The URL of my blog is myfinancialfreedom.blog. But what is financial freedom really about? Financial freedom is the third stage of a journey which fundamentally improves your financial situation step by step. The first stage is financial stability, the second stage is financial independence and the last stage is financial freedom. Financial freedom is most accurately defined such that all your expenses are covered by passive income streams. Read more about the three stages of financial freedom in this blog post!
Stage 1: Financial stability
The first step before even thinking about financial freedom, should be to gain full control of your finances and ensure financial stability. I define financial stability as having i) positive net worth and ii) a fully funded emergency fund.
Positive net worth – defined as sum of all of your assets minus the sum of all of your liabilities – might sound like a very low threshold. But if you bear in mind that there are 16.6 million US households (equivalent to 14% of all households) in this situation, this threshold is in fact not low at all. How would you even get to a negative net worth? I think there could be many reasons ranging from no assets combined with consumer loans or a current account in overdraft, to student loans and excessive mortgages on your home, i.e., with negative home equity.
If you add the second condition, a fully funded emergency fund, it becomes obvious that the threshold for financial stability is actually quite high. 69% of American adults have savings of less than $1,000. So a whopping two thirds of the US population will not qualify for the first stage of financial freedom! This number is quite shocking from my point of view.
For the sake of comprehensiveness, I would highlight that the emergency fund is for unforeseen expenses or irregularities in your life (e.g., broken car, sick family member, you lose your job, etc.). I recommend that the emergency fund covers 3 months of your costs. If you spend e.g., €2.000 per month on all sort of expenses, the emergency fund should comprise €6.000. The funds should be readily available, e.g., in a savings account and is not required to contribute to your investment income. For more details, please refer to my article on the emergency funds (in German for now).
Reaching the stage of financial stability is the first step in the journey to financial freedom. Accomplishing positive net worth and having a fully funded emergency fund, are important steps to have full control of your finances. Not only have you built sufficient reserves to pay for unexpected expenses – this should already give you plenty of peace of mind! What is more important, you have also begun to actively monitor your assets & liabilities and have established a mechanism for saving up money in the regular course of you financial life.
Stage 2: Financial independence
Financial independence goes already way beyond financial stability. In addition to the accomplishments of a positive net worth and a fully funded emergency fund, financial independence asks for passive income streams which can cover all of your fixed costs.
Being able to cover fixed costs through passive income streams, has two important implications: i) you know your fixed costs and hopefully manage them proactively and ii) you have built sizable and well-functioning passive income streams. So, two quite significant boxes to tick!
Fixed costs are defined as expenses which are the same month after month without changes due to our individual spending behavior. Examples include rent or mortgage payments, health insurance, power, heat & hot water charges, the gym membership, etc. The tricky thing with our personal fixed costs is that they occur quasi automatically and eat into our earnings irrespective of what happens. Proactively managing and actually minimizing fixed costs should be a priority for every one of us! The lower your fixed costs are, the more financial leeway and flexibility you will gain. In other words, the lower your fixed costs are, the sooner you will reach financial independence as defined above.
There is a lot to be said about passive income streams, of course! To summarize, passive income streams can originate from capital or systems. You have either gathered sufficient amounts of capital which deliver regular interest payments or dividends, or you have built business systems which generate income, e.g., ad sales on a website, royalties from a book you published, etc. To cover fixed costs, the capital stock need to be substantial or the business systems quite established and well-functioning. In summary, it’s quite an accomplishment to reach financial independence!
Why is financial independence so important and such a critical milestone on the journey to financial freedom? Well, once you can cover all your fixed costs through passive income streams, you are quite independent from regular employment income. This means that you are basically free to quit your job without risking immediate turmoil in your financial life. I am not advocating to just quite your lives as employees as soon as possible. Personally, I don’t see employment as serfdom or wage slavery as others may perceive it. Employment can be fulfilling and enjoyable – I consider myself for instance lucky enough to really enjoy my job! But the knowledge of financial independence will let you make choices at your salaried job very conscious and a lot more reflected – believe me!
Stage 3: Financial freedom
The final stage of the journey is indeed financial freedom. I put up a very high bar for financial freedom to make sure it is sustainable and not dependent on a radically frugal lifestyle or a very bullish stock market. I would consider a person financially free if they:
- Have positive net worth
- Have a fully funded emergency fund
- Can cover all their expenses (fixed and variable/discretionary) through passive income streams
- Can also cover an additional ~30% of their expenses through these income streams
- Have added an extra “volatility buffer” of ~6 month of expenses to the emergency fund, bringing the emergency fund to 9 months of expenses. Indeed, this means planning for the unexpected, as dividends might get cut or a business system may collapse.
High thresholds, you think? Well, the first two criteria you already knew. The others thresholds might seem high, but I don’t see financial freedom as an easy accomplishment anyways! Covering all costs (fixed and variable/discretionary) is the ultimate core of the definition of financial freedom.
But why do I add ~30% of additional expenses as well as a “volatility buffer”, thereby lifting the bar further than you might have expected? First of all, it is uncertain what happens to our lifestyle and spending behavior once we become financially free! It is very unlikely that we profoundly change our habits which got us to financial freedom. Still there is lots of time for additional hobbies, trips and activities which may cost more money than before. In a conversation with blogger who already retired early, it came out that their cost did in fact not rise compared to the life during employment! While there is certainly more room for travel and adventure costs, there is time for the optimization of fixed cost and spending might actually be more conscious than it used to in a hectic professional life. You could therefore be ready for an exciting time with the extra 30% 😉
Finally, you might be surprised about the “volatility buffer”. The rationale behind is that both your actual spend as well as the performance of your passive income streams will be varying over time. You might spend more due to travel or home refurbishments in a given year. Also capital market performance or the actual yield of your system based passive income streams might vary year by year. Rather than having to adjust your lifestyle every year in line with these variations, I advocate for a volatility buffer to compensate for it. The tricky part will be to replenish the buffer in times of lower spend or superior performance of the capital markets!
In which stage am I personally?
I am currently in the stage of financial independence. I could cover my fixed costs (housing, car, insurance, child care, etc.) through the income from my investments, i.e., I can benefit from capital based passive income streams. However, I do not cover my fixed costs through these income streams at the moment. I rather reinvest this income to benefit from compounded interest. Applying this strategy, I intend to reach the next stage, financial freedom, much faster and within the next approximately 2-3 years. Financial freedom might, however, be reached later, if we chose to buy a home eventually.
I feel very fortunate that I have come this far along the journey to financial freedom already. This was mainly possible due the implementation of savings habits early in my life, especially through a mechanism I call “automated saving” – saving 20% of your income and adding 50% every additional Euro earned. This proved to be very powerful for me as I increased my employment income in the course of my professional career.
Let me finish with a question: In which stage are you? Feel free to share where you stand in your journey to financial freedom!