, but most importantly: your saving rate. If I cost 30000$ per year to live, I need to save 750000$, then I am going to have to lower my column on the right an try to find a way to make the left column higher. All what’s left in my bank account is going to 1. emergency fund, 2. assets. Hey, this can be your house as well or debt, most importantly debt!
Cutting down bad debt
Debt is not good, but especially bad debt. That unpaid credit card, that car loan, or anything that sinks you into the ground must go before you start building real assets. When you repay debt, not only you are doing a great thing to yourself but you are reducing your stress and double building assets because you cut down interest that they would charge you.
Creating a Budget
Hey! It’s not that hard, you can use pen and paper or like me, use Google Sheets which already has a built in budgeting template! But you absolutely need to know how much you spend and where. Some financial institutions like Royal Bank of Canada have tools to track that spending for you, even easier!
Building an Emergency Fund
Third step would be building an emergency fund of a couple of months of expenses however you feel is best for you. I tend to stick with 3-6 months depending on my situation at a certain point in time.
Fueling Up Assets
Investing, that’s what I am talking about! Portfolio building and hey, ETFs and Mutual Funds maybe! Assets will pay you to have your money in them. I’m not talking about the safe stuff that barely beats the inflation, I’m talking about the portion of your assets that pays more which is equity, REIT, small businesses, real estate and the like. Bonds are safe and can help reducing the risk which is good as well but depending on how old you are, you might want to consider more or less bonds.
The green part is what must go into investments/emergency fund, i.e. all the exceeding cash. But wait, let’s revamp Joe’s cash flow a bit! Let’s say Joe really wants to become FI and took some measures to get there. But Joe is an homeowner so he has fixed expenses. He also has a car loan, a wife and one child. That means he cannot cut down as much as he would like. But by making coffee at home, making a lunch before going to work and a few other things. Also by asking for a small raise, he managed to get down to this. Remember that Joe’s wife is working as well!:
How much is Joe making a year? Nope, not 55000’ich, he’s making 43000-24000 = 19000$ a year.
Could You Cut Down Even More?
The answer is: probably! For example, Joe could go to work biking if it’s safe and not too far. He would save a bunch of money in gas and in car repairs. There are always new ways to save more, but one must find what he/she really likes to do and not cut down that. For example, if you really like traveling, that one trip a year might not be a good place to cut because it’s something that makes you really happy and enjoy life. On the other hand, is that lottery ticket really necessary, or that extra shirt? Find what really makes you happy and what is just pure spending.
I won’t go into too much details in this post because I am really just giving some information about FI. Most of the time investing requires a bit more knowledge that you might want to acquire to save yourself big bucks in management fees. Anyways, investing will make your money grow exponentially on the long run and depending on how you invest.
As for myself, using ETFs is the way to go with a mix of stocks, bonds and REIT. I also like to fuel that small business I have. But one could own a multiplex and make money renting it for example. I personally prefer what is non tangible.
What About Joe?
Joe decided to invest in ETFs as well (hey it’s my character, I decide!), he built a portfolio that would return maybe 5-6% annually and will add 19000$ a year in RRSPs, TFSA and, if more space is required, regular investments. Here is what Joe would get approximately:
Thanks to GetSmarterAboutMoney.ca‘s calculator, it will take Joe about 22 years to become FI, but even less because now he reduced his expenses. Around 20 years for Joe let’s say, not bad! If he’s 38, he is going to be done by 58. I will still put 60 because he wants to do a few trips once he retires and because of taxes on regular investments accounts.
I must admit that Joe’s situation is not what people want to hear because most of them wanting to be FI a bit earlier. There is still extreme FI if you prefer. Cut down expenses to a minimum, rent for as long as possible, bike to work, reduce, reduce more! We will take Mary’s example for this one. She’s really dedicated to financial independence and, like Joe, has a job paying around 43000$ after taxes per year but she managed to cut down her expenses to 15000$ per year. Pretty incredible isn’t it? Her income is now 28000$ a year.
Her cash flow:
Her FI plan:
That means it’s going to take her around 14 years because of taxes and the like. That’s more interesting?! Cut down more expenses, make bigger salary or even have riskier investments and you can become FI quicker.
So What Is the Goal?
That depends on you honestly. Many people stay in the workforce even if they are FI. As for myself, it gives me choices, the choice to do what I like and to go where I want. I like to work but I also want to have more freedom and safety from a financial standpoint. Control your finances, don’t let them control you. I have other motivations as well but people will always need to work, that’s why I am not talking about retirement because it’s not what it is. The choice of what to work on and getting money out of the motivation factors can be great.
This post reflects my opinion on the subject, it may differ depending on your situation and other factors. Take this as guidelines I have established from experience.