Personal Finance 101 - Financial Independence
How to Eliminate Debt and Retire with Financial Security
The principles of achieving financial independence and a financially secure retirement are the same throughout the developed world. The key essentials have been known for years, and a moments reflection will show why these have stood the test of time.
Personal Finance Secret #1 - Spend Less Than You Earn
This is the big one. In terms of personal finance, Charles Dickens' fictional character Micawber summed it up when he stated:
"Annual income twenty pounds, annual expenditure nineteen pounds nineteen shillings and sixpence, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and sixpence, result misery."
Achieving financial independence means saving up enough money over a working life so that income from employment is no longer necessary. To do that it is necessary to keep outgoings less than income. There is no other way.
There are only two exceptions to this rule. One is investing in education early in life. Provided a college education increases earning power throughout working life, spending more than one's income to go to university is usually a good idea since a lifetime of extra earning power exceeds the cost of the debt.
The second purchase where it has been a good idea to spend more than one earns has usually been the roof over one's head. This is because this is a need which would otherwise cost rent, and real estate has usually increased in value faster than the costs of a mortgage. As the recession of 2008-10 showed, some sense of proportion is still necessary.
Personal Finance Secret #2 - Carry No Debt Apart from Mortgage and Student Loan
No other exceptions are acceptable for a prudent operation of an individual's personal finances. No car loans, holiday loans, home equity loans etc. If the money hasn't been saved up, the purchase is not affordable.
An important corollary of this is carry no credit card debt. There is nothing wrong in using credit cards, as long as they are paid in full each month. Carry a balance over, and warning signs are flashing. Spending is exceeding earnings, and the result will be misery in the long run.
Personal Finance Secret #3 - Own the House Free And Clear by 50 or 60
Mortgage-holders with children should aim to own their house outright by 60, the child-free should perhaps consider owning free and clear by 50. Income in retirement is usually lower than when working, and paying a mortgage is harder on a lower income. Home renters can factor rent into income needs for #4 below to achieve the same security.
Personal Finance Secret #4 - Aim to Draw down No More than 4% of Retirement Savings a Year
At the start of working life, when earnings increase rapidly, it is easy to spend the extra on lifestyle improvements. Some of that is good - but saving some of the increases in earnings towards retirement early in life is easier than catching up later. A 25-year-old who saves $500 a month until 35, then stops but continues to compound his money at 8% per year ends up with $1,000,324 at 65. Someone starting at 55 saving $500 a month to 65 compounding at 8% will only have $91,473 at 65 (ref 1).
Drawing down at 4% a year in retirement means that for a retirement income of $40000 a year, investment capital has to be 25 times that much - $1,000,000. The 25 year old could get that saving for 10 years at $500 a month, but the 55 year old will have to save more than $5000 a month to achieve it. Drawing down more than 4% a year from the retirement capital risks a financial crisis doing serious wealth damage (ref 2).
Personal Finance - the Secret to Achieving Financial Independence
Spending less than income is the magic from which the rest follows. This common sense principle runs counter to modern culture and the advertising that bombards consumers with the message they can have it all- now, on credit. Spending less than earnings makes it possible to save money and avoid debt. This puts such an individual ahead of those who spend up to their available credit, paying once for their goods and paying again for the interest to borrow the money. #3 and #4 are refinements, saving enough so that the income from capital is enough to live on means financial independence from having to work to make ends meet.
References
1) The 4 Laws of Financial Prosperity, Blaine Harris and Charles Coonradt. Franklin Covey, 2009, ISBN:9781933976860
2) Work Less, Live More, Bob Clyatt. Nolo, 2007, ISBN:9781413307054
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