Someone forwarded me this awesome article and I definitely believe its worthy of sharing.
Charlotte writes in with a reader mailbag question to which my answer ran a little long:
“I understand the goal of financial independence. You want to reach a point where you live off of the interest of your investments. I don’t understand how it’s realistic for the average working person to get there before retirement and that’s if you view Social Security to be that kind of return on investment. I mean, I can see it if you win the lottery or something like that, but not as a path that any regular person can follow.“
This is a path that anyone can follow. Ten years ago, I would have found the idea of this kind of financial independence completely ludicrous before the age of seventy. Right now? I think it’s totally realistic and I hope to arrive there within ten years or so.
There are a few keys to making this work that I think will illustrate the process for you.
First and foremost, you need to focus on maximizing the gap between your spending and your income. The “gap” is an idea I often talk about, but it’s avital one. The larger that gap, the faster financial independence will come.
Obviously, there are two ways to increase that gap: spend less and earn more. If you spend less, then you have a larger chunk of your income left behind for saving and investing. If you earn more, than you have more total money to deal with.
Ideally, you’re tapping into both sides of this, and the stronger you push both sides – earning more and spending less – the larger your gap will be and the faster you’ll reach financial independence.
An illustration of this perhaps works best. Let’s say you have a job where you earn $30,000 a year and right now you’re spending every dime of that. You’re paying off student loans, covering rent on a nice apartment, and making payments on a car.
Now, let’s say you move to a smaller apartment that’s really close to the mass transit system. You sell your car, pay off that loan and drop the insurance, and suddenly you’re only spending $24,000 a year. You take that extra $6,000 and throw it straight into your student loans, knocking them out in, say, three years. Now, you’re spending only $22,000 a year.
At the same time, you work hard at your job and move up to $36,000 per year, plus you start a side gig writing a blog about your career focus that earns you another $8,000 per year. You’re now earning $44,000 per year and only spending $22,000.
All of those moves have increased your gap. Things like eliminating cable television, cutting out or reducing a cell phone package, paying off a debt, cutting out frivolous spending – those all reduce your annual spending. Things like getting a raise at work, starting a side gig, seeking out a new and higher-paying job – those all increase your annual income. All of those things increase your gap.
At the same time, increasing your spending or decreasing your income reduces your gap. Often, when people reach a point where their income significantly exceeds their spending, they undergo lifestyle inflation and start buying all of the things that they “deserve” – usually the result of the nonstop marketing messages we’re exposed to. They get a new smartphone. They get a nicer car. They “upgrade” their wardrobe. They start looking for a nicer apartment. Soon, they’re back at a level of spending equal to their income rather than earning more than they spend.
In order to reach financial independence early, you have to avoid this kind of lifestyle inflation. Period. Your annual spending needs to be tightly capped and the excess of your income needs to be socked away.
If this sounds “miserable” or you’re looking for a “compromise,” then you’re not putting financial independence front and center. You have other goals – and that’s fine. However, you can’t simultaneously expect to live a luxurious life and also retire at 45 unless you’re earning an incredible amount of money… but I’m not talking about people who start mega-successful companies.
The truth is that when you hear about people who have achieved that kind of financial independence, they’ve spent a lot of time spending far less than they earn. Now, that can mean that they earned a lot of money or it can mean that they lived a very frugal lifestyle or it can mean some balance of both. What it doesn’t mean is that they “compromised” and had a small gap. In every one of those cases, the gap between their spending and their income had to be sizeable and it had to persist for quite a while.
It’s up to everyone – well, at least everyone who wants this kind of life – to decide how aggressively they want to pursue it. If you don’t want to pursue it hard at all, just contribute to your retirement plan at a notable rate and you’ll slowly move in that direction as retirement approaches. If you’re willing to sacrifice some creature comforts in order to get off the treadmill sooner rather than later, start looking at big spending cuts in your life and start looking at a second job or a side business of some kind, because both will be needed to succeed.
That’s the truth about financial independence. It’s a marvelous goal, but it requires a tremendous amount of work and a fair number of difficult choices to make it there before retirement. Some people are willing to pursue it – others aren’t.
The Simple Dollar