Due to its unclear definition, the idea of “financial independence” is also difficult to understand. The most often recognized definition of financial independence is when you have saved around 25 times your yearly expenses. Your funds are now independent of your paycheck.
The notion of financial independence will change as the FIRE movement grows. Everybody’s financial life is unique, and I believe that everyone achieving financial independence should have a distinct definition so that they know when they’ve arrived.
My Concept of Financial Independence
For as long as I’ve been aware of it, I’ve been a supporter of the Financial Independence, Retire Early (FIRE) movement. In my book, anything that enables individuals to take charge of their wallets and lives earns an A+.
It is often misunderstood, with many people believing it is about “early retirement” and spending 40 years on a beach. The fact is that most people pursuing FIRE are more concerned about “financial independence,” which means having the financial flexibility to work on whatever projects they want.
The limits of FIRE’s conventional math
The conventional concept of financial independence is based on two rules of thumb.
1. The 25 times rule, which claims that you have enough money to retire if you save 25 times your yearly living costs.
2. The 4% rule is then applied to estimate how much of your retirement nest fund you might live on each year.
If you spend $50,000 per year on living expenses, the 25-times rule indicates that you will need at least $1,250,000 to retire ($50,000 X 25). If you followed the 4% rule, you could take up to $50,000 each year ($1,250,000 X 4% ) and meet your living expenses in your first year of retirement. In future years, the amount you remove rises in line with inflation.
It is essential to note that financial rules of thumb might provide a rough estimate but are far from accurate.
The 4 percent rule should not be relied upon by early retirees.
The first drawback of the 25 times and 4% rule is that the study that informed these guidelines was designed for a 30-year retirement. If you intend on retiring for more than 30 years, you run the danger of outliving your money if you rely on the 4 percent rule to finance your retirement lifestyle.
Risks associated with investment assumptions and the sequence of return risks
The 25 times rule and the 4 percent rule imply you have a 50/50 portfolio made up of 50% equities and 50% bonds. Given current bond rates, it may be unrealistic to expect a 50/50 portfolio to provide high enough returns to maintain a 4 percent withdrawal rate for 30 years.
One solution to this dilemma might be to weigh your portfolio such that equities outnumber bonds. This raises the projected return but raises the total degree of risk in your portfolio. A larger stock weighting exposes you to what is known as the sequence of returns risk.
The sequence of return risk refers to the potential that the stock market may fall considerably during your early retirement years. If you remove 4% of your portfolio at the same time, it will lose 20% or more of its value; it is doubtful that your portfolio will be able to sustain your targeted yearly income throughout retirement.
Everyone’s definition of financial freedom is different.
There’s a reason we call financial planning “personal finance.” What constitutes a smart financial decision is mostly influenced by the specifics of your financial condition. Overspending has far more serious implications for someone who is heavily in debt than for someone who has $100,000 in the bank.
Our aims are another distinct element that must be considered. If you want to retire in your 40s, you will need to make quite different financial decisions than someone who wants to retire at 65. When defining what it means to be “financially independent,” it is essential to base your definition on your unique financial situation and goals.
Keep in mind that financial independence is distinct from retirement.
When someone retires, it indicates they no longer intend to work.
You don’t have to rely on your present income to support your lifestyle if you’re financially independent.
Yes, you could wait until you could support your lifestyle fully via your assets, but you’d most likely be waiting a very long time.
You may also be called financially independent if you can support your lifestyle with a mix of your investments and income from a business, employment, or side-hustle that you like doing.
That is the foundation around which I have built my notion of financial freedom.
Financial freedom as understood by me.
When two requirements are satisfied, I shall consider myself financially independent.
1. When my debt-to-accessible-net-worth ratio is less than one; and 2. When my side-business has covered my usual living costs for at least two years.
That term is both particular and technical, so let’s dissect it and make sense of it.
When my assets (excluding the value of my house) exceed my debts, and I am certain that my business will pay my future living expenses, I will consider myself financially independent.
So, what exactly does “debt to Usable net value” imply?
“Usable net value” is a word I used to describe how your money is advancing you toward financial freedom.
It is simply equivalent to your net worth (assets minus debts), which excludes the value of your home as an asset but includes your mortgage as a liability.
Here’s a brief hypothetical scenario to demonstrate the distinction. Assume my assets and liabilities are as follows.
- House: $500,000
- Mortgage: $300,0000
- $25,000 in student loans
- $50,000 in investments
- $10,000 in cash
$235,000 in net worth
Usable net value = -$265,000
In that situation, I’d move from almost a quarter-million dollars in positive net worth to roughly a quarter-million dollars in negative net worth.
I remove the value of my primary residence from my net worth calculation because equity is so tough to acquire, especially if I like living in my house.
What exactly is a debt-to-accessible net worth ratio?
The “debt to equity ratio” is a financial phrase that analyzes the overall amount of debt a firm bears relative to its equity.
In terms of personal finance, I evaluate my overall debt to my available net worth (my equity.)
In the above-mentioned hypothetical case, my debt to accessible net worth would be -1.26 (-$265,000 $235,000.)
Assume that after a few years, I worked on gradually paying down my debts and increasing my investments until my obligations and assets looked like this.
- $500,000 for a house
- Mortgage amount: $200,000
- $375,000 in investments
- $25,000 in cash;
- $700,000 in net value
Net wealth available = $200,000
Debt to available net worth ratio = 1 ($200,000 in debt $200,000 available net worth.)
It’s worth noting that the entire value of my cash ($25,000) and assets ($375,000) is $400,000, which is double the amount of my debt.
This is the moment at which I will feel financially comfortable enough to cease stressing on money savings. The aim would be for my side business to allow me to continue saving a lot of money, but if it only covers my living cost each year, I’ll be financially independent.
Even if I never saved another dollar, my assets would continue to grow over time, and my mortgage would ultimately fall to zero.
I want you to be able to take something practical away from this post. So, my challenge to you is to define financial freedom in your own words.
Here are a few things to think about.
- How much money do you presently have saved?
- Your existing financial obligations.
- How much of your net worth is derived from your home?
- Do you have any children? If so, when do you anticipate them being financially self-sufficient?
- Do you consider a job or a side business to be part of your concept of financial independence?
- If so, how much money do you need to make?
- Do you have a working partner or spouse?
Take your time, think about it, and let me know what you come up with as your concept of financial independence in the comments.