7 Stages of Financial Freedom

“Life is a journey, not a destination.” - Ralph Waldo Emerson

We all like to think that Financial Freedom is a final destination that we will one day reach. Once we reach it, there will be unicorns and rainbows and all our problems will just vanish. However, if we were to think this way we would be in a world of disappointment. Financial freedom, like life isn't a destination. It is a journey, and like a good journey each stage has its own set of adventures and lessons we can learn from.

Stage 1: $1,000 Emergency Fund

Stage one of financial freedom is to have $1,000 in your bank account as an emergency fund. If this sounds familiar to you, I borrowed it from Dave Ramsey and his baby steps. Dave Ramsey was the first personal finance expert that had a real impact on my wife and I. When we first got married we were trying to figure out how to pay down our $105,000 of student debt, following his baby steps really helped us to feel like we were making progress in our personal finances.

For many of you, you likely have already reached stage one. If so, congratulations. Having $1,000 in cash may not seem like much and definitely far from complete Financial Freedom, but it is an important step to starting your journey. Some studies show that more than half of Americans can’t cover a $1,000 emergency expense with their savings. By having $1,000 liquid cash in the checking account, you are doing better than half the people out there. So, if you’ve already achieved Stage 1, give yourself a pat on the back and let’s move onto Stage 2.

Stage 2: $0 Debt (Except the House)

Stage 2 of Financial Freedom is to pay off all debt except the mortgage. This includes debt like credit card debt, student loans and car loans. The pursuit of financial freedom requires that you aren’t being weighed down by debt. If you have accepted debt as a normal way of life, you have to start thinking differently.

Debt should not be considered normal. Especially for those of us pursuing financial freedom. When we normalize debt, we normalize lifestyle inflation. We normalize debt payment as a regular part of life. Worst of all, we normalize the background hum of financial stress. If you have debt right now, vow to recognize it as something that needs to be rid of, not to be accepted as a normal way of life.

My wife and I used what Dave Ramsey calls the Debt Snowball method to pay down our student loans. You essentially list out all your debts in order of balance, from the smallest to the largest, regardless of the interest rate. Then you squeeze out as much as possible from your budget and tackle the smallest one until it is gone. Once it is gone, you focus your effort on the next, second smallest debt until that one is gone as well. You keep going until all your debt is gone. By tackling from smallest to largest, you gain momentum in your debt paydown journey - like a snowball.

Stage 3: 3-6 Months of Emergency Fund

Stage 3 is to have between 3-6 months of expenses saved in your checking account as an emergency fund. The specific months depend on your personal preference and the stability of your job. My wife and I prefer the 6 months. Given we are more risk averse when it comes to preparing for unexpected events, but the key is to have enough cash in your checking account to handle emergencies and life events. Life events like job transitions or emergencies like your water boiler breaking down.

Because you have cash, you don’t need to borrow money. You have already paid off all your debt in stage 3, so you don’t want to get yourself into a position where you might need to be burdened by debt again. Stage 3 really starts to really give you both the mental and emotional breathing room when it comes to your finances. You can start planning for the long term future. You can strategize your career pathway. You are no longer making short-term financial decisions to survive.

Level 4: 1-Year of Expense

Stage 4, is to have 1 year of annual expenses saved. Because this is a large sum of money, it would be a combination of your cash and investments. This is what I believe is the real pivotal point where many of us go from a short-term survival mode to long-term wealth building mode. When you have one year of expenses saved, you essentially have what JL Collins famously calls, the F-You money. If you really don’t like your job, you have the ability to quit and look for a new one without the fear of financial catastrophe. If your company is downsizing and you are unfortunately on the list, you don’t have to stress out like many others. You kind of welcome the downtime.

We live in a time where an average person will have multiple careers in his or her lifetime. For me personally, I’ve made 3 major career shifts in the last 20 years. Completely changing my occupation and the industry I worked in. The world is changing quicker than many of us can adapt to, and having 1 year of expenses will give us the cushion to successfully make these transitions.

Another interesting thing you’ll notice starting happening at this point is the power of compounding in your portfolio. When you have $1,000 in investments and the market is returning 10% a year, $100 doesn’t feel like a lot. But when you have $100,000 in the market, now that 10% annual return just made you $10,000 without you needing to do anything. If the 10% return continues, your $100,000 will essentially double to $200,000 in little over 7 years. This is how the wealthy get wealthier and at stage 4, you are getting a glimpse of it.

