In 2020 the total household debt was $14.56 Trillion. That comes to roughly $118,000 of debt per household. Over 20% of student loans are held by baby boomers. That’s over $336 billion owed by people over the age of 50. Their average student loan amount is $40,000/family, which is really depressing considering the average cost of tuition in 1990 was only $4000/year (source). Imagine paying student loan payments every month for 30 years and still having more debt than you started with. That’s equal parts crazy and disheartening. Financial independence is the solution.
What if instead of paying on your student loans until you die, you could be retired on a beach sipping cocktails at 45? That’s what financial independence is. It’s the ability to quit working because you’ve saved up enough that your money does the working for you. When asking “what is financial independence?” you’ve probably got some questions like:
- How much money do I need to retire?
- How do I make my money work for me?
- Can I possibly save enough before I die?
- You live in the Midwest, where is the nearest beach?
These are good questions (especially the last one: beaches in Kansas just aren’t the same). Let’s break it down.
1. How much money do I need to retire?
Financial experts will throw out random numbers like $1 million or $3 million. Retirement groups will often give you a number that’s a multiple of your salary. For example, Fidelity says you need 10 times your salary to retire. Those numbers are a good starting point, but they aren’t perfect. This is because your salary doesn’t determine how much you will need to save. Your spending does. If you make $100,000/year but only spend $40,000/year, does your actual income matter when it comes to what you’ll spend in retirement?
Your salary doesn’t determine how much you will need to save. Your spending does.
Enter the 4% rule, a recommendation widely used by retirement accountants, that says a retiree can safely withdraw 4% of their retirement account every year and increase each year for inflation. This means that a new retiree with $1 million can withdraw $40,000. The next year they can withdraw $41,000 assuming inflation is 2.5%. They can continue to increase this withdrawal with inflation forever. As an aside, this assumes you have a retirement account that is 60% in stocks and 40% in bonds. That has to do with risk tolerance and diversification, which is something we can discuss in another post.
So how much do you need to retire? If you apply the 4% rule to your annual spending you’ll find that the number you need to retire is 25 times your annual spending. For example, if you typically spend $36,000 in a year then you only need $900,000 to retire. However, this assumes that you’re retiring tomorrow. If you plan to retire in 20 years, expect your annual spending to have roughly doubled due to inflation. Therefore, if you spend $36,000 now, in 2041 you’ll probably be spending somewhere around $72,000, and will need to have saved closer to $1,800,000. Also, you need to consider that spending isn’t static. Obviously plans change after decades: marital and familial status can change, housing and transportation costs change, and inflation will increase the cost of essentials.
2. How do I make my money work for me?
The crucial goal in financial independence is finding a strategy to make your money work for you. In order to do that you need to buy assets. Assets are things that increase in value and make you money. This means a car is not an asset, but a house is. Other assets include stocks, bonds, and gold. I believe that the stock market is the simplest and best way to grow your wealth.
But how do you know which companies to invest in? If you had invested $1,000 in Amazon in 1997, your investment would be worth over $1,850,000 in 2021. If you had invested $1,000 in Tesla in 2012, you would have over $127,000 in 2021. On the other hand if you had invested in Enron you would have lost it all. How do you pick winners? Easy! Invest in every company, that way you’ll have picked all the winners. You can do this with a total stock market index fund. It invests in every company weighted by the amount of money the company has. This means that you’re more invested in bigger companies with consistent track records. Another option would be the S&P 500 index fund, which is very similar except that it only invests in the top 500 companies.
How do you pick winners? Easy! Invest in every company, that way you’ll have picked all the winners.
Over the last 50 years the stock market has produced an annualized return of over 10% per year meaning if you have $500,000 invested in a total stock market index fund, you will make (on average) $50,000/year.
3. Can I possibly save enough before I die?
I’m a millennial, and I know many of my fellow millennials have resigned themselves to work until they’re dead. In their thinking businesses no longer offer pensions, social security will run out by 2035, houses are becoming increasingly unaffordable, and they’re never going to get to retire. Let’s take a look at if they’re right.
Say I calculate my spending to be $40,000/year. Using the 4% rule my retirement amount comes to be $1,000,000 (Remember, this is assuming I retire tomorrow). If I saved $1000/month in a savings account it would take 80 years to reach $1,000,000. In that case I wouldn’t have to worry about retirement because I would dead long before I had enough to retire. Obviously that’s not practical (and you shouldn’t have more than $250k in a savings account anyway).
The key here is to use a total stock market index fund. Every month you stash money away into the index fund and eventually you end up making more money from interest than you are contributing each month. What this means is that, using the same number I calculated above, I would only need to save $155/month for 40 years to reach $1,000,000. That’s half the time and less than a fifth of the amount I’d need to save per month! And if I did save $1000/month, I would reach $1,000,000 in less than 23 years.
Imagine being able to retire in a little over 20 years without even breaking the bank. $1000 per month is definitely a good amount of money, but it’s not an exorbitant amount of money. That’s the difference between buying two new cars and buying a couple used Toyota Corollas so you can avoid making payments. If you could retire in half the time it takes for most people with your only sacrifice being making the decision to buy reliable (gently) used cars instead of new ones, why wouldn’t you go for it?
4. You live in the Midwest, where is the nearest beach?
Finally the question we’ve all been waiting for. I’ll be honest: I don’t sip cocktails on the beach. I don’t like the taste of alcohol and I would much prefer hiking in the mountains to sitting on a beach. Unfortunately, we don’t have any mountains in Kansas either. Fortunately, my hail-damaged 2012 Hyundai Sonata can get us to Colorado Springs in under 8 hours. So that’s a start. Once I retire maybe I’ll buy some land in the mountains and build a cabin in the woods. Everyone’s got to have a retirement goal. It makes the sacrifices that much easier.
Is There Hope for Getting Free from Debt?
How can a family overcome their $118,000 of debt? First let’s address the fact that this number is based in a little fear mongering. $81,000 of that number is due to mortgage debt, which is not necessarily a bad kind of debt. But let’s assume the other $37,000 is credit cards and student loans. How do you find financial freedom when debt seems to grow daily? The answer is consistency. Consistently earning, consistently saving, and consistently prioritizing what’s truly important over what’s not.
Prioritize paying down debt, prioritize saving for the future, prioritize giving to a charity or volunteering your time. All of those things are worth prioritizing because they are more important than buying new things or keeping up with the Joneses. Find out what’s truly important to you and put all your effort into pursuing it. After you’ve found what is important to you, cut down on or cut out what is not.
What do you think? Are you pursuing financial independence? Let us know in the comments below!