Building Financial Independence
Building financial independence relies on a combination of decreasing cost of living, increasing the amount that is saved, and increasing the amount of money you earn from those savings. Many Americans live paycheck-to-paycheck, which means that they have no savings and no financial independence. For most of these people, building independence is not possible, but for some, financial independence simply requires budgeting.
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 cost 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 increase the amount you save is to set aside money from every paycheck before you spend anything. Determining how much is discussed in greater length later.
Increasing the amount in savings can increase your temporary independence by increasing the amount of money you have to live off of; and it can increase your permanent independence by increasing the amount of money that is working for you (increasing your passive income and capital gains).
Increasing the Efficiency of Savings
Your savings is more efficient when it is producing more income. Increasing the efficiency of your savings would require moving it from something like a simple savings account into something like a mutual fund or into a property to rent out. The amount you have in savings will start growing instead of staying the same. This increases your temporary financial independence by increasing the amount in your savings. This increases your permanent financial independence because it will increase your passive income and/or capital gains.
One Final Note: Factoring in Inflation
Some of you are thinking “that’s good and all, but what about inflation?” 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. It also means that your savings cannot buy as much next year, even though it 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. This means that your savings will be able to accommodate the higher cost of living. If you are permanently financially independent, you should consider the increasing cost of living that arises from inflation.