How to Become Financially Independent in 5 Years or Less
by Sara Glakas
Have you ever heard of a wage slave?
Even worse... are you one?
Wage slaves may live in big houses. They might drive Porsches. It doesn't matter how "rich" you look, if you can't walk away from your job -- even for a second -- because you would no longer be able to pay the bills, you're a wage slave.
Most people want to retire at some point. Some people even want to retire early. Others just want a short-term retirement to raise their kids, travel or simply smell the roses.
Regardless of the "why," the problem is usually the "how." How do you pay your bills without that paycheck coming in each month? How do you escape wage slavery?
First, you need to spend less than you make. If you can't (or won't), you will never be financially independent.
Second, your savings must generate enough income to pay the bills for you. That means a) you must grow and protect your savings, i.e. your net worth, and b) your wealth must generate a decent amount of cash.
Sounds easy enough, right? You'd be surprised how many of us get this wrong!
The World's Worst Investing Idea
If you're like most investors, you probably just heard yourself say, "All I need to do is find a few high-flying investments that supercharge my net worth, then I'll have enough to retire."
Stop right now. You're heading down the wrong path.
If your plan is to double or triple your money by using any number of get-rich-quick schemes -- penny stocks, day trading, excessive leverage -- I'm here to tell you that it will not happen. Ever. You are chum in the water to professional traders who eat investors like you for breakfast.
Warren Buffett, the most famous and successful investor of all time, spends all day every day thinking about what he's going to invest in next. For all his efforts, he has realized an average return of 19% a year over his career. Do you have some reason to think that you can do better and achieve triple-digit returns in your spare time?
You cannot compete with the pros. So step away from the ledge and examine the other elements of wealth creation first. You can achieve your goal of financial independence -- you just have to tackle it from a different angle.
The Fast Track to Financial Independence
A financially independent person's investments generate enough income to live on. But there's another way to look at it: A financially independent person can live on the income generated from his or her investments.
See the difference in perspective?
The first point of view focuses on investing -- a difficult endeavor to control.
The second point of view focuses on spending -- a variable that is very simple to control. Not necessarily easy, but simple. The #1 reason people stay in wage slavery is that they spend too much.
Your savings rate is the percentage of your total income you're able to save, assuming that you need the rest of the income to pay the bills. And if you aren't willing to save more than you spend, I will guarantee you that you'll never have financial freedom.
The beauty of focusing on your savings rate? There's zero risk involved. Anyone willing to make the lifestyle changes to achieve an 80% savings rate can easily retire in five years, and maybe sooner with a little bit of investing savvy.
To find out how soon you could retire, you just need one simple formula. Let's look at an example.
Assume you have a job that pays you $50,000 a year. But you've cut your expenses by so much that you only need $20,000 a year to live comfortably. Your savings rate is ($50,000 - $20,000) / $50,000 = 60%.
Once you have your savings rate figured out, you can use this next formula to calculate how long it will take you to achieve financial independence:
Assuming a 5% return on investment, post-taxes, you can achieve financial freedom in:
- 13.3 years if you save 60% of your income;
- 8.6 years if you save 70% of your income; and
- 5 years if you save 80% of your income.
[Quick caveat: This formula assumes that you're on the fast track to financial independence -- 5, 7 or 10 years. As you can see from the formula, it takes an extreme savings rate to achieve.
If you're on a slower, more traditional path to financial independence -- 20, 30, 40 years or more, it's more appropriate to use a formula that takes long-term compounding -- earning interest on your interest -- into account. Our Simple Savings Calculator will tell you how long it will take to meet your goals.]
The point is, regardless of how far you're willing to take it, knowing that anyone can achieve financial independence in a very short amount of time is powerful stuff. And your savings rate, i.e. your lifestyle, is intimately intertwined with your ability to become financially independent when you want.
Making Sure Your Investments Keep Up
After all that hard work of boosting your savings rate to build your wealth, you don't want your investments to let you down once you need the income. Let's go back to our example to see why.
To generate $20,000 in investment income, you need $399,000 to throw off 5% a year, every year. Congratulations -- your investments are now paying you enough to live on! You no longer need a salary because you've achieved financial independence. Get ready to hand your boss your letter of resignation.
But remember, to maintain financial independence, you need your wealth to keep generating about 5% a year, year in and year out. Small variations in income will even out over time, but you'll need to avoid really massive swings -- especially massive swings lower.
Being reckless and chasing "the next big thing" is as close as you can get to a surefire way to kill your golden goose. Filling your portfolio with risky, temperamental investments that you don't have time to babysit is like throwing money down the toilet.
A better alternative: Only invest in stocks you can buy and hold for five or 10 years, preferably investments that pay dividends and interest income all the while.
If you want to reach financial independence quickly, you need a plan. Luckily, the plan only has two steps. First, get your lifestyle under control.
Here's Three More Ideas to Help Reach Your Financial Independence:
- Free yourself from credit card debt this year. Learn how to pay 0% on your balances for up to 21 months in The 4 Best Credit Cards for Balance Transfers.
- Pay off your mortgage to free up an extra $1,000 to $2,000 every month. Check out 3 Ways to Pay Off Your Mortgage 15 Years Early.
- Shrink and eliminate your car payments.If you're paying 6% APR or more, it's time to know The Top 3 Reasons to Refinance Your Auto Loan.
Second, focus on finding the best investments for generating those powerful passive streams of income over the long run (Check out our Lazy Man's Retirement Portfolio for ideas or work with a trusted financial advisor for help on this).
Follow these steps, and financial independence will be in your grasp faster than you ever dreamed.