In the last few years, the trend of financial freedom has gained popularity among many people. They want to be financially free to gain control of their time and spend it with family or fulfil other goals, hobbies, aspirations, etc. In August, as we celebrate freedom, let us also understand the concept of financial freedom and the steps to achieve it.
What is financial freedom?
The phrase “financial freedom” can have different meanings for different people. For some people, it may mean:
- Working for passion or pursuing their hobby rather than working for money,
- Spending time with family, relatives, friends, socialising, travelling, etc.
- Engaging themselves in community work, getting involved in social activities, doing charity, or giving back to society in any other way(s)
However, one common meaning of financial freedom that can make all the above possible is having enough money to take care of all your current and future financial goals. Once you have enough money, you gain control of your time, which you can then use for any of the above activities or pursue anything else you desire.
Why should one aim for financial freedom?
We have a lot of dreams and desires. While in a salaried job, self-employment, or business, pursuing all our dreams and desires may or may not be possible. If you can pursue all your dreams and desires along with what you do to earn a living, then nothing like it. If not, you should aim for financial freedom, post which you can pursue all your dreams and desires.
Steps to achieve financial freedom
You will need to take the following steps to achieve financial freedom:
Step 1: Assess your current financial situation
As a first step to achieving financial freedom, you must assess your current financial situation by preparing cash flow and net worth statements. A cash flow statement will give you an insight into your income(s) and expenses. You can invest the difference between your income and expenses towards your financial goals.
A net worth statement will give you an insight into your assets (what you own) and liabilities (what you owe others). You can use your assets to generate income for fulfilling your financial goals. You can systematically plan to repay your liabilities and become debt free.
Step 2: Prepare for contingencies
In your financial freedom journey, there will be unplanned or unexpected contingencies. You cannot stop these contingencies from happening. But you can be financially prepared to face them by having an emergency fund, life insurance, and health insurance.
Depending on your current financial situation, profession, and other factors, you can build and maintain an emergency fund equivalent to 3 to 9 months of income. A term life insurance plan is your family's financial backup in your absence. The money from a life insurance plan can be used to pay for all financial liabilities and goals if you meet with an untimely and unexpected death.
You should buy an adequate amount of health insurance cover for the entire family. It will save you from paying the huge hospitalisation bill from your pocket if you or a family member gets hospitalised.
An emergency fund, term life insurance for family bread earners, and health insurance for the entire family are your stepping stones in the financial freedom journey. They help you keep financial worries related to any contingencies aside and stay focused on the financial freedom journey.
Step 3: Plan for your financial goals
Okay, so you are prepared for contingencies. Now, you can move to the next leg of the financial freedom journey, which is planning for your financial goals. You can do financial goal planning in the following manner:
- List down all your financial goals
- Classify them into short-term (to be achieved within 3 years), medium-term (to be achieved within 3 to 7 years), and long-term goals (to be achieved beyond 7 years)
- Make a financial plan for each goal and start implementing it
- Review the financial plan regularly (once every 6 months to 1 year) and take corrective action, if required, till the goal is achieved.
Step 4: Adopt budgeting
You have made a financial plan for all your goals and have started investing towards it. However, some of you may realise that you don't have enough free cash flows to invest towards all the financial goals at the same time. In such a scenario, you may adopt various budgeting methods to allocate your income towards expenses and investments.
You may start with the 50/30/20 budgeting method that allocates 50% of income for needs, 30% for wants, and 20% for savings and investments. Gradually, you should increase the allocation towards savings and investments beyond 20%.
Once the allocation towards savings and investments increases significantly, you may switch to the “Pay Yourself First” budgeting method. This budgeting method first allocates income towards savings and investments for fulfilling financial goals. The remaining amount can then be used for spending towards needs and wants.
Budgeting methods help you accelerate your journey towards financial freedom.
Step 5: Plan the repayment/prepayment of loans
Have a proper plan in place to repay/prepay your loans. You should give first preference to repayment of high-cost debt such as credit card outstanding, personal loan(s), etc. For any long-term loan, such as a home loan, you can have a prepayment plan to finish it before the usual tenure. Some of the steps for prepayment can include:
- Paying 1 extra EMI every year
- Setting aside some money every month and using the accumulated money annually for making a lump sum prepayment.
- Increase the EMI annually by 5% or 10%
- Using lump sum cash flows like an annual bonus from the job, redemption proceeds from financial products, etc., for home loan prepayment
Once you repay/prepay your loan(s), it will free up cash flows which can be redirected towards investments for financial goals. It will help accelerate your financial freedom journey.
Step 6: Create passive income sources
In your financial freedom journey, ideally, you should not rely on a single source of income. You should start developing multiple sources of passive income. They will ensure a steady flow of income from multiple sources. If one source of income stops temporarily or permanently, you can fall back on other passive income sources. Some of the passive sources of income that you may consider include:
- Monthly interest income from fixed deposits, bonds, etc.
- Rental income from real estate
- Dividends from equity shares
- Distributions from REITs, InvITs
- Regular monthly/quarterly cash flows from alternative investments like peer-to-peer (P2P) lending, invoice discounting, asset leasing, etc.
Financial freedom journey: Balance between enjoying the present and securing the future
You should try to achieve financial freedom at the earliest. However, you should not sacrifice enjoying the present in the process. Your financial freedom journey should balance enjoying the present and financially securing your future. The 50/30/20 budgeting method allocates 30% of income towards wants that allows you to enjoy the present. It allocates 20% towards savings and investments that allows you to secure your future financially. The financial freedom journey is important, but at the same time, it should be enjoyable.
Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.