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Imagine never having to work another day in your life unless it was doing something you absolutely loved! That is what financial independence is about.

Basically, this amounts to having enough savings and investments that you can live off of the interest alone.  In other words, the interest from your savings provides sufficient cash flow to cover all of the living expenses for the lifestyle that you desire. Financial independence effectively allows you to retire if you so choose.

Here is the basic outline for achieving financial independence:

1. Spend Less Than You Earn

This point seems obvious but it something that most people don't put into practice.  In North America today, the average spends 101% of their annual income.  This means that they are accumulating debt each and every year. This seems absolutely ridiculous but it is the way a lot of people live.

The first step then, is to increase your knowledge of your expenditures.  I outlined this in an earlier article from this series, Raising Your Financial Awareness.  Once you understand your financial situation, there are many steps you can take to reduce your expenses.

There are several sites that outline ways to live more frugally which you may want to check out if your spending is getting out of hand:

• Free Money Finance
• The Simple Dollar
• Get Rich Slowly

While you are reducing your expenses, you should also be looking to increase your income by generating more value and developing multiple income streams.

2. Invest the Difference

Take the difference between your income and your expenses and use it to grow your savings. How much do save and invest? Most books recommend starting out with 10% of your income which is a reasonable amount for most people.  For others, it may be a stretch and you might have to decrease your expenses or increase your income in order to reach that amount. You can always save more than 10% - at this point in time, I aim to save at least 20% of my income. 

In general, if you can save a higher percentage, I would recommend it provided that you are not diminishing your quality of life.  Increased savings should result from the elimination of frivolous expenses and increases in your income.

Now, what do you do with the money you are saving?  First, create an emergency fund which holds enough money for 2 to 24 months of expenses depending on what you need to feel financially secure.  Beyond that, you invest your money so that you can make your money work for you.

3. Utilize the Power of Compound Interest

Compound interest is the key to your financial freedom. 

"The most powerful force in the universe is compound interest" - Albert Einstein

The power of compound interest depends on three factors:

• 1. The contribution - This is the money that you invest. It is the 10%+ that you put aside from your income to grow your savings. The more money you add regularly, the larger your yield from the interest.
• 2. The rate of return - This is the interest rate you receive on your money. A high interest savings account currently yields about 3.5% which basically accounts for inflation. As a result, your money will not increase in value by simply letting it sit in a savings account. My suggestion is that you take the time to study investing and consult with a financial adviser. Investing in the stock market can yield results of 10-15% over the long term if you take your time learning and perform your due diligence. You can also use a managed portfolio if you would prefer to have a professional choose your investments for you based on your risk profile.
• 3. Time - The more time you allow interest to compound on your money, the greater your total savings will be. So, when is the best time to start saving? Yesterday. The next best option is today. The longer you allow interest to accumulate on your money, the greater your return will be. In fact, a smaller contribution compounded over a longer period of time will often produce a higher return that a larger contribution compounded over a shorter period of time. To see an example, click here.

When Do You Spend Your Savings

In short, you don't.

 The money you accumulate is designed to give you financial freedom.  That is, you want to accumulate critical mass of funds such that you can live the lifestyle you desire solely off of the interest you receive.  Therefore, you are never to spend the principal.  The interest is only to only to be spent once you have accumulated your critical mass of funds that will yield enough interest to pay for all of your expenses.

The Critical Mass

To estimate the critical mass your require for the lifestyle you want to live, you simply take your yearly living expenses and divide the amount by the interest rate you expect.  Make sure to adjust for an inflation rate of about 4%. Take a look at the example below (we will ignore taxes for simplicity):

Yearly Expenses = $50,000

Interest Rate Expected = 12%

Inflation Adjusted Interest Rate = 8%

Critical Mass = $50,000 / 0.08 = $625,000

So, in this example, approximately $625,000 of funds are required for financial freedom.  Now, to reach this goal, consider a couple who start saving at age 25 with a yearly income of $60,000. At 10% savings, they will contribute $6,0000 a year to their investments.  At a 12% interest rate, they will achieve this critical mass at age 48 (23 years). 

There are several ways to increase the speed at which financial freedom is achieved:

1. Simplify your lifestyle - In the above example, if expenses are reduced to $35,000 a year, financial freedom could be achieved in approximately 20 years.
2. Increase Your Income - At an income of $80,000 a year, 10% savings results in $8,000 a year. This means that 21 years are required.
3. Increase Your Savings - Saving 20% of a $60,000 income results in financial freedom after 18 years.

A higher interest rate can also produce quicker financial freedom, however, the most successful investment strategies typically result from consistent gains made over a long period of time as opposed to going for a huge return in a short period of time.

The next post will cover how to manage your money so that you can achieve financial freedom.

This post is part of a series on mastering money & wealth:

1. Intro
2. Raising Your Financial Awareness
3. Commitment and Focus
4. Wealth Mindsets
5. Clean Up Your Limiting Beliefs About Money
6. Generate a Higher Income By Creating More Value
7. 25 Ways to Create More Value
8. Create Multiple Streams of Income
9. The Key to Financial Freedom
10. Money Management
11. Summary and Resources