August 10, 2010

Six Stages of Financial Freedom

A while back I reviewed a book called The Complete Idiots Guide to Getting Rich   One of the ideas in the book that I really liked was what they called the 5 stages of wealth.   (see my review for details on their 5 stages)    Their idea got me thinking about the different stages of financial freedom.    Wealth and financial freedom are pretty similar but I have a little different take on the idea of financial freedom and I think theres some different milestones.   So I decided to start with their idea and give it my own twist and interpretation to create 6 stages of financial freedom.

This is what I came up with:

6 Stages of Financial Freedom

Stage 1 : Spend less than you earn.
Stage 2 : Pay off consumer debts
Stage 3 : Build a solid cash reserve
Stage 4 : Assets generate income to pay basic living expenses
Stage 5 : Assets generate income for comfortable living standard
Stage 6 : Assets generate income for comfortable living plus luxuries and some left over

Stage 1 : Spend less than you earn.   

This is the first step towards achieving any kind of financial success.  If you're spending more than you earn then you'll just be digging your debt hole deeper and you'll never get financial freedom.   Once your spending is under control you've got the ship pointed in the right direction.

Stage 2 : Paying off consumer debts

Paying off your credit cards and other consumer debts is a good step towards financial freedom.   Freeing yourself from credit card debt is a major milestone in financial freedom.   Lacking obligations to debts is part of being financially free.   You could include your student loan debts in this step as well especially if the debt is at a higher % rate.  I do not include mortgages in this stage since they are based on the homes equity.

Stage 3 : Build a solid cash reserve

A solid cash reserve will give you financial freedom so that you can get through a short term economic hardship such as job loss or unexpected major expenses.  Having a large pile of cash gives you a lot of financial freedom.  If you don't have cash on hand then you may feel tied to a job you hate or stuck in a situation that is not a positive one.   A decent amount of cash will give you the money to do things that you wouldn't have the option to do otherwise.    Your emergency fund can be some of your cash reserve but this stage is more than having a basic emergency fund.

Stage 4 : Generate income to pay basic living expenses

The next step is to build assets or investments that will start to generate income for you.   The style of investment is up to you.  You might have dividend paying stocks, rental properties that generate rent or simply bonds that pay a yield.    Your goal for stage 4 is to get enough investments so that they can generate enough cash flow to pay your basic living expenses.    By 'basic living expenses' I mean your utilities, food, clothing and some minimal amount of discretionary income.   This is a lower standard of living than most of us would choose for ourselves but enough money to live off of if you had to do so.   Once you've accomplished this stage your financial freedom will increase because you won't be solely dependant on working for an employer or the state of the economy around you.   If you get laid off abruptly then you can fall back on the cash flow generated by your assets.  Your own assets will give you a safe financial base you can fall back on if you ever need to or want to.

Stage 5 : Generate income for comfortable living standard

The next stage of financial freedom is where your assets are generating enough money that you could comfortably live off the cash flow.  At this stage you have a reasonably comfortable standard of living which goes past the basic 'pay the bills' level of stage 4.   The comfortable living standard pays the basic bills like stage 4 but also gives you extra money for some entertainment, travel, gifts  and a bit of a margin for safety.   At stage 5 your assets generate enough that you can safely quit working your 'day job' if you choose to do so.  This is the stage that I consider to be real 'financial freedom'.  Your assets now generate enough money that you are really financially free from work.  

Stage 6 : Generate income for comfortable living plus luxuries and some left over

The final stage of financial freedom is where you have more than enough money to live off of.   This means you have the income for the comfortable living standard of stage 5 plus more money on top of that.   Basically you have more money coming in than you spend by a decent margin.  You can spend all the money you want to (within reason) and still have money left over.    While its certainly nice to have the financial freedom of stage 5 its even nicer to have the amount of money at stage 6.   Stage 6 financial freedom really gives you true freedom from financial worries.

You need to decide on the dollar amounts

You'll notice that I don't cite specific dollar amounts for stages 3 to 6.   The exact amount will depend on your situation, your spending habits and the cost of living in your area.   You should figure out your expenses and then decide the amounts for yourself.   Maybe you'll be able to cover your basic expenses for stage 4 with $10,000 a year or maybe you'll need $25,000.   The amount you'll be satisfied with for stage 5 and 6 really depends on your own goals.  

Should you pay off mortgage?

You might be wondering why I don't have paying off your mortgage as one of the steps.  I do think that for many people that owning their home free and clear is a major stage of financial freedom.   It is the next goal that my wife and I have.   However paying of a mortgage may or may not make sense for you and I don't think its necessarily a universal goal.   If you want, you can add it as a step in the system around stage 4.

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