Building Financial Independence
Both types of financial independence discussed increase based on a couple of factors. Basically, building financial independence relies on a combination of decreasing cost of living, increasing the amount that is saved, and increasing the efficiency of its savings. Nearly 80% of Americans live paycheck-to-paycheck, which means that they have no savings and no financial independence from their jobs. For most of these people, building independence is not possible, but for some, financial independence is just some budgeting tweaks away. If you are trying to figure out how to tweak your budget, then this is where you should focus your changes in order to increase your financial independence.
Decreasing Cost of Living
Decreasing your cost of living helps to build both temporary and permanent independence. The less you spend, the farther the same amount of money goes - or the less you need to be earning to cover it. Therefore, decreasing your cost of living increases your temporary independence because you will be able to survive longer before you run out of money and must return to work. Decreasing your cost of living increases your permanent independence because your passive income and capital gains do not need to generate as much to cover your costs.
Perhaps just as powerful is not increasing your standard of living. “Lifestyle Creep” is the term for slowly allowing yourself to spend more money - it is the financial equivalent of failing a diet and developing a donut habit. Going shopping more often, eating out more, buying a new car instead of a used car - these are all examples of lifestyle creep. Sometimes, it is okay to allow a little lifestyle creep - we discuss that in Getting a Raise - but you should always be careful about how much you allow your lifestyle to creep.
Increasing the Amount in Savings
The most successful strategy to increasing the amount you have in savings is to save money directly out of every paycheck, before you spend any. Determining how much is discussed in greater length later.
Increasing the amount in savings can do two things: first, it can increases your temporary independence by increasing the amount of money you have to live off of; and, second, it can increase your permanent independence by increasing the amount of money that is working for you and therefore increasing your passive income and capital gains.
Increasing the Efficiency of Savings
Increasing the efficiency of your savings means moving them from something like a simple savings account into something like a mutual fund or into a property to rent out. This means that the amount you have in savings will start growing instead of staying the same. This increases your temporary financial independence once it has grown by increasing the amount in your savings. This increases your permanent financial independence because the growth of your savings is what is used to cover your living expenses.
One Final Note: Factoring in Inflation
Some of you are thinking “that’s good and all, but what about inflation?” And you are astute to think that. Over a long period of time, inflation matters. Inflation means that your cost of living goes up every year, even if you are not buying more things. Inflation means that your savings cannot buy as much next year, even though they didn’t shrink.
The solution to this lies in the efficiency of your savings. When you save your money in something like a mutual fund, it will usually (certainly on average over several years) grow faster than inflation. That means that savings of that type are worth as much next year and the higher cost of the same lifestyle is already accounted for. It means that, if you are fortunate enough to be permanently financially independent, you should allow your savings to grow with inflation while you spend the excess to fund your lifestyle. (This means that your passive income and capital gains should actually account for ~102% of your income; the extra 2% will be an increase in principal to ensure that the spending power of your principal stays the same)