How to Become Financially Independent
Financial independence is usually defined as having enough wealth to support your lifestyle without having to work. Sounds great, right? But how can you become financially independent?
Becoming financially independent is not an overnight process and takes hard work and dedication. But, no matter what Level of Financial Independence that you’re currently at, FI can be achieved by taking a series of steps and making smart decisions.
8 Steps to Financial Independence
1) Understanding Your Current Financial Status
The first step to becoming financially independent is to understand your current financial status. This involves getting a clear picture of your income, expenses, debts, and investments. You can start by making a list of all your debts and expenses. This includes everything you’re currently spending money on including your rent or mortgage, utilities, food, transportation, entertainment, student loan payments, car payments, etc.
Once you know all of your expenses it’s time to figure out all of your income sources, including your paycheck, rental income, dividends, stocks, savings account interest or any other sources income you might have.
There are two main levers to pull when becoming financially independent, you can either decrease your expenses or increase your income, but ideally you will do a combination of the two.
So start looking at all of your unnecessary expenses first and start with the largest ones. For example, you could sell your new car which has a $500.00 monthly payment on it and buy a much cheaper car that will help you achieve your goals of becoming financially independent.
Once you have a clear understanding of your income and expenses, you can create a budget. This will help you determine how much money you have left over each month after paying all your bills. This extra money should first be used to pay down debt, then build an emergency fund, then for investing as you work your up the ladder of Financial Independence.
2) Paying Down Debt
Paying down debt is a crucial step in becoming financially independent. High levels of debt can put a significant strain on your finances and limit your ability to save and invest. One of best way to pay down debt is to focus on paying off the debt with the highest interest rate first. This will help you save money in the long run as you will pay less interest over time.
There is also a strategy known as the Snow Ball Method. The Snowball Method is a debt repayment strategy that involves paying off debts in order of smallest to largest, regardless of interest rate. The idea is to start with smaller, easier-to-pay debts to build momentum and motivation to tackle larger debts.
Here is an example of how the Snowball Method can be used to pay off three different credit card debts:
Credit Card A: $1,000 balance, 18% interest rate
Credit Card B: $2,500 balance, 18% interest rate
Credit Card C: $3,000 balance, 22% interest rate
If you have $500 each month to pay off debt, then make the minimum payments on cards B and C and put the rest towards paying off Credit Card A. In a couple months Credit Card A will be paid off and you can then repeat the process with Credit Card B.
3) Building an Emergency Fund
An emergency fund is a pool of money that you set aside for unexpected expenses, such as a medical emergency or a car repair. Having an emergency fund can help you avoid going into debt during tough times. It is recommended that you have enough money in your emergency fund to cover three to six months of expenses.
Also, be sure to have your emergency fund in an easy to access savings account and don’t be tempted to put it into stocks or Bitcoin, we’ll get to the investing stage later.
An emergency fund should be easily accessible in case of unexpected expenses, such as a job loss, medical emergency, or car repair. A high yield savings account is a relatively low-risk option that provides a modest return compared to investments like stocks or mutual funds. Additionally, savings accounts are FDIC insured, meaning that the funds are backed by the government, providing added security. This can give peace of mind knowing that the emergency fund will be there when it is needed and will not be subject to market fluctuations that can occur with investments. Ultimately, the goal of an emergency fund is to have quick access to cash in case of an emergency, and a high yield savings account is a good option to achieve that goal while also earning some interest on the funds. There are a lot of options out there and Ally (as of 2023) has rates between 3-4%.
4) Investing in Retirement Funds
Investing in a company-offered 401(k) plan can be a great way to save for retirement and build wealth over time. If your company offers an employer match, it can be especially attractive because it is essentially FREE MONEY. An employer match means that the company will match a portion of an employee’s contributions, usually up to a certain percentage.
Some employers will match 50% or even 100% of your contributions. So if you put in $1,000 you can automatically get a free $500 or $1000! This is usually capped at a certain percentage of your salary so be sure to talk with your boss or HR manager to figure out how you can fully take advantage of this option because it can be a significant boost to your retirement savings.
Investing in a 401K or IRA also has tax benefits, as contributions are made pre-tax and grow tax-free until they are withdrawn in retirement.
5) Building a Diversified Investment Portfolio
In addition to investing in a retirement fund, it is also important to build a diversified investment portfolio. A diversified portfolio means that you invest in a variety of assets, such as stocks, bonds and real estate. This helps to minimize the risk of losing money because you’re not relying on a single investment to provide all your returns.
If you’re new to investing, then the simplest way to get started is with low cost index funds that track the S&P 500. With the click of one button you can instantly buy shares in the top 500 companies in the US!
While it is tempting to try and pick individual stocks, there are several benefits of investing in the S&P 500.
Diversification: The S&P 500 is a market capitalization weighted index that tracks the performance of the 500 largest publicly traded companies in the United States. By investing in the S&P 500, you can spread your investments across a wide range of industries and sectors, reducing the impact of any single stock’s performance on your overall portfolio. This helps to mitigate risk and can lead to more consistent returns over time.
Low Costs: Investing in an S&P 500 index fund typically has low fees and expenses compared to actively managed funds or individual stocks. This can help to maximize returns and minimize the impact of fees on overall portfolio performance.
Convenience: Investing in the S&P 500 index is easy and convenient, requiring only one investment decision. You do not need to spend time researching and picking individual stocks, which can be a time-consuming and complex process. The S&P 500 is widely followed and well-established, making it an accessible investment option for many people.
6) Living Below Your Means
Living below your means is another key to becoming financially independent. This means spending less money than you earn and avoiding unnecessary expenses. This can include things like eating out less, cutting back on entertainment expenses, and reducing your monthly bills. The great thing is, is that once you learn to live with less, you’ll realize that you don’t need all of this stuff to be happy. This also makes you less reliant on these luxuries which can increase happiness and peace of mind.
7) Avoiding Lifestyle Inflation and the Hedonic Treadmill
One of the main reasons that most people never become financially independent is because of lifestyle inflation. This is the tendency to increase your spending as your income increases. While it is natural to want to improve your lifestyle, it is important to avoid this trap as it can quickly eat away at your savings and prevent you from becoming financially independent. Instead, try to live on a set budget and only increase your spending as necessary.
The Hedonic Treadmill is a psychological phenomenon that refers to the tendency for people to quickly return to their baseline level of happiness after experiencing a positive or negative event, regardless of its impact on their life.
This can result in a never-ending cycle of chasing after pleasure and material possessions, thinking that they will bring happiness, only to find that the initial burst of happiness is short-lived.
The hedonic treadmill is fueled by a number of factors, including societal and cultural pressures to pursue material wealth and success, the brain’s tendency to adapt to new stimuli, and the human tendency to focus on what is lacking in life rather than what is present.
By recognizing and understanding the hedonic treadmill, individuals can make conscious choices about their priorities and strive for a more fulfilling and meaningful life, rather than constantly chasing after fleeting pleasures.
8) Staying the Course
Becoming financially independent requires a mindset shift. You have to want it more than your brand new car, big screen TV, etc. Similar to losing weight, a short term mindset will usually fail and you’ll eventually be back to your old habits.
So, when times are tough or your motivation is low, it’s important to take a long term view and stick with your plan.
Always remember that the path to Financial Freedom is a marathon and not a sprint. It requires discipline, patience, and a long-term mindset. By following these steps, you can take control of your finances and become financially independent.