Stage 5: 5-Year of Expense

Stage 5 is where you have 5-years worth of annual expenses saved and invested. If you arrive at this stage at an earlier point in your life, like in your twenties, you are effectively “Coast FI” according to the Financial Independence world. Essentially you have enough invested in the market that even if you don’t invest any more money going forward, the compounding will allow you to have enough to retire when you reach the age of 65. If you are at this stage right now, really congratulations. You have really achieved more than the majority of Americans will ever achieve in a lifetime.

The compounding effect on your portfolio is really kicking in now. For example, let’s say your annual family expense is $100,000 and you have saved and invested $500,000 in the market. At a simple 10% market return, your portfolio is growing at $50,000 a year. That’s half of your annual expense. Of course, you aren’t spending this amount and it’s being reinvested into your portfolio which allows you to grow that portfolio, let’s say a same trajectory of 10% a year. Which means without you doing anything, your investment will have grown to $1,000,000 in little over 7 years.

I’m simplifying everything here of course - there are a lot of factors that go into market returns. But the point here is that when you get to Stage 5, you will really start to feel the power of financial freedom. At this stage, you can take calculated risks in your life. My wife and I definitely felt this when we reached this stage. It allowed us to start dreaming about where we wanted to be in 10 years. And if we wanted to pursue that new career or new experience, can we take some risks now given that we have the cushion. It allowed me personally to slow down from my day job to spend more time on this channel and the website.

Stage 6: 10-Year of Expense

You reach Stage 6 when you have 10-year worth of annual expenses saved and invested. At this stage, your portfolio returns could be equal to your total annual expense. Using the same estimate as earlier, assuming a $100,000 annual expense, you now have $1,000,000 in your portfolio. At 10% annual return, your portfolio is generating $100,000 from market return alone. This is quite amazing if you think about it. Imagine how many hours you have to work a year to make that $100,000 a year. Your sweat, blood and tears go into making sure your family is financially taken care of. The $100,000 pays for the house mortgage. Food on the table. Insurance. Your son’s orthodontist expense.

When you have a 10-year worth of annual expense in the market, it essentially is generating that same amount, but without the sweat, blood and tears. It is truly passive income and it is quite an amazing feat if you are able to reach this stage. You might even start to feel rich. But this stage is also where you want to also check yourself because it represents a danger point for many. When you have this much money in the market and you feel the emotional freedom that comes with it, it's also possible to fall into complacency when it comes to your budget. You stop looking at the right side of the menu when you order food. Instead of continually shopping at Old Navy, you jump to Banana Republic. Nothing wrong with Banana Republic, but what happened to Gap? You can’t just skip it on your way to lifestyle inflation. You should definitely congratulate yourself when you get to this stage, but also don’t lose focus.

Stage 7: 25-Year of Expense

Stage 7 is 25 times your annual expenses saved and invested. This is the ultimate financial freedom because when you have 25x your annual expense invested in the market, you have the choice to completely retire from work. The rationale behind the 25x your annual expense comes from what’s called the 4% rule. The basics of the 4% rule is that when we only pull 4% from our portfolio a year, the investment will continue to grow ahead of inflation allowing us essentially to live off our portfolio forever. Like a Goose that continuously lays the golden egg.

In the example of $100,000 annual expense, this means when you have a portfolio of $2.5 million dollars, 25x the $100,000, you are basically financially free. You can pull $100,000 a year from your $2.5 million dollar portfolio for the foreseeable future and it will never run out. Of course, there are a lot of nuances here that I’m not covering like inflation and prolonged market downturn, but that’s for another time. The basic notion here is that when you achieve stage 7 you can retire from work if you choose to do so. Or you can pursue a different career that you didn’t before because of financial reasons. Or you can choose to travel the world with your family. The choice is yours and the world is your oyster.

If you feel like you are too late to the game and you don’t think you’ll ever reach this stage, don’t lose heart. There are many who are pursuing Financial Freedom even much later in life. My friend has a website called Late Starter Fire where she chronicles her own personal journey of pursuing financial freedom in her late 40s. It is never too late to start. The choice is yours.