How close are you to financial independence? What if I tell you that you can calculate this number down to a reasonably precise percentage. Regardless of where you stand financially, knowing where you are is a great way to help you move closer toward your goal of financial independence. Like measuring distance or time, knowing where you are currently helps make a long journey more bearable.
Financial Independence Ratio (FI Ratio)
Financial Independence Ratio, or FI Ratio, is basically your passive income divided by your expenses.
Financial Independence Ratio (FI Ratio) = Passive Income ÷ Expenses
First, do not confuse this with Cash Flow, which is your Income minus Expenses. Second, to smooth out the fluctuations, it is best to measure the average passive income and expenses over the past 12 months when you do your calculation.
What is Considered a Passive Income?
In the context of financial independence, you can very broadly define passive income as income from any source that doesn’t require active participation, i.e., not a job. So, we could include all of the following:
- 4% of Investment Portfolio – The 4% amount is based on the 4% Safe Withdrawal Rule. If you invest in a tax-free or a tax-deferred account, you don’t have access to this money until you turn 59 1/2.
- Social Security Benefits – You can look up your benefits on the Social Security website. But remember that you do not have access to this until you reach the minimum age of 62.
- Pension Benefits
- Other Passive Income – In another article, we have identified 21 ways to generate passive income. Any money you make passively counts toward your passive income. The most common sources are rental properties and investment income.
A Note About Early Retirement
For those that are considering early retirement, remember that you have to plan your financial independence in two stages. The first stage is before you have access to your retirement savings, pension benefits, and social security benefits. The second stage comes into play when those income sources become accessible without penalty.
This means that if you want to retire early, you have to depend on investments in your taxable accounts and other passive income sources.
Calculating Your Financial Independence Ratio
Let’s take a look at some examples.
Jane is 25 years old. She has $50,000 in IRA and $75,000 in 401(k). She has no other passive income. Her expenses average $35,000 per year.
FI Ratio = Passive Income ÷ Expenses
FI Ratio = 4% x ($50,000 + $75,000) ÷ $35,000
FI Ratio = 4% x ($125,000) ÷ $35,000
FI Ratio = $5,000 ÷ $35,000
FI Ratio = 14.29%
John is 45 years old. He has $250,000 in IRA and $375,000 in 401(k). He has two rental properties that generate $10,000 per year in profit. His expenses average $75,000 per year.
FI Ratio = Passive Income ÷ Expenses
FI Ratio = [4% x ($250,000 + $375,000) + $10,000] ÷ $75,000
FI Ratio = [4% x ($625,000) + $10,000] ÷ $75,000
FI Ratio = [$25,000 + $10,000] ÷ $75,000
FI Ratio = $35,000 ÷ $75,000
FI Ratio = 46.67%
Basically, when your FI Ratio is 100% or more, you have achieved financial independence!
What is Your FI Ratio?
Did you try to calculate your FI Ratio? I did a rough calculation and looks like we are currently at about 40%
How to Achieve Financial Independence Early
Once you understand the formula, it is so much easier to work toward financial independence because (1) you know where you are today, and (2) you know the key variables that impact your ability to achieve financial independence. Let’s go through the key variables.
1. Cut Your Expenses
As you can see above, your expenses is a major variable. Let’s take a look at Scenario #2 above. If you cut the expenses down from $75,000 to $70,000 per year, the FI Ratio goes up from 46.67% to 50%. This is one reason why people who are gunning for early retirement practice frugal living (aka, “Lean FIRE”). Each dollar you save helps you achieve financial independence faster!
2. Pay Off Your Debt
When you pay off your debt, you achieve two things simultaneously. First, you reduce your expenses by the same amount as your debt payments. Second, you have more money to pay toward other debts, i.e., Debt Snowball, or you can invest the extra money. For example, if John is paying $2,000 a month for his home mortgage, that is $24,000 per year. When the mortgage is paid off, his expenses will drastically drop from $75,000 to $51,000, causing his FI% to jump from 46.67% to 68.63%!
3. Invest More Money
Another important variable is your investment portfolio. Although we are counting only 4% of your retirement portfolio toward your yearly income, do not think this is an insignificant factor.
We only count 4% because this portfolio has to be able to sustain you for 25+ years through your entire retirement. The 4% amount is just saying that you cannot use it all at once and have to strategically withdraw your money through retirement to make it lasts.
As you invest more money, you also need to invest for the best returns according to your time horizon and risk tolerance level. For most people, this is about an 8-10% return, which is the historical returns for the S&P 500.
4. Build Passive Income Streams
Last but not least, and perhaps the hardest thing to do out of these four ideas, is to build passive income streams. Some of the most reliable ways to generate passive income include:
- Investing in income-generating investments. These investments include dividend investing and investing in bonds and REITs. However, you have to be careful because growth investing is a much better option for younger investors. As you grow older and your risk tolerance level decreases, income investing becomes a safer and more desirable option.
- Rental properties. This is a proven income-generating investment. Rental properties can add a significant amount of cash flow once the mortgages are paid off. When you get tired of managing the properties, you could hire a property manager or sell your properties and reinvest the money in other income-generating investments.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.