Financial independence

Financial independence is the status of having enough income (from investments, passive businesses, real estate, etc.) to pay for one's reasonable living expenses for the rest of one's life without having to rely on formal employment. The core path to achieve financial independence focuses on maximizing one's savings rate through lower spending and/or higher income. Income earned without having to work a job is commonly referred to as passive income.

There are many strategies to achieve financial independence, each with their own benefits and drawbacks. To achieve financial independence, it will be helpful to have a financial plan and budget to get a clear view of current incomes and expenses and to identify and choose appropriate strategies to move towards certain financial goals. A financial plan addresses every aspect of a person's finances.[1]

Passive sources of income to achieve financial independence

The following is a non-exhaustive list of sources of passive income that potentially yield financial independence.

Bank fixed deposits and monthly income schemes
Business ownership (if your business does not require you to operate)
Dividends from stocks, bonds and income trusts
Interest earned from deposit accounts, money market accounts or loans
Life annuity
Notes, including stocks and bonds
Oil leases
Patent licensing
Pensions
Rental property
Royalty from creative works, e.g. photographs, books, patents, music, etc.
Trust deed (real estate)
investing in transportation where you earn a given amount of money on a daily basis/weekly depending on the agreement you signed

Approaches to financial independence

If a person can generate enough income to meet their needs from sources other than their primary occupation, they have achieved financial independence, regardless of age, existing wealth, or current salary. For example, if a 25-year-old has $100 in expenses per month, and assets that generate $101 or more per month, they have achieved financial independence. They have no need to work a regular job to pay their bills.

On the other hand, if a (for example) 50-year-old earns $1,000,000 a month but has expenses that equal more than that per month, they are not financially independent, as they still have to earn the difference each month to make all their payments.

However, the effects of inflation must be considered. If a person needs $100/month for living expenses today, they will need $105/month next year and $110.25/month the following year to support the same lifestyle, assuming a 5% annual inflation rate. Therefore, if the person in the above example obtains their passive income from a perpetuity, there will be a time when they lose their financial independence because of inflation.

If someone receives $5000 in dividends from stocks they own, but their expenses total $4000, they can live on their dividend income because it pays for all their expenses to live (with some left over). Under these circumstances, a person is financially independent. A person's assets and liabilities are an important factor in determining if they have achieved financial independence. An asset is anything of value that can be readily turned into cash (liquidated) if a person has to pay debt, whereas a liability is a responsibility to provide compensation. (Homes and automobiles with no liens or mortgages are common assets.)

Since there are two sides to the assets and expenses equation, there are two main directions one can focus their energy: accumulating assets or reducing their expenses.

Asset accumulation

Accumulating assets can focus one or both of these approaches:

Gather revenue-generating assets until the generated revenue surpasses living/liability expenses.
Gather enough liquid assets to then sustain all future living/liability expenses.

Expense reduction

Another approach to financial independence is to reduce regular expenses while accumulating assets, to reduce the amount of assets required for financial independence. This can be done by focusing on simple living, or other strategies to reduce expenses.[2][3]

Cut your fixed expenses wherever possible. (E.g., keep your internet service but discontinue cable; lower your phone plan type if you don't use all its features, etc.)

References

"What your financial plan should cover | Financial planning | GetSmarterAboutMoney.ca". GetSmarterAboutMoney.ca. Retrieved 2017-10-16.
Early Retirement Extreme: A philosophical and practical guide to financial independence.
Your Money Or Your Life: 9 Steps to Transforming Your Relationship With Money And Achieving Financial Independence.