What’s the difference between being financially free and being financially independent? What do these terms really mean?
Many people use them without fully understanding what they mean or how to get there.
In this blog post, I’ll go through the five steps to reach financial freedom – and even generational wealth.
Level 1: Debt-free
First and foremost, you need to get rid of all your expensive debt. This could be consumer debt, quick loans, and overdrafts on your credit cards.
It doesn’t make sense to start investing if there’s a hole in your bank account where money is pouring out.
The rule of thumb is that you can start investing if you expect the return on your investment to be higher than the rate on your loan.
If you pay 15 percent on your loan and expect to get a return of 8 percent on your investments, you’re setting yourself up to lose money. You pay more for your loan than you gain on the investments.
In reality, it’s hard for beginners to get a consistent rate of return that’s higher than 10-15 percent a year, so any loan with an interest above 10 should be paid off as soon as possible. This should be your first priority.
But if you have a mortgage of one or two percent, it’s a no-brainer to keep that loan and start investing, as it’s not too difficult to earn more than that in the stock market.
Level 2: Financial security
To reach level 2, you need to build enough cash savings to cover any unforeseen expenses like car repairs, a new fridge, or sudden medical bills.
You should have about a month’s salary in a separate account for these kinds of unforeseen events so you don’t stress out about money on top of having to deal with some kind of misfortune.
Knowing that you have the money for any sudden mishaps creates a sense of calm in your mind – and you really need that if anything happens.
Level 3: Financial Self-Reliance
To reach level 3, you need enough cash savings to be able to quit your job at any time.
This should be about six months’ salary, preferably in a separate account.
Having this will create a feeling of freedom and having the luxury to choose. When you get up in the morning, you go to work because you choose to, not because you have to.
Level 4: Financial Independence
To reach level 4, you need to invest and be able to cover basic expenses like food and housing with the return on your investments.
How much do you need?
It depends on both your expenses and the return you expect to make on your investments.
Here’s my method. It assumes that you get a minimum return of 15 percent:
- You add up your monthly expenses.
- You multiply that by 12 to get a year’s worth of expenses.
- Then you take the yearly amount and divide it by 0.08.
- That’s the amount of money you need to have invested with a minimum return of 15 percent.
A little note here: Not everyone can expect to make 15 percent consistently in the stock market. It requires a method, and for me, value investing has worked well. You can read more about how I invest in my e-book by clicking here.
If your basic expenses add up to $2,000 per month, you need $300,000 invested at 15 percent.
Knowing that you’ll never have to let your kids go hungry or leave your home creates a feeling of security.
But be aware: at level four there is no room for luxuries like parties and vacations.
Level four is meant as an alternative to unemployment benefits.
If you want to include fun and luxuries, you need to get to the next level…
Level 5: Financial Freedom
To reach level 5 you need to create a consistent return that can cover a completely ordinary life with all the normal luxuries like ski trips, birthday parties, and living upgrades.
How much money do you need to live well and have fun?
It’s the same method as above – you just add all the fun and parties to your expenses and divide the total by 0.08.
Why divide by 8 percent if you expect to make 15 percent annually? Because you want to save room for taxes and have a margin of error.
What if you don’t expect to make a consistent 15 percent return on your investments?
What if you invest in index ETFs and expect around 8 percent annual return on average?
You do the same as before, add up your monthly expenses, multiply by 12 to find yearly expenses, and instead of dividing by 0.08, you divide by 0.04.
What do you do when you reach this level?
You can either stop and decide to live comfortably for the rest of your life.
Or you can also choose to advance to the next level…
Level 6: Generational Wealth
At this last level, you have more than you can spend, and you can influence the world by giving to charity.
Did you know that Warren Buffett has donated more than $37 billion to charity? Imagine how much you can change the world with $37 billion.
The family behind the Danish shipping firm Maersk created a fund that donates money every year to things like helicopter landing sites and new football fields. Their most important donation was the Copenhagen Opera House, which was the most expensive opera house in the world at the time of construction.
When you reach this level, you’ll be able to impact the world long after you die.
If you were to set up a fund that donated money, what causes would you want to support?
To learn more about investing, read my e-book. You can download it here.