Financial Independence
What is 'financial independence'?
Financial independence is really the pot at the end of the rainbow. It's the mother load of personal finance. I sometimes am afraid to say "financial independence" because people, if they've watched any late night TV and heard "Get rich quick - no money down real estate - become financially independent", are turned off from financial independence. I define financial independence as being able to afford the lifestyle that you desire, without having to work. There are two pieces to that definition that are really important. One: the lifestyle that you desire - whatever that lifestyle may be - it might be right where you are today, or you might have some dreams and goals about where you want it to be. It's coming up with what kind of life you want. The second part of financial independence - and this is the cool part - is being able to afford that without having to work.
Why is financial independence important?
Financial independence, in a word, gives you freedom. It gives you flexibility, being able to afford the lifestyle that you desire without having to work. That's a beautiful thing. Financial independence just gives you choices. It gives you the ability to do whatever you want and not have to worry, "Am I going to be downsized? Am I going to lose my job? Am I going to be able to afford my next mortgage payment?" Financial independence just gives you the freedom and the security that people really, really need.
What is 'earned income'?
Earned income is the sound of your alarm clock going off in the morning. Earned income is when you wake up at five in the morning, it's still dark out, and you go into the shower and you're half asleep. Earned income is basically the income that someone earns by going to work every day. You're trading your time for money. Whether you have your own company, you have your own business, or you work for the man, it's earned income either way.
What is 'passive income'?
Passive income is money that you earn that doesn't require your day to day activity. To earn passive income you don't need an alarm clock. Basically, you earn the money but you don't have to be that involved in the active work. A few examples are if you have rental real estate, so you get a check every month from the renter you don't really have to do that much, or if you have investments and they're earning interest or paying dividends, you don't have to do anything for that. It just come to you passively so that's why it's passive income.
What role does passive income play in financial independence?
Financial independence is all about passive income. The definition of financial independence is being able to afford the lifestyle you desire without having to work. The without having to work part: that is where passive income comes into play.
How does financial independence differ from being 'rich'?
There's a huge difference. There's financial independence and then there's being rich. Let's take a look at two couples. Let's say one couple earns $600,000 a year and the other couple earns $100,000 a year. Which couple would you rather be? Which couple is financially independent? The obvious answer would be, of course, the couple who makes $600,000 a year. That's got to be financial independence. Actually, that only looks at one piece of the equation. Financial independence looks at how much money you are earning, but also, more importantly, how much you are spending. The couple who earns $600,000 but they're spending $700,000 a year do not have financial independence. They are going into debt. The couple who earns $100,000 a year, if they are spending $90,000, well, guess what, that's financial independence.
How does financial independence differ from retirement?
Retirement is inevitable. Retirement comes when you basically aren't able to work or just don't want to work anymore. Usually, retirement happens at about age 60, 65, maybe 70; it's basically when you just stop working. Retirement differs from financial independence because with financial independence, you can be 35 and be financially independent, you can 45 and be financially independent. Just because you retire, doesn't mean that you can afford the lifestyle you desire without having to work, but financial independence does.
What is my 'financial independence factor'?
Your financial independence factor really focuses on financial independence. It's looking at: "How many days each month can my passive income pay my bills?" There's a really fairly simple formula - it looks kind of complicated, but it's actually pretty simple - that will tell you how many days each month your passive income can support your lifestyle. Basically, you start off by putting down your passive income - sources like rental income, Social Security, maybe you have a pension, royalties (if you wrote a song and get money every month). That's included in passive income. The next piece of income to look at are your investments. Total all of your investments - your CDs, your IRAs, your 401(k)s, your taxable accounts. Whatever they are, wherever they are, add them up, put that here, and multiply it by .33%. Why .33%? It seems kind of arbitrary. What that means is over the course of a year, it's about a 4% return, a 4% withdrawal rate. If you have a million bucks and you earn 4% per year, you can conservatively take out about $40,000 a year without dipping into the principal. You would put that here. You would then total what is the total monthly income that you get from passive income and from your investments. You then look at your monthly expenses. Add them all up; put it here. You divide your income by your expenses, and you multiply it by 31. And the result is the number of days per month your income will pay your expenses.
How can I increase my financial independence factor?
There are two ways to increase your financial independence factor. One is to increase your income so there are a couple of things you can do there. You can increase your true passive income, which would be rental income, social security, things like that. You can increase your investments, because the larger your investment account is, the more income that it'll produce every single month. The second one is you can reduce your expenses. So by doing either of those things, you can increase your financial independence factor.
What does financial independence not guarantee?
Financial independence doesn't guarantee that you are going to be happy, unfortunately. I don't think anyone has actually ever been able to come up with a formula for what makes people happy, but we know for sure that just having money alone isn't enough to do it. But, having said that, I'd rather be rich and unhappy than poor and unhappy.
