Becoming financially independent is something that just about anyone has as a lifetime goal. However, not everyone can achieve it; with the reason being that financial independence is a marathon and not a sprint. It is a process that calls for unwavering effort and commitment over a period of time. On the other hand, everyone has their own definition of financial freedom, so the destination and the path that takes you there is unique only to you.
It is never easy to achieve financial independence. Unless you are ready to implement and stick to the plan, this goal will forever be a dream.
For example, more than 61% of the UK adults are not financially independent according to a study done by King Street Wealth Management.
Ideally, the state of financial independence is where you have enough income to pay your living expenses for the rest of your life without being dependent on others or employed.
How much money do you need to be financially independent?
The good news is that you can start now your journey for financial independence. One of the best ways to gain this status is by investing in assets that will earn you passive income during your retirement years.
But that is easier said than done. Investing is never an easy thing to do, whether you are Warren Buffet or a newbie.
The 4% Rule for financial independence
Luckily, there is a formula you can use to gain financial independence. It is called the 4 percent rule.
The 4% rule was designed after a study conducted in the mid-1990s by the financial advisor William Bengen.
What this rule does is help establish how much of an asset portfolio can cover all your annual expenditure.
For instance, if you had £100,000 in your portfolio when you retire, using the 4% rule, you can withdraw £4,000 in your first retirement year.
According to this rule, 4% of your portfolio should be able to cover your annual expenses and nothing more. This means that your wealth should be 25 times your estimated yearly expenses.
This rule was suggested by the Financial Independence, Retire Early (FIRE) movement. The objective of the movement is for gaining financial freedom and retiring early.
If you want to gain FIRE, you will have to maximize your savings rate by increasing income and or reducing expenses.
The goal is to create enough portfolios until it is able to provide you with enough money to cover your living expenses throughout your retirement years.
Traditionally, financial experts recommend 10% to 15% of saving provided your annual expenses = income – savings, while neglecting your investment returns.
With that framework;
At a saving rate of 15%, it will take you (1-0.15)/0.15 = 6 years of work to save for 1 year of your living expenses.
This example shows that as your saving rates increase, the time to retirement decreases. So if you want to become financially independent in less than ten years, you need to save at a 75% rate to be able to amass 25 times your average yearly living expenses.
The 4% rule works under the assumption that you will not be adding to your assets again after retiring.
Practically, this is not possible since you are not going to spend the next 60 years of your life sitting on the beach with cocktails in your hand.
Another thing, the rule assumes that you will always withdraw up to 4% from your investments, but in some cases, you may not require the full 4%, particularly if you have other income streams, meaning there is a possibility you will leave more funds in your portfolio for growth.
Perhaps one of the biggest drawbacks of the 4% rule is the market dips, which can significantly affect your investments, forcing you to start working again. This is among the biggest risks associated with this movement and is called the “early sequence of returns”.
How to become financially independent
You can achieve a state of financial independence by making some lifestyle adjustments and investing more.
For instance, you can reach this state by:
Reducing your expenses can help you reach financial freedom sooner and is usually the first thing you should be considering when you start this journey.
Think about this, cutting just $100 a month of your expenses can lower the amount you will need to obtain financial independence by a whopping $30,000.
Cutting on expenses can allow you to live on less today as well as in the future, thus reducing the number of funds you will need to invest in order to earn the income required for you to become financially independent.
Another upside of cutting your expenses is that you will have a lot of money to invest, therefore increasing your worth significantly.
Find a way to increase your income
When reducing your expenses, you want to make sure that you don’t get too extreme. You still need good foods and exercises to help you with your overall wellbeing as well as a good house and vacation to relax your mind.
But other than reducing your expenses, you can increase your income. For instance, you could launch a side hustle that can generate your income to complement your current income.
Another way to reach financial freedom is by investing. Luckily there are many ways you can invest your money today in fields such as the stock market, cryptocurrency lending, crowdlending, etc…
Whether you have increased your income, cut down expenses, or both, you are likely to have a lot of money lying around, which you can put toward your objectives of financial freedom.
Eliminate your debt
Eliminating revolving, non-housing debt is one of the best ways to free up money for investing and saving.
There are ways that you can use to get rid of your revolving debt, such as asking your lender to reduce the rate, pay more than the minimum payment due on your revolving account or ask your lender for a lower credit limit.
Knowing where you are financial can help you avoid derailing your efforts for financial freedom.