How to be financially independent? To understand this, lets establish a correlation between a marathon runner and a financially independent person. A marathon runner takes years of training to cover one full marathon of 42.195 kilometres. In first few attempts one may not be able to run continuously even for half a kilometer. But step by step training enables the person to run a full marathon.
Similarly, becoming financially independent is a ‘tough & distant’ milestone of life. It can take years for a common man to reach this milestone. But the process of reaching cam be made very encouraging. Achieving ‘one goal at a time’ can keep the motivation going. No matter how far is the ultimate goal, but sense of achievement (with smaller-goals) will keep the person driven in right direction.
Immense satisfaction is felt when one achieves one smaller-goal. To be financially independent, it is essential to fix the right goals. Target one goal at a time to prevent yourself from getting overwhelmed. Achievement of financial independence can happen only slowly. Take it slow, follow a right direction and one day you can be sure to be financially independent. In this article we will learn about those strategic goal fixing. Right goal fixing is key to the achievement of financial independence. As the process is slow, we cannot afford to have a wrong start. We must take care to prevent the possibility to start-all-over-again. Restarting the process of financial independence start-up can be frustrating.
Step 1: Prepare yourself for the worst: Build an Emergency Fund
People often get sleepless nights thinking what happens to their family in case of job loss. What happens if ones meets an medical emergency? The list of such unexpected expense can be endless. Best is to keep oneself prepared for such extreme, uneventful happenings.
Idea is not to think like a pessimist. Instead financial intelligence asks one to become temporarily critical/pessimist and prepare ones finance for such mishaps. Money is purse can work wonders for people. Imagine yourself backed by $10Mn dollars worth of asset. Will you be still afraid of your boss? Will you be still afraid of annual appraisals in job? Will you be still forced to entertain bully clients? The answer is no. Money/Asset support can do wonders to one personality and the way one leads life. This is the first big leap towards being financially independent. Give yourself a milestone to build emergency fund. To quantify emergency fund, count numbers as ‘number of months of expense’. Suppose Jack’s monthly expense is $1,000. Jack has $2,000 in emergency fund. It means Jack has ‘2 months worth of expense’ in emergency fund. As a rule of thumb one must have a minimum of 6 month worth of essential expense in emergency fund. Do not stop when target of 6 months is finished. Keep funding your emergency fund bit-by-bit each month. The bigger will be the emergency fund the better.
Tip 1 – Start using personal finance software’s like Mint.com etc
Step 2: Take Steps: Become Debt Free
These days it has become too easy for people to avail loans. People are in habit of buying things that they cannot afford. This has become possible as bank loans has become too easy to avail. We often see people buying cars they cannot afford. These days people even buy mobile phones & TV etc on EMI.
As if this was not enough, people first swap their credit cards for high transactions & then convert them to EMI. This is a financial blunder. Rich people avail loan to leverage their profits. Poor and middle class avail loan to buy things they cannot afford. This is one big hurdle in becoming financially independent. I have seen young people in early twenties starting their career with huge education loan to pay-off in next years. These are those people who starts to think that carrying-debt is part of life. But in reality our target should be to be debt free. How to be debt free? The easiest way is to list down all debt/loans that one is carrying (except home loan). Few debts can be like education loan, car loan, personal loan, auto loan, credit card balance etc. Normally financial gurus will ask you to pay-off the costliest debt first. But a more practical suggestion is to start easy. Pick up that loan whose outstanding is minimum. Fix a target and start saving money to pay off this loan completely. Finishing off loan will work as a huge motivation. This will further encourage people to pay-off bigger loans.
Tip 2 – Start using loan prepayment calculators to calculate savings due to early loan clearing.
Step 3: Start Building: Cushion Savings
Emergency savings and debt-pay-off is different. They cannot be counted as cushion savings. What is cushion saving? Consider a pole vaulter falling from 6 meter high level directly on ground. He will really get badly hurt. Now consider that pole vaulter is falling not directly on ground but on one layer of cushion.
