The key to achieving financial independence is to create an effective budget. I have found that a realistic budget can be the core of a number of calculations which help to determine various metrics related to financial freedom. In this article, I will have an in depth look at this often overlooked tool and show how powerful it can be.
Why You need a budget
A budget is the most basic element of any financial plan. It enables you to forecast how much you are likely to spend over a particular time period such as the next month, week or year. Once you know the likely number, for example, expected monthly expenditure, you can calculate how much money you can set aside for investments or savings by subtracting the amount from your take home pay.
Of course things are not always perfect and during some months you will spend more than expected. This can be mitigated by having a cash buffer in your current account; a minimum bank balance which you are comfortable with. This can be as little as £200 and it can also help to avoid bank charges for overdrawing.
Know your essential and discretionary expenses
As you can see from the budget template above, the expenses are split into various types: essential, discretionary and work. It is important to know your essential expenses as these will let you determine your progress towards financial independence. Essential expenses are a necessity, usually occur monthly and include food, accommodation, utilities, property or council taxes.
Discretionary expenses are not needed and can include travel, eating out, entertainment, gifts and recreation. These a lot easier to eliminate or reduce when required. I have also included work related expenses as these can be substantial depending on your occupation or how you travel to work.
Some jobs require costly clothing, training or travel which may have to be covered by the employee. It is not uncommon for UK commuters to pay upwards of £5,000 or $7,250 a year on rip-off train fares. Costs like this are life changing and can easily derail any plans for financial stability.
Calculating your Financial Independence numbers
Once the budget is ready and verified to be realistic it will be come possible to estimate how much you need to have in investments in-order to declare financial independence. Simply multiply the essential monthly expenses from the budget by 12 to get the annual figure and then multiply further by 25. Work related and discretionary expenses are excluded here.
Financial Independence Fund = monthly expenses x 12 x 25
Note that, based on the 4% rule, this would only provide coverage for your core essential expenses but not include any extras or lavish spending. Such a low amount may not seem sufficient but can have an extremely powerful psychological impact and I will explain why. You should also realise that the amount is low only as a figure, but as the money is generated as passive income it is worth a lot more than money generated actively. Active income involves work, is heavily taxed and requires your to trade your time for cash.
If you can cover your base expenses would you be more comfortable to step away from a job you don’t like or take several months or weeks off to go travelling without worrying about money? The answer for me is yes.
If you can cover your base expenses would you be more comfortable to step away from a job you don’t like or take several months or weeks off to go travelling without worrying about money? The answer for me is yes. A lot of other options will open up for you such as trying another occupation, becoming a contractor, self employment, volunteering etc.
Goal Progress – a useful insight
A really useful insight that can be gained from this exercise is to determine how far you are from financial independence. As a percentage this is determined by dividing your total investments by the financial independence figure calculated above. I regularly do this calculation and share my result here.
The progress number will vary inversely to how big you budget is: an increased budget will reduce the number and cutting you budget will increase the number, bringing you closer to financial independence, which shows the important of cutting costs and saving more. Tracking these metrics will help to optimise your finances according to your goals.
Other articles on investing
- The Snowball – How compound interest can make you rich
- Building a low cost investment portfolio of Index Funds
- Why you should invest only for the long term
- How to invest intelligently in a Bull market