Financial Freedom is when you have sufficient wealth to live a comfortable life without having to worry about money.
It’s a dream that many people have but few actually achieve, but it’s not impossible to reach.
The key to financial freedom is to understand the different levels and work towards achieving them. No matter what your situation is, you can always improve it and get to the next level.
In this article, we will go over the 5 Levels of Financial Freedom and how you can reach them.
Level 1: Get Out of Debt!
The first level of financial freedom is to get out of debt!
Debt can be a heavy burden and can hold you back from reaching other levels of financial freedom. The goal at this level is to pay off all your (bad) debt, including credit cards, car loans and student loans. Once you’re debt-free, you’ll have more disposable income each month to put towards savings and investments. To achieve debt-free living, you need to create a budget and stick to it. Some financial gurus like Mr. Money Mustache even go so far as saying that you should treat your debt like an emergency. Meaning that if you have (bad) debt, you need to pay it off ASAP, at all costs.
Differences Between Good and Bad Debt
It’s also important to distinguish between “good” debt and “bad” debt. Good debt is typically considered to be debt that helps you make money in the long run, such as a low-interest mortgage on a house or property that increases in value. In this case, the debt is seen as good because the asset you bought with the debt has the potential to increase in value over time, thereby helping you build wealth. You also need a place to live anyways so paying a mortgage instead of rent will help you reduce your expenses over time.
On the other hand, bad debt is debt that does not offer any long-term financial benefits, such as high-interest credit card debt or debt on a depreciating asset like a car. In this case, the debt is seen as bad because it does not generate any income or add value to your financial situation. Instead, it often results in paying more in interest than the amount you originally borrowed, making it harder to get ahead financially.
When paying off “bad” debt there are two schools of thought and both make sense depending on your situation and on your personality.
The first is to pay off your debt with the highest interest rate first. This debt is “costing” you the most money and should be dealt with first, but there is another method that appeals more to human nature which is called The Snow Ball Method.
The Snowball Method is a strategy for paying off debt that involves focusing on paying off your smallest debt first, while still making the minimum payments on your other debts. For example, if you have 3 credit cards open and Credit Card A has a balance of $500.00, Credit Card B has a balance of $800.00 and Credit Card C has a balance of $2000.00 then using The Snow Ball Method, paying off Credit Card A with $500.00 first makes the most sense, even if it has a lower interest rate than the other credit cards.
You will see results and gain momentum faster if you’re able to pay off an entire credit card balance.
Once the smallest debt is paid off, you then use the extra money you were putting towards that debt to pay off the next smallest debt, and so on, creating a “snowball” of extra money that gets larger as you pay off each debt. By focusing on paying off one debt at a time, the snowball method can help you stay motivated and see progress in your debt repayment journey.
Level 2: Build an Emergency Fund
Once your (bad) debt has been paid off, it’s time to move onto the second level of financial freedom, which is building an emergency fund. An emergency fund is a savings account set aside for unexpected expenses, such as medical bills or car repairs. The goal at this level is to have three to six months of living expenses saved in this account. So first, sit down and figure out how much your monthly expenses are (rent, car payment, groceries, school supplies, entertainment, etc.) and then aim to have three months set aside. Once you get that amount, try to get it up to six months.
Imagine how it would feel if you knew that you could take care of anything that life throws your way, this is what it feels like to be at Level 2 of Financial Freedom.
To achieve this level of financial freedom, you need to start by setting a monthly savings goal. Then, make sure you’re putting a portion of your income into this account each month. This will help you build up your emergency fund over time. Also, put this money into a savings account that is earning interest. As of 2023, there are a lot of savings accounts that are paying 3-4% interest like Ally Bank.
Level 3: Start Investing in Your Future
The third level of financial freedom is to start investing in your future. This includes investing in stocks, money market funds, real estate funds, etc. The goal at this level is to build a diversified portfolio of investments that will provide you with passive income.
Also, don’t be tempted to stick your emergency fund into these investments. This is because investing in something like the stocks needs a longer time horizon than three to six months. Over the long run, the stock market almost always goes up, but during shorter time periods, it could go down and you don’t want to have to sell when it is down just because you have an unexpected expense like a car repair.
To achieve level 3 of financial freedom, you should first start but putting aside a certain amount of your paycheck every month and first putting it into low cost index funds, like the SP500. This gives you access to the top 500 companies in the US and means that you don’t have to pick any winners or losers, you get the aggregate of amazing companies like Apple, Microsoft, GE, Boeing, Tesla, etc. without having to worry about whether one of them is going up or down this quarter.
Level 4: Freedom From Your Job
The fourth level of financial freedom is freedom from your job. This is the point where your passive income from investments meets or exceeds your living expenses. The goal at this level is to have enough wealth to live off of your investments, without having to work for a paycheck. A simple calculation to figure out how much you need for this level is to use the 4% Rule.
For example, if you have saved up and invested $1,000,000 then you just multiply this by 4%:
$1,000,000 x .04 = $40,000
This means that you can spend $40,000 every year or $40,000/12 months = $3,333/month
This rule also works by taking your yearly expenses and then multiplying them by 25x. So if your yearly expenses are $2,000 a month, then you just need to multiply this by 25 which will give you $500,000.
Also, you might have noticed that the lower your monthly expenses are, the less you need to save for financial freedom. So start attacking your monthly expenses first and learn to live with less.
Financial Freedom Level 5: Wealth Accumulation
The Fifth Level of Financial Freedom is the continued accumulation of wealth, skill and time accumulation. At this level, you have accumulated a significant amount of wealth and have the financial resources to do what you want in life. The goal at this level is to continue growing your wealth and using it to make a positive impact on the world.
To achieve wealth accumulation, you need to have a long-term investment strategy in place and this can be something as simple as a two fund portfolio, with 40% of your money in cash or bonds and the other 60% in a low cost ETF.
If you reach the stage where you quit your job, you’ll also find that you’ll have a lot more free time on your hands. This can be a double edged sword, especially if you derived a lot of your identity and feeling of accomplishment from your job. This is because there will be a big hole where your job used to be. It is important to fill this with productive activities like learning new skills and hobbies. It will be extra beneficial to find a skill that also helps you make some extra money so that you can continue to grow your wealth. This can include things like building websites, teaching guitar lessons, installing solar panels, etc.
Another important area of your life that you will want to consider investing in is in your relationships. The data on long term happiness is pretty clear and says that happiness is highly correlated with close relationships. Take your new found freedom and time to reach out to friends and family members that you have lost contact with. Now that you have monetary wealth, it’s important to have wealth in your personal relationships as well.