Today, financial independence or even saving every month sounds like mission impossible. Between rising inflation, rising gasoline, food and even energy prices, these concepts seem far away.
However, although it is complicated, it is not impossible. With discipline, good organization and knowledge about investments, you can enjoy a financially peaceful life, without any shocks or scares.
There is a method on the rise around the world, especially in the United States, that makes it easier to achieve this favorable economic state. Read on to learn about the FIRE method and learn how to apply it to your personal finances to enjoy tomorrow.
What is the financial independence that the FIRE method assures you?
Financial independence can be defined as the economic state in which our passive income exceeds our expenses. In other words, it consists of accumulating as much capital as possible by saving and investing, so as not to have to depend on a job or a contracting company, and to retire before the established age.
Since in Spain we have the public retirement pension, we can understand financial independence as the income we need to not have to work (early retirement or take a long break from work) or to live better once we are retired (an additional income to the public pension).
That additional income that would give us financial independence should come from our savings and investments.
Financial independence allows you to follow more the lifestyle you want, and not the one imposed on you by third parties. In the case of people who have achieved this financial status, they are free to pursue their own dreams: a big trip, surrogacy, or an adventure. They have the ability to do it whenever they choose because they have done their homework ahead of time.
It’s even what some call ‘the best money can buy’. Financial independence means the ability to rethink how you want to live your life when you want to.
The FIRE method, a solution for financial security
On the other hand, financial security is a short-term benefit you get from pursuing financial independence.
Financial security is a shield against all the unforeseen events that might otherwise have posed a financial problem. It is a financial cushion that protects you from unexpected situations such as losing your job or from the arrival of unexpected events such as an emergency home repair, an illness or a pandemic, with all that that implies.
Financial freedom requires having a cushion that covers your family’s financial needs (fixed expenses) for a minimum of three to six months. This is a sufficient period of time to recover from a possible setback, such as a long-term illness in any of the family members. Put another way, financial independence allows you to buy time to get over a bump in the road.
Sometimes, those bumps can occur suddenly and without having built up the financial cushion, so you need help from others. In these cases, you can count on a personal direct credit to alleviate the expense as quickly as possible because it is easy to obtain and does not involve formalities such as changing banks.
What is the FIRE Method?
Optimizing your family finances and moving faster toward your financial goals is easier with the FIRE method, which stands for Financial Independence, Retire Early. Or, translated into Spanish, Independencia financiera, Jubilarse Pronto.
The method allows us to move toward either of these two financial goals: financial independence or early retirement, whichever we desire. Ending our working life early may not be a priority if you are still young, but achieving that financial freedom can be a lifelong goal to strive for.
As the experts say, after all, saving more, spending less and investing well to achieve our goals and meet our financial calendar are always positive things.
How to achieve Financial Independence through the FIRE method?
Differentiate what is important and what is not important for your future.
The main basis of the FIRE method is to cut back on consumerist or unwanted purchases, in order to save as much money as possible that you will enjoy tomorrow. In more philosophical words, you will put your future happiness before instant materialism.
To do this, you must learn to better manage your salary and money so as not to invest it in purchases that will not pay off in the long run. As it sounds easy, but we know that in practice it gets complicated, it always comes in handy to have some tool, such as an excel and a guide to save better, to help you achieve financial independence as soon as possible.
It is very important to know in depth what you spend your money on by making a budget, as well as to start selecting what is superficial and what really matters to you. As a result of the choices you make, according to the FIRE movement, you should save more than 50% (and ideally 70%) of your current income.
Your time is worth money. Don’t waste it.
Saving and cutting expenses, although at first sight it may not seem so, have a lot to do with time. Economists say that time is a commodity. Time can be used to improve your quality of life now or it can be used to buy free time in the near future to do what you want to do.
Come on, you can decide to work less now when you are young and enjoy certain things or decide to work the same now and enjoy more when you retire or advance your retirement age.
If we translate this into hard cash, since most purchases are made with money we have earned, we can quantify how many days or hours of work it took to buy a certain object.
Let’s put the essence of time in the FIRE method into numbers. If you earn 40 euros an hour and add up to 2,000 hours a year when you buy a 40,000 euro car, you will have put in about 1,000 hours of work to get it.
If you think about it this way, maybe you would have preferred to do something else with your money and your time.
If you think of your purchases in terms of time, it is likely that some impulse purchases will lose interest and that more expensive purchases will require a little more thought.
Especially if you set a medium to long term goal that will recede every time you get carried away with superfluous spending. That car that has cost you a thousand hours of work takes you a thousand hours away from an early retirement.
Investment as the essence of the FIRE method and betting on the long term.
The last trick that the FIRE method brings to the table is investment. In times of inflation, you must be very careful where you invest your money. And, above all, always do it wisely.
To invest your money and for it to multiply in the long term, it is best to bet on a mutual fund or the stock market, and play it safe.
And, as investing is a primary tip of the FIRE method, you need to learn how to save first to be able to move on to the second step: making investments.
That’s why the FIRE Method comes up with a number so you can calculate how much you need to have saved by the time you retire or retire from the labor market. The trick is based on multiplying your annual expenses by 25: that’s the amount you should have saved in the long term. Therefore, you should accumulate and invest 25 times what you spend in a year.
To make it easier, let’s imagine that