In this case his hurt will be reduced considerably. The more will be the cushion layers, softer will be the landing. In financial terms, high ‘cushion savings’ will make a person financially more independent. If question is how to be financially independent, building cushion savings is the answer. I personally know a person who has amassed good cushion savings. One day I jokingly told him “you must have got good salary increment. This is why you are spending so lavishly”. His answer surprised me. He said, “my friend, the money that I am spending now is my 2 years back salary”. I curiously asked him for more clarity. He said, the salary that he earns each month goes directly into bank deposit. He does not touch it to manage next month’s expense. This month he is managing spending from bank deposit that he made 2 years back. Today his 2 years back fixed deposit got matured.
What does this tells us about this person? One thing is clear that this person does not live paycheck-to-paycheck like us. Instead he has enough cushion savings which will last for next 2 years. Even if the person losses his job, he can still manage his livelihood from cushion savings. Creation of cushion savings is an essential step after emergency fund creation and debt repayment. Taking this step will really ensure financial independence for a person. Generally people start investing money soon after emergency fund creation and loan repayment. But this is not the right time to start taking risks. Better approach will be to first build cushion savings. One must have a minimum cushion savings of next 6 month worth of expense.
Tips 3 – Start a new, high interest yielding savings account and name it as cushion savings account. Target is to stop living paycheck-to-paycheck.
Step 4: Start investing money: Retirement
Retirement plan has two big advantages. First it allows us to save tax in short term. Secondly, as holding time in retirement linked savings is very long one can invest in ‘high risk high return’ options. As a rule of thumb, one must invest a minimum 30% of ones gross income in retirement plans.
A part of retirement savings in India (EPF) will be managed by the company in which one is doing a job. But this portion will only be 12% (employee) + 12% (employer). This is mandatory and people cannot avoid it. But the balance 6% (not less not more) must be saved & invested each month by individual. Once a person starts to build retirement savings in tune of 30% per month, serious wealth building starts to happen. It is also true that too must investment in retirement linked pans are also not advisable. That is why we have to put a cap of 30% for retirement plans. One may want to invest more than 30% in retirement plan. But we must invest extra money elsewhere. We will discuss other investment options in step 5 & 6 onwards.
Tips 4 – Start evaluating how much money you need for retirement. If question is how to be financially independent, then substantial retirement fund is a one big leap forward towards it.
Step 5: Start Saving More: Child’s Higher Education
Experts say that nothing eats away more money than an unplanned education expense of children. One often neglect this priority. Imagine, how easy it would have been if one start to save money from the day child is born. Investing $30/month @ 12% per annum will amass $15,600 in 15 years.
On an average, a parent has more than 15 years before this priority becomes an obligation. As a rule of thumb, a person must save 10% of ones take home salary for child’s higher education. Education is becoming more and more expensive every year. It is mandatory for parents to start saving early for child’s higher education. Otherwise at fag end of time one will have to depend on education loan. Education loans are very expensive. Presently in India, education loan comes at an interest rate of 12-13% per annum. Considering that education fund will be required after long period of time (>15 years), one can easily consider investing savings in equity linked schemes. In long term returns from equity is fantastic.
Tips 5 – Start a SIP in equity linked mutual fund & keep the money locked for next 10 years atleast. You will be surprised to see your corpus grow from nothing to millions.
Step 6: Start: Prepaying Loans (Home Loan)
This is particularly true for properties in prime locations held for longer period of time. Hence, even if we delay prepayment of home loan, giving priority to other loan prepayment, is a wise decision. Moreover home loan also allows us to save income tax. But some might still ask why home loan prepayment cannot be in step 3. Why home loan prepayment comes after emergency fund, cushion savings, child education etc? Consider this, suppose one looses job and has no money to manage immediate needs. In this case, to meet immediate needs one may sell the property. What does this mean? It highlights that immediate needs management is TOP PRIORITY. Home loan prepayment helps to save money, but emergency savings creation, costly loan payment, cushion savings creation & child education are MORE important. After one has completed the step 5, he/she is actually very close to financial independence. A person having enough savings, no costly debt, sufficient child-education fund, and has a house of his own, is all set to lead an independent.
Tips 6 – Home loan prepayment can save one huge sums of money. Home loan is probably the biggest debt for a common man. Prepaying this debt should be in common mans priority.