How we understand financial freedom, and how we actually should

In reality, it is best understood as a graded process that gets built over time. In other words, financial freedom is about gaining increasing flexibility over time.

November 24, 2021 8:44 IST | India Infoline News Service
Financial freedom or financial independence is not just a point but a process.  We use the term financial freedom too loosely. Some interpret financial freedom as having started financial planning while others interpret financial freedom as zero borrowings. One common definition of financial freedom is when you have a few months of savings to fall back upon.

However, all these definitions are too narrow or just focus on one aspect of financial freedom. In reality, it is best understood as a graded process that gets built over time. In other words, financial freedom is about gaining increasing flexibility over time. One way to look at this process is to divide Financial freedom into seven phases. Here is how.

1) Basic financial freedom – Understanding your financial position

This is not exactly financial freedom but the first step to financial freedom. Here you have a personal balance sheet in front of you and clarity about your finances. For example, you have a total understanding of your financial assets, real assets, your loans, credit cards, liability due to guarantees given etc.

Here the focus is just on understanding your financial position and where you stand. You know whether your assets are sufficient to cover your liabilities or whether your liabilities are in excess of your risk. The latter situation happens when you use consumer loans to splurge on conspicuous spending.

2) Auto mode – You can meet your expenses without borrowing

This auto mode stage is the second stage of financial freedom. You must first reach this stage. If each month you need to borrow to run your home or for your regular expenses, then you are not getting anywhere too far with respect to financial freedom. Either you have to enhance your income sources or cut down on spending.

This is an important step as it helps you create the necessary budget to start savings and make the most of your income. At the end of the day, you become wealthy in the long run not by how much you earn but by how much you save. For that to happen, you first need to get onto this basic auto mode.

3) Sigh of relief – Some savings to fall back upon

This is the third stage. You are not really taken care for a longer period of time but you are not living from salary to salary. You don’t start checking your SMS for salary credit by the time the last week of the month. Here you still have not started thinking about the future but many people in India would be quite happy to reach this stage.

4) Emergency fund ready – No consumer debt to worry about

This is the ideal situation you must have when you start financial planning. Once you start your financial plan, you cannot be disturbing your mutual fund investments for your daily needs or even for emergencies. You must have 6 months of routine expenses stashed away in a bank, or better still in a money market fund.

The focus is not returns but liquidity. When you start your investment journey, this emergency fund gives stability to your plan. The idea of putting the money in a money market fund is to have easy access to the money, yet earn above market returns. Above all, no high cost consumer debt like credit cards and personal loan is a pre-condition.

5) Entrepreneur’s dream – Can live off savings for 2 years

When you decide to branch out on your own, the big worry is funds. It is said that any new venture takes time to flower. In this period, a stash of 2 years of full expenses well invested would come in handy. That allows you to focus on your dream project without worry about mundane things like bills, school fees, rentals, EMIs etc.

6) Truly independent – You can now live off your investment income

This is what most people dream about. It is not too difficult. For example, if you start saving in a mutual fund SIP at the age of 21, by the age of 45, you can have enough to decide not to work any longer. Of course, if you had an added bonus like stock options or an inheritance, that is icing on the cake. But this is the stage most people really dream about. Investments are enough to take care of your expenses, your loans are repaid and you can choose whether to work or not.

7) Utopian idea – Much more money than you would ever need

This is the highest form of financial freedom and is Utopian for most people. That is when you have abundant wealth created through equity and property. You not only have enough for your family, but you also have enough to give away. This is the stage, you can think about bequeathing wealth, inheritance planning, charity, asset diversification etc.

Remember, financial freedom is not just a static concept. It changes over time. The trick is to progress through these stages of financial freedom.

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