5 pointers to check your Financial Independence

Behavioural Finance expert Sarah Newcomb shares pointers that will help you make better decisions.
By Sarah Newcomb |  17-01-20 | 
 

Financial vital signs are a quick and (relatively) simple way to monitor your overall financial health, ensuring that you are in a position to be a successful long-term investor. If the foundations of your financial life are shaky, it will be harder to ride out tough storms in the market. But if you know you are on solid ground, you’re more likely to stay calm and focused in turbulent markets.

Here, I’ll outline a few metrics that I find most relevant when it comes to taking your financial temperature. Regardless of which you choose to track, setting and monitoring progress toward financial goals is easier when you have clear metrics on which to focus.

Net Worth Over Time

This one is simpler than you might think. Add up the market value of everything you own, and then subtract the total of everything you owe. Whatever is left (even if it’s a negative number) is your net worth. Think of it this way: If you had to pay off all your debts tomorrow, selling off assets to do so if necessary, how much would you have left over? Watching how that number changes over time gives a simple indicator of whether you are moving forward or backward, financially.

Why it matters

Many people shy away from looking at their net worth because they know they won’t like what they see. Student loans, mortgages on homes that have lost value, and other debts can overwhelm, but this vital sign gives you an indication of the level of financial freedom you have. If your debts overwhelm your assets, then financial independence will remain out of reach. It is fine to have a negative net worth while you are in the beginning of your financial journey, and all debt is not bad. But in order to achieve financial independence, your assets will need to provide you enough income to sustainably cover your cost of living, including any debt payments.

Watch your change in net worth over time. Is it increasing? Good. If not, take a good hard look at your spending and debt and ask yourself if they are making you stronger or weaker overall.

Debt/Income Ratio

Similar to net worth, the debt/income ratio is a measure of how much your debt load is weighing you down. Unlike net worth, your debt/income ratio is a measure of your monthly debt obligations compared with your income streams.

To estimate your DTI, simply add up all of your monthly debt payments (mortgage, auto loans, personal loans, credit cards, school loans) and subtract that from your pretax monthly income. There are different schools of thought about what constitutes a “good” DTI, but if you want to qualify for the best interest rates and credit cards, keeping your DTI below 36% is a decent guideline.

Why it matters

 Your debt/income ratio affects your creditworthiness to financiers, and it can have a large impact on the cost of borrowing money. If you have a high DTI, you will be charged higher interest rates for borrowing, which can turn into a vicious cycle of debt.

Months of Safety/Freedom

If you stopped work today, how long could you maintain your current lifestyle without tapping into your long-term investments?

To estimate this, divide your total liquid savings (cash and cash equivalents) by your total monthly expenses. The result is the number of months you could go without a paycheck before you would feel the effects in your day-to-day life.

Why it matters

The months of safety metric tells you how long you could afford to spend looking for a new job, should you ever want or need to. Having several months of safety stored up offers wonderful peace of mind, and knowing you have the freedom to change your circumstances lets you know that you are in the driver’s seat of your own life and work--which is an important life goal for many of us.

Impatient people (of which I am one) want to see our money grow quickly, so it’s really tempting to rush into the stock market before laying down this safety net. It’s important to remember that short-term stability is the foundation for long-term solvency. Ignoring your emergency/freedom fund to chase investment returns is a very risky move. It is wiser to focus on this stabilizing measure before taking on long-term investments, because if your safety net is insufficient, you are more likely to need to draw money from your long-term investments before they mature, thereby sabotaging the strategy on which those investments were based.

Financial Independence Quotient

Your financial independence quotient is the proportion of your current income that you could sustainably replace if you stopped all work today. In other words, what proportion of your cost of living could you cover using only the income from your assets, while leaving enough invested to continue growing for the foreseeable future?

To estimate this, you need to know two things:

  1. Your total annual spending (average per month x 12 is fine)
  2. The total annual income you can generate from your assets without draining your principal (for a quick-and-dirty measure, you can use the 4% rule)

For example, if you are currently earning $80,000 per year and saving 15% of that pretax, then your goal for financial independence would be to replace the $68,000 pretax income you currently live on (we’re assuming here that income minus savings equals spending).

Now, let’s say you have a rental property that brings in $12,000 per year and $100,000 in an investment account. You would estimate your FIQ as follows:

Income streams:

Rents: $12,000
Investments: $100,000 X 4% = $4,000

Your FIQ would be (12,000 + 4,000) / 68,000 = 23.5%. That means that you are roughly 24% financially independent.

(Note: These are very simple estimates meant to illustrate the larger idea. We are glossing over lots of details such as specific tax laws affecting rental income versus investment income versus salary, and so on. These details matter when you are making the move to retire, but when you are simply tracking your progress toward the long-term goal, they aren’t materially important. Remember, we’re all about smart shortcuts here.)

Why it matters

Tracking your FIQ over time can be a great motivator because it gives you an idea of how far you have come and how far you still need to go before achieving full financial independence.

Financial Stress

There are plenty of other financial health metrics that warrant a look, but the last one I will talk about here is your own level of financial stress. On a scale of 1-10 (1 = never, 10 = always), how often do you worry about your financial situation? Lowering that number over time is good for your psychological health--and your blood pressure.

Taking your financial vitals at the beginning of the year provides focus for your financial life in the near term. What metrics are looking good, and which would you like to improve on? By the end of the year, what do you want your number to be?

When you have clear, simple metrics to track as you move toward or maintain financial independence, you can make your financial decisions with more purpose, clarity, and direction.

This article initially appeared in Morningstar.com

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