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As Americans, we are incredibly lucky to live with a great deal of personal freedom. No one can tell us what music to listen to, what career path to follow, or how many kids we can have. It is an amazing thing, but many of us choose to give up those freedoms by placing ourselves under significant financial restraints. We turn our lives over to the control of employers, credit card companies, and lenders. As such, in honor of the 4th of July, I wanted to discuss what it really means to have financial freedom.
Financial Freedom vs. Financial Independence
Many personal finance bloggers, myself included, are working to achieve financial independence. Financial independence is defined by having enough income generating assets so one doesn’t need to work. A financially independent person has enough investments, be it mutual funds, real estate, or private investments, that earn enough each year to fully support their lifestyle. They may choose to work, but they don’t need to. Achieving financial independence, especially before the traditional retirement age, is a goal that requires significant planning and focus. While this is an amazing thing, it isn’t for everyone, and I believe it differs from financial freedom.
Financial Independence: Having a net worth sufficient to fully support one’s lifestyle in perpetuity.
Financial Freedom: The ability to consistently live without financial stress.
To me, financial freedom is the step before financial independence. It means having a financial situation that can weather the ups and downs of life without causing money arguments and stress. The arrival of an unexpected bill doesn’t turn your life upside down or make you afraid to open the mail. You don’t give a chunk of your income to interest payments on consumer debt. You may not be able to sustain joblessness forever, but a short period of unemployment won’t push you into debt. In a nutshell, you control your money; it doesn’t control you!
The Markers of Financial Freedom
In my opinion, financial freedom should be the American Dream for all U.S. families. Without it, you simply don’t have the freedoms of life this country is meant to give us. So, what do the finances of a financially free person look like? How do you know if you are one? And what milestones should you be chasing to get there? Here are the five markers of the financially free.
1- You don’t live paycheck to paycheck
Breaking the paycheck to paycheck cycle is absolutely key to achieving financial freedom. People living paycheck to paycheck know they are entirely dependent on their employer. If their check comes in a few days late or a few dollars short of where they expected, they are forced into a money panic. This doesn’t sound anything like freedom.
My favorite budgeting app, YNAB, believes you have broken the paycheck to paycheck cycle when you can “live on last month’s income.” This means a financially free person has saved up and planned such that every month, on the first of the month, all the money they will need to for the next 30 days is already in their bank account! For instance, I’ll be paid on the July 14th, but I won’t need to touch or even budget that money until at least August 1. A beautiful and freeing thing!
2 – You have a healthy emergency fund
The next step to financial freedom, having a strong emergency fund, is highly related to breaking the paycheck to paycheck cycle. In fact, living on last month’s income means you’ve essentially built a one-month emergency fund. However, for a financially free person, they have a sufficient emergency fund that sits outside their regular checking account, to help them weather the large, unexpected expenses. This fund helps them cover a deductible for a significant home insurance claim, medical bills, or a job loss.
An emergency fund gives you flexibility. It allows you to keep crises short term, instead of being forced into debt that extends for months or years beyond the actual event. In general, a 3-6 month emergency fund is ideal, depending on your career and expected timeline for being able to find a new job in case of a layoff. However, if you are starting out, working on a $500 emergency fund, then $1,000, is enough to move to the next step and start taking control away from your creditors.
3 – You don’t carry consumer debt
A financially free person doesn’t hand over a chunk of their income every month for unnecessary, high-interest debts. They don’t have credit card debt, personal loans, or car payments. (If they do need a car loan to be able to purchase a vehicle, it isn’t for a new car and paying it down is a priority.)
In 2015, Credit.com estimated that the average American spends almost $280,000 just on interest payments in their lifetime, and that number typically increases with income level. This transfers a huge portion of Americans’ income away from wealth building and investing and into the coffers of banks, credit card companies, and lenders. People who are financially free live within their means and use their income to their advantage, not someone else’s. Not carrying consumer debt gives them a lower bare bones budget in case of job loss, but also allows them to prepare for an enjoyable future and retirement.
4- You save consistently and adequately for retirement
A financially free person pays themselves first. They contribute at least enough to their 401(K) to receive the full match from their employer, if available. They also invest in a Roth or Traditional IRA such that, along with their 401(K) contributions, they are saving a minimum of 10% of their income. Retirement may be 10, 20, or 30 years in the future, but financial freedom means knowing that time is your greatest asset.
Whether or not you have a goal of early financial independence, almost everyone will need to retire someday. To do so comfortably, or even to maintain your current quality of life, you have to accumulate sufficient assets to support you when you can no longer work full time. The best way to do this is to start saving and investing early and often. A person who has achieved financial freedom has a plan for their future, and they’re acting on it!
5 – You carry sufficient life insurance (or assets)
A single person, without dependents, may not need to worry about this last piece of the puzzle for financial freedom. However, any income earning or service providing adult with dependents needs to have a plan for the worst. You don’t want to build a life of financial freedom that falls in on your family if you pass away unexpectedly. That’s why you need life insurance.
Term life insurance is cheap and can cover your debts, support your family for a period, and provide for your kids. It provides coverage through the years you would need it and allows your personal asset building to take over as you age and your children grow up. (If you have retirement or other assets, over and above any debts, those can be subtracted from your life insurance needs until you don’t need any at all.)
True financial freedom needs to remain through the worst of times. On the road between financial freedom and financial independence, life insurance gives you that peace of mind.
Make financial freedom your American Dream!
If you aren’t financially free today, make it your goal to get there by next year’s Fourth of July! By living the way you are today, you’re taking on stresses you don’t need and giving up control of your life to others. No matter your income, a few simple rules and habits can get you on the right track. Set some concrete goals, and follow the Roadmap to Financial Health to get you on the right track!
For those who are financially free, isn’t it an incredible feeling? I hope you are spreading the word to your friends and family that just because a life of borrowing is normal, it isn’t ideal or necessary. Because, come on, we didn’t fight for sovereignty and freedom to be normal!
Are you financially free? If not, do you have plans to get there? Drop a note in the comments and let’s start a conversation about taking control of our lives and wallets!