What is financial independence?
Financial independence is when you are no longer dependent on anyone else to allow you to cover your expenses. This means you no longer need to work to pay for your weekly shop or any of your other living expenses as you are generating enough income from your investments or passive income streams to allow you to cover these costs.
Achieving financial independence is a simple enough idea in that you save more and spend less so that your investments grow quicker and allowing you to live of the returns generated by these investments.
Table of Contents
- What is financial independence?
- Why pursue financial independence?
- Calculate income needed in retirement
- The 4% rule
- Retirement calculators
- Reduce your expenses
- Boost your income
- Passive investing
- Achieving Financial Independence
Why pursue financial independence?
Many people do not enjoy their jobs. They hate the 9 to 5 and long to break free but instead of doing something about it they soldier on. Many of them are working long hours leaving them too tired and exhausted at the end of the day to relax and enjoy themselves. If you can achieve financial independence then you can pack in your job pack your bags and go enjoy your life doing something you want to do.
Financial independence would allow you to forget about your money worries and to spend time looking after your children, or grandchildren. It would allow you to go and see the world whilst you are young enough to enjoy it. It allows you to relax, play golf, yoga and, just chill for a bit.
At the same time, you can volunteer or work somewhere where you really want to work as opposed to chasing the money for your next promotion and the stress that brings with it. Being able to work part-time and bring some enjoyment back into your life certainly sounds appealing but how do you become financially independent?
Calculate income needed in retirement
If you want to achieve financial independence then the first thing you need to do is to calculate how much money you spend each year to know how much you need to make to become financially independent.
To do this you need to use a budgeting spreadsheet such as the one at Moneysavingexpert or to use a good old fashioned pen and paper. Essentially you need to know how much your outgoings are on food, rent, utility bills and all your other costs. You need to include all your annual costs so do not forget to include one-off costs such as holidays, having the car serviced or buying birthday and Christmas presents for your friends and family. Be sure to include some emergency costs to cover unexpected expenditure on items such as having to replace your boiler or have your roof fixed. Once you know this figure you can work backwards to know how much money you need to make to cover these costs.
The higher your annual spending then the longer it will take you to achieve financial independence. How long is that I hear you ask. Well, it depends on what the Safe Withdrawal Rate is? This is the rate that you will be drawing down on your savings and needs to be able to last you through retirement. If you burn through your money too quickly you will need to make money elsewhere during retirement to sustain your lifestyle such as working as a barista. The aim is therefore to have a number that is safe.
The 4% rule
Many people aiming to achieve financial independence and to retire early such as use a figure of 4%. This figure comes from research that was carried out by 3 professors of finance at Trinity University and is widely known as the Trinity Study. This study analysed data from the markets from 1925 to 1995 and concluded that a safe withdrawal rate was 4%.
You can then take your annual spending figure of say £25,000 and divide it by 4% to give you your Financial Independence figure of £625,000 meaning you would need to have £625,000 to be financially independent. To work out how quickly you can reach this magical number you need to divide this £625,000 by the amount you are saving. So if you are saving £20,000 a year it will take you 31.25 years to reach financial independence if you have no savings already. If you have savings then you need to reduce the £625,000 by the amount you have in savings.
It sounds obvious but if you want to achieve financial independence quicker you need to be reducing your expenses or increasing your savings rate or preferably both.
Reduce your expenses
Cutting costs allows you to save money and make your budget go further.
One of the biggest costs most people have is their mortgage and reviewing this on a regular basis to ensure you are on a competitive rate. Other areas that should be reviewed regularly are utility suppliers, home insurance, broadband packages, credit card rates, personal loans and car insurance. These can all be quickly compared quickly using price comparison sites such as comparethemarket or moneysavingsupermarket amongst others.
Other areas where costs can be cut are grocery shopping as do you need to buy premium products or would the supermarket’s own branded products taste just as good but at a cheaper price. Do you need that coffee on the way to work in the morning? Do you need to have the latest iphone or can you get by on a slightly older version which is still a good product and is quite a bit cheaper than the latest model?
Boost your income
To increase your income you can ask your boss for a raise, take on extra shifts, look for a better paying job or try to get promoted at work.
Your income is not restricted to your main job though as you can look for a second job or some side hustle that will allow you to make some money in your spare time by offering services on sites such as Fiverr or in the real world by offering gardening services, dog walking, renting out a spare room or any number of different money-making opportunities.
You can also earn income from passive money making ideas such as renting out a spare room, making sure your savings are in the best savings accounts, suing peer-to-peer lending and selling photographs or ebooks online.
You can also earn money by decluttering your home and selling old books, clothes, toys, and electrical gadgets on eBay or Facebook to raise some additional cash.
A good way to save money on your investments is to invest in Tracker Funds as these have low fees and tend to track the market. Tracker funds are advocated by Warren Buffet as he recommended Vanguard as the fund manager he would use in his annual report to Berkshire Hathaway annual report previously.
The advantages of Index Funds are they are cheap as they are not constantly trying to beat the market so incur significantly lower dealing costs and they track the market. Very few active managers can consistently beat the market despite their higher fees so it makes sense to pay less and track the market.
Achieving Financial Independence
Anyone can achieve financial independence if they can reduce their expenses, allowing them to save their money and to invest this wisely so that they can achieve Financial Independence sooner.