According to Financial literacy surveys, half of Americans are financially illiterate. (Differences of Financial Literacy). Are you one of them? In this post, I talk about two financial goals that should be part of everybody’s financial planning. Those two are financial security and financial independence.
Financial Security
Let’s start with the first, financial security. Of the two milestones, financial security represents the lower amount of saving necessary for living. This amount consists of the minimum amount of savings required to survive off the interest. Let’s break this down.
As you likely already know, as you accumulate capital you can invest that money in things that return interest. The larger the amount of capital, the larger the amount of interest that can be earned. Let’s say you have save $100,000. Calculating a conservative 4% interest per year, you will earn $4000 per year from the interest. At $1 million, that’s $40,000 per year.
For financial security the question becomes, “how much interest do I need to earn to simply survive?” In other words, assuming you lose your job and have no back up sources of income. Can you survive? What’s the minimum amount needed to pay for shelter, food, health, taxes, and clothing? In this calculation, omit bonus expenses such as vacations, movies, eating out, maintenance of your boat (unless you’re living on it), and any other extraneous expense. The point of this calculation is to figure out a worst case scenario. Can you survive for the rest of your life off the savings you have accumulated? It may not be a glamorous life, but it’s life.
Reaching this goal can provide an immense level of relief. But it doesn’t end there.
Financial Independence
Financial independence represents the amount of savings required to flourish off the interest. Independence requires a higher level of savings than financial security. With independence you get to add all of those extras expenses back into the calculation. Those vacations you planned, those nice jeans you like to wear, the dinners out with friends. They are all in the calculation.
For financial independence the question becomes, “how much interest do I need to earn to live at my current standard of living?” For most mid-aged middle-class individuals, their current expenses suffice. If you’re younger or unhappy with your current spending ability, using a slightly higher goal may help. But there’s a real danger in that. If spending constantly rises along with your income, you will never be happy. The financial independence becomes a moving target, making it that much harder to reach.
Once you hit that goal – retirement. You’ll have enough money to retire and not work another day of your life. Its mentally liberating to know you could stop working tomorrow and be financially set for life. Not that you have to retire, but you’ll be financial able too afford it.
What about?
Perhaps you see the value in each of these calculations, but are unsure about how to apply it to your life. For example, when calculating shelter costs, do you consider the current house or assume you sell it and live somewhere else. This is especially relevant to financial security. For example, suppose you pay $1800 a month in mortgage payments. That’s a large expense, requiring a much higher amount of capital to survive. Suppose you sell your house and increase your capital by $200,000. Instead of living in a house, you could get an apartment. Would the increased interest from the new capital pay for an apartment? Perhaps you could buy a smaller house with the $200,000. That would reduce the amount of expenses needed to survive. Heck, you could even purchase some land and put up a shack to live, keeping most of the capital and decreasing your expenses. Which scenario works for you? That’s something only you can answer. Once you answer it, you can improve your calculation.
You might ask, what about Social Security? Don’t count on it. As Social Security Administration admits, it will be insolvent in 2033. Welfare or food stamps? Who knows if and how long those will last. The point of the exercise is to make as few assumptions as possible. Calculate financial security and independence without these incomes streams. If they go away, you’ll still be secure. If they are still around, then you will get a nice bonus.
Some of you may also be concerned about inflation and rightly so. If the cost of goods increase significantly, then the original expense calculation will fail. Figuring that out requires more help than I can provide in this article. That leads to my next comment.
Financial Planning
Finding a good financial planner is worth their weight in gold. They can help make these calculations, running through contingencies and probabilities. They can help with the “what about” scenarios and help guide you in calculating your financial security and financial independence goals.
Even without a financial planner, you can do back of the envelope calculations yourself. For example, last year I calculated that our family needs $800,000 for financial security and $2.4 million for financial independence. I was happy to see we’ve passed the financial security goal. This was a huge relief considering the pandemic and the uncertainly with the economy. Now, its on to financial independence.