How to achieve financial independence

Smart money management for financial independence

There is no overnight formula to becoming rich - unless you win the lottery. And even with this, holding on to the lottery win and making sure that it doubles or triples over time requires some seriously hard work. In fact, financial independence is just one of the "pit stops” in the journey toward financial freedom. And the ultimate goal is actually financial abundance.

At the core of this process is money management. Smart money management is more than working hard enough to get a promotion or higher pay, seeking out multiple income streams, or going into business because it's more profitable than being a paid employee. It's also about your economic philosophy, financial goals, and spending and saving habits.

A high-paying job can't get you financial independence or freedom from debt if you're living beyond your means. In the same way, an average income does not always mean a hand-to-mouth existence and the absence of a savings account. Many people successfully build substantial emergency funds on a regular office employee's salary.

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7 stages of financial independence

To become financially independent is a process. Here are the stages many will go through to achieve financial independence. Find out where you are and what your next move should be.

Stage 0: Dependence

The opposite of financial dependence, this stage suggests a complete dependence on others.

At one point, even the most successful and the richest of millionaires were at this stage. With no means and no capacity to earn money, we all depend on our parents to provide for our needs when we're young.

You're also in this dependent stage if you're spending more than what you're earning. You'll know you're here if you've been forced to take out a payday loan, a loan from the bank, or borrow money from family and friends to get by. Either way, this suggests a dependency on something or someone to cover expenses you simply can't pay for.

Stage 1: Solvency

Solvency is the first step in the surviving phase. In this stage, you're able to meet all of your financial commitments, pay all your bills, and you don't rely on someone or something to help you cover your expenses. You may still have loans, but you're not adding anything new and more importantly, you can meet your payments every month.

If you're a student, your first step to solvency is to get a job that will allow you to earn enough so you wouldn't have to depend on your parents for your essentials. If you're already making some money, achieving solvency can entail getting a higher paying job, doubling your income stream, or cutting down on your expenses.

If you've been stuck in Stage 0 because of debt, then one way to achieve solvency is to renegotiate with your creditors for friendlier payment terms or a lower interest rate so you can still meet the required payment and still have enough money left to cover all your other bills.

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Stage 2: Financial stability

Once you're able to consistently meet your financial commitments, have paid off some debts, and you're able to keep your expenses down, then you can start saving. This extra money can be your rainy-day fund, a cash reserve that you can turn to when an unexpected expense crops up.

Ordinarily, in stages 0 and 1, if you find yourself saddled with an emergency expense, the only choice is to borrow money, take out a loan, or fall behind on paying your bills because you have to cover the emergency instead. This wouldn't be the case if you had some savings tucked away.

At this stage, it's still perfectly acceptable and normal to have some significant debts. You might still be paying your student loan, or you might have a mortgage to settle every month, but you've paid off most of your consumer debt (i.e. credit card debt) and there's no need to get into more significant debt.

Stage 3: Debt freedom

At this point, you've established enough stability in your expenses and managed to start setting aside money for an emergency fund. Since you've paid off most of your consumer debts, the next step is to start working through the high-interest major ones. Settling even one high-interest loan can mean one less item to worry about and added savings for you. This means working to pay off any debt on investment, a student loan, or the mortgage on your car or house.

In this stage, you have enough money and means not just to survive, but to also start thriving. You don't live a hand-to-mouth existence. You have cash reserves that can help if an emergency arises, and you're almost debt-free.

This is when the value of money is more than just a safety net and is now a tool to help you create a much better, more comfortable life. You can start to use your money for investing purposes.

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Stage 4: Financial security

This stage highlights the value of a good investment. If you've been saving money consistently somewhere between stages 2 and 4, then you've put some of your money into worthwhile investments that can deliver short, medium, and long-term returns. In this stage, you should be able to enjoy the benefits of those investments.

If your investment income is adequate to cover your basic major living expenses, such as housing, food, utilities, and transportation, then you've reached the stage of financial security.

This doesn't necessarily mean that you can now quit your job. The basic idea is that, if for example you spend about $1,000 every month for these living expenses, then you have more than enough savings or income from your investments to cover this monthly $1,000 cost for the rest of your life. This doesn't cover expenses on the miscellaneous stuff, the small comforts you allow yourself, and that's why you still need the income from your job.

Stage 5: Financial independence

Between stages 4 and 5, you continue earning money, and you're saving and investing more of it until, at some point, your investment earnings are enough (more than adequate) to cover your current lifestyle. This means your investment income is sufficient to pay for your necessary expenses AND the other miscellaneous ones, too, for the rest of your life. This is when you can now say it's okay to quit your job and go country hopping and not worry about your expenses both in the present and the future.

There is no set or a specific amount that lets you know you've achieved financial independence. Because lifestyles vary, a simple man can say that $20,000 is more than enough to cover everything he would need every year for the rest of his life, but another person may need $50,000 or $80,000 to cover their basic lifestyle needs and the occasional holiday abroad.

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Stage 6: Financial abundance

The last stage in the continuum is the point where you have enough for your lifestyle, both the basic and the comforts, and then still have some more that you can use on other things. You have enough surplus from your passive income that you can use it to invest in more business, buy real estate, donate to a charity, or even start one.

In this stage, we're not just talking about smart money management, but smart asset management. How do you control these passive assets? How do you allocate the income from these different investments? Who are the people who will benefit from these assets and investments at a later time? How will they be divided or distributed to your family and loved ones? These are all things you can consider if you've reached financial abundance.

A final word on financial independence

For most people, financial independence is seen as the end goal and they give little attention to the other stages before it. This view turns financial freedom into a mirage, an impossible dream, a "financial unicorn." Many of us just end up somewhere between stages 2 and 3, or sometimes 4, and never try to move beyond these stages.

But by thinking of financial independence as a process, the goal becomes much more achievable and realistic. It also makes the journey less challenging and less frustrating. You don't have to get stuck, or worse, choose to be stuck in just stage 1.

If you can manage to do away with your credit card debt, that's great. Then you can focus on saving 5% of your income this month, but later in the year, you can try to bump it up to 10%. By next year, you can start working to pay off your student loan. The point is that each and every action, no matter how small, becomes a crucial stepping point closer to the other end of the continuum.

These stages of financial independence also lead you down a path to a basic and essential part of smart money management: making investments. From stages 4 to 6, work and income from your job take a backseat. You are not relying on your paycheque to cover your basic expenses, and you've turned your attention to building and managing your investments.

Every penny saved and every debt or loan settled are steps that will take you closer to the goals near the freedom end of the continuum. For most people, there's no way to skip these steps, so what's the point in wishing for a lottery jackpot? Take heart in the fact that this is your journey and that your own choices and efforts can get you past financial bumps and into clear sailing. Gaining financial freedom is about building your skills, yourself, and your net worth.