The journey to financial independence can be a long and difficult road for regular people like you and me. We have been saving and investing diligently for almost 20 years and we’re not quite there yet. Our income is above average and our spending is a little below, but it’s still a long road. We never had any big windfall so our wealth was built solely on our income. Also our lifestyle is modest, but not overly frugal. We only spend a little less than the average US household annual expenditure of $53,495 (Bureau of Labor, 2014.) I imagine most of you are in a similar situation and are slowly working toward financial independence. There is a beginning, middle, and end to this journey. Let’s take a look at these 3 major milestones to financial independence.
1. Spend Less Than You Make
Spending less than you make is the first step on your journey toward financial independence. It sounds simple, but it takes most of us many years to reach this point. RB40Jr is just four and he costs us around $600 per month and I can’t imagine how much college would cost in 13 years. He probably won’t make any meaningful income until he finishes college.
Even then, it’s difficult to spend less than you make. A lot of people fall into the consumerism trap and spend more money than they can afford. Luckily, we always lived within our means and rarely spend more than we make. Hopefully, we’ll be able to impart this important step of the journey to our kid by the time he is a young adult.
Here are the important points in this first step.
- Find a way to make decent income. The easiest way is to get an education in a well paying field and work hard to get ahead. Starting a business and side hustling are also great ways to make money and gain experience.
- Live frugally when you’re starting out. Most of us lived through the starving student phase. We rarely spent money on entertainment and luxuries when we were students and we still enjoyed life. You need to keep that habit for a while even after you land a well-paying job and don’t spend all your income like many young people do.
- Pay off all consumer debt. Those high interest consumer debts are a huge drag on your wealth building progress. It’s like trying to run with those training parachute on. You can do short sprints, but it’s impossible to run a marathon with debts hanging over your head.
- Start investing as early as possible. It’s not enough to save, you need to invest, too. Most young people won’t be able to invest much, but they will gain invaluable experience as the stock market goes through the boom and bust cycles. It takes a long time to formulate an investing strategy that you will be comfortable with and the earlier you start, the better off you’ll be.
2. Invest more than you spend
Spending less than you make is just the first step to financial independence. If you want to get there quicker, you will need to invest a sizeable portion of your income. Most financial advisors advocate saving between 10 to 20% of your income. I don’t think that’s enough. It will take you 40+ years to reach financial independence if you only save that much.
Instead, I encourage you to invest more than you spend. This is a tall order for most people because the gap between income and expense is usually very small. Most people spend almost all of their income, that’s why the US personal saving rate hovers around just 5%.
We have been investing more than we spend for many years now. I had a good income when I was an engineer and we lived a modest lifestyle. It was easy to save more than we spent. We continue to save and invest more than we spend even after I quit my engineering career in 2012. Mrs. RB40 is still working and that gives us a chance to continue saving and investing. We invested $47,677 so far in 2015 and that’s just a tad more than $44,602 we spent. If you invest more than you spend, you will reach financial independence in a reasonable timeframe. This is one reason why it’s important to track your income and expense. You can use your annual expense as a baseline for your financial independence calculation.
Here are some pointers on how to surpass this milestone.
- Increase your income. It’s much easier to invest more than you spend if you make decent income. If you can barely pay your monthly bills, then you should concentrate on increasing your income first.
- Take advantage of the tax advantaged accounts. We have been maxing out our 401k and Roth IRA for years. This helps defer tax and the compound interest will add up through the years.
- Minimize lifestyle inflation. It’s easy to spend more when you get a raise, but you should take the long view and invest most of that instead of spending it.
- Buy income generating assets. Your home isn’t an investment, it’s a liability. You’re spending a lot of money every month to live there. Almost everything you own is just depreciating assets.
- The stock market and rental properties are proven investments. The income they generate should increase over time and beat inflation. These two investments are great ways to generate wealth.
- Reinvestment counts. We reinvest most of our investment income. That’s the basic concept of compound interest. As your investment income increases, it becomes easier to invest more than you spend.
3. Passive income exceed your expense
This is the last step to financial independence. Once your passive income exceeds your expense, then you’ve done it! Unfortunately, most people never reach this point. They either spend too much or didn’t invest enough to generate enough passive income. Of course, there are other sources of passive income such as Social Security benefit and pension. Those are great, but our generation can’t really count on them anymore.
In Q3 2015, our passive income covers about 60% of our expense. That’s not bad, but we’re not quite there yet. We’ll keep working on it until we reach this milestone.
Here are some things to keep in mind while working toward this goal.
- Keep at it. The journey to financial independence is a marathon. It will take most of us 10 to 20 years to get there even if you’re dedicated. Keep at it and eventually, we will reach the finish line.
- Cost of living can make a huge difference. We could move to a lower cost of living location and our passive income should cover all of our expense. It’s tough to uproot your family, though. We love Portland and we’re not quite ready to leave yet. Perhaps that’s why Californians are in such a bad state when it comes to retirement saving.
3 Major Milestones to Financial Independence
So those are my 3 major milestones on the journey to financial independence. They might seem difficult, but we have to remember the journey can take many years. Even to reach the starting point (spend less than you make) already will take up a major portion of our lives. If we are diligent, the 2nd and 3rd leg of the journey will be much shorter than 21 years.
Of course, you’re not quite done even when you reach the 3rd milestone. You need to be vigilant so you can make adjustments as needed.
What do you think of these 3 milestones? Where are you in the journey to financial independence?
For 2018, Joe plans to diversify his passive income by investing in US heartland real estate through RealtyShares. He has 3 rental units in Portland and he believes the local market is getting overpriced.
Joe highly recommends Personal Capital for DIY investors. He logs on to Personal Capital almost daily to check his cash flow and net worth. They have many useful tools that will help every investor analyze their portfolio and plan for retirement.