In our last post (here) we went through the power of defining your vision and goals and the merits of saving vs. spending. In this post we will go through the math behind financial freedom. We have Mr. Money Mustache to thank for this simple math, check out his blog here: Mr. Money Mustache. Reading his posts have helped me bring my background in financial planning and my vision as a financial professional together to give me a strong purpose as a Financial Planner. This purpose drives me every day.
Step 3: Make your Budget
The math behind financial independence is wildly simple and it starts here:
“Budgeting is telling your money where to go instead of wondering where it went.”
How much do you spend every month? Do you know? If you don’t, you should. Your monthly expenses and the income you bring in to support them are the basics of your financial life. If you spend every dollar you bring in, you won’t get ahead. If you spend a little of what you bring in, you will have success beyond your wildest dreams!
Many of us don’t know how much we spend on a monthly basis, this is why we need to budget. You need to direct your income where to go so that it doesn’t fly out the door for things that don’t matter to you. This goes for recurring expenses (food, rent, utilities, student loans, cell phone, etc) as well as discretionary expenses (these are expenses that aren’t recurring and are in reality optional).
1. Gather a few months of your statements.
2. Go through your statements and categorize your purchases and expenses on a separate sheet of paper.
3. Review each category
· Does your spending line up with your goals and values?
· Are there any categories you can reduce or eliminate?
· Are you overspending in any areas? If so, take a moment and ask yourself why?
4. Take some time and set spending limits for each category
· See if you can stick to these for the next few months.
· Note if you are overspending in any one category, is an adjustment necessary?
This process can be an eye opening experience for you! The point of a budget is not only to help you prioritize your savings and set limits for yourself, it can also be helpful to those that are “fearful” of spending their money. For those it shows that it’s OK to spend some money and still accomplish your goals. For those of you that are spenders, see if you can go a month or two without an impulse purchase. Sleep on big financial decisions for a few nights before you pull the trigger on a purchase. Use this exercise as a spring board to make some financial changes in your life that you have been delaying.
Make a budget.
Step 4: What’s your Net Worth?
Alright, you’ve worked through your budget and know how much you're spending, what’s next?
If your goal is financial independence, your investments need to spit out enough income to support your monthly expenses. We need to figure out how much you need invested/saved to make that happen.
The tipping point is usually about 20-25 times what you spend on an annual basis to make financial independence your reality. If you spend $30,000 a year, you will need between $600k and $750k saved/invested to make that happens. That may seem like a lot of money but the point of this exercise is to show you the math behind it so you start to believe it can and will happen for you. To make it a reality you need to let simple math and compound interest work for you. In Mr. Money Mustache terms, if you live off 1/3 of your income you will be able to save and invest the other 2/3. Since you need 20x what you spend, after ten years (10 years x 2/3 of your income you have been saving = 20/3 of your expenses). After 10 years you will have enough invested and in the bank to become financially independent and live off the income that your investments spin off. This math is variable and you can change it to suit your needs. As an aside, just because you have achieved financial independence doesn’t mean you have to quit your job. It does mean you can if you want to! That’s the point of this!
So, how do you know when you’ve hit your financial independence number? What’s your yardstick for success? Your yardstick is NET WORTH and you need to track it. All this takes is a sheet of paper and some time. Grab your account balances (assets) and balances of debts that you owe (liabilities) once a month and use this math to track your progress:
1. Add up your assets
2. Add up your liabilities
3. Subtract your liabilities from your assets (assets-liabilities=net worth)
4. The number you are left with is your net worth!
How does your number compare to last month? Has it grown? Has it fallen? How do you feel about your progress? What’s important is to keep an eye on this number and how it’s trending. As time goes on you will become aware of how your spending and saving habits change this number. There is also data aggregation software you can use to track your budget and net worth in a more efficient manner. I use Mint and Advizr to track these numbers for myself. Check them out.
Track your net worth and reflect on your progress regularly.
That’s it! That’s the simple math behind financial independence.
The next post in this series is on what hindrances may currently exist in your financial life and the powers you can use to accelerate growing your net worth.
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