When you reach financial independence, or FI, working becomes optional. You can retire, semi-retire, switch to your dream work, volunteer, become a full-time parent or travel the world — regardless of your age.
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“Your FI ratio is simply the percentage of your living expenses that you can cover with passive income from investments,” explained chartered retirement planning counselor Michael Santiago of Launch That. If you spend $5,000 each month and can generate $2,000 in passive income, you have a 40% FI ratio. “When your passive income can cover 100% of your expenses, you’ve reached financial independence, regardless of your net worth.”
If the idea appeals to you, here’s what you need to know about FI ratio and a few other important metrics. Also, check out these tips to help you along your journey to financial independence.
FI Ratio vs. Net Worth
Your net worth is a tally of all your assets minus your liabilities, or debts.
“Many people calculate their FI number by multiplying their annual living expenses by 25,” said Steven Keys of Trip Of A Lifestyle.
In other words, they reverse-engineer their target net worth from the 4% rule. Historical returns suggest that you can likely survive on a nest egg for at least 30 years — and often indefinitely — if you withdraw 4% in the first year, and only increase your withdrawals by the rate of inflation after that. By multiplying your annual living expenses by 25, you reach that 100% number that you can then withdraw 4% from.
Keys knows a thing or two about financial independence and early retirement — he and his wife retired at 29.
Still, setting a net worth often makes the process feel daunting and non-intuitive. By focusing on income and expenses with your FI ratio, the goal feels more tangible.
Santiago said, “Your net worth fluctuates based on market conditions. It can feel discouraging when you keep saving and investing, but your net worth keeps dropping alongside the stock market. Your FI ratio paints a more vivid picture on where you are on the path to financial independence.”
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Making Your Personal Finances Intuitive
On a conceptual level, everyone understands that if they spend less money, they can save more and grow their net worth, and maybe someday that might translate into… something.
When you calculate your FI ratio, it becomes instantly clear that lowering your living expenses makes it easier to retire early or reach financial independence. Continuing the example above, if you cut your living expenses from $5,000 to $4,000, then your FI ratio jumps from 40% to 50%.
“Expenses are half the equation,” said Stephen Kates, principal financial analyst for RetireGuide. “If you are spending too much, you need far more assets and passive income to reach financial independence.”
Kates also pointed out that most people never achieve a high savings rate, because they keep spending more as they earn more. Tracking your FI ratio shines a spotlight on that problem: “If you are susceptible to lifestyle creep, you may find your FI ratio stagnant even as you save and grow your net worth.”
An Easier Leap to Your Ideal Work
Because of lifestyle creep, many people find themselves chained to their high-stress, low-fun day job through the “golden handcuff.”
But tracking your FI ratio also makes it obvious that you can unshackle yourself with passive income or by trimming expenses. If you earn $2,000 in passive income each month and spend $5,000, you could quit your stressful day job today if your dream job pays $3,000 a month.
Joe DiSanto, founder of Play Louder, offered another lens to look through. “Your FI ratio also helps make it clearer when you can semi-retire, like I did. You might work part-time or on passion work, while covering some of your expenses with passive income.”
The Risk of Focusing on FI Ratio
DiSanto offered a word of caution, however, against exclusively focusing on FI ratio. “Earlier in your life, it’s more important to prioritize growth than income.”
Why? Because income-oriented investments tend to deliver lower returns. You need growth and high returns more than you need stable income while you’re working a full-time job.
“As you build your net worth and start considering financial independence, you can shift your investments to prioritize income,” DiSanto said. “Some investors pursuing FI opt for real estate, because it can generate both high returns and passive income.”
That could mean well-known strategies like rental properties, or it could mean hands-off investments like real estate syndications, private partnerships, private equity real estate funds or private notes.
3 Numbers To Track Each Month
Consider tracking three numbers each month to keep a pulse on your personal finances: FI ratio, net worth and your savings rate — the percent of your monthly income that you put toward savings, investments or early debt payoff.
Together, these three numbers provide a snapshot of both where you are and where you’re headed. You don’t have to track these manually with a spreadsheet, although that can help, too.
“I use Quicken Simplifi to track metrics like my passive income and expenses,” added DiSanto.
Other options include YNAB (You Need a Budget) and Empower. For a free option, Credit Karma can track your spending and net worth automatically, pulling data from your bank and brokerage accounts.
They say that which gets measured gets done. If you want to reach financial independence at an early age, measure your progress — and watch yourself ditch your day job long before your friends.
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This article originally appeared on GOBankingRates.com: Rethinking Rich: Does ‘Financial Independence Ratio’ Matter More Than Net Worth?
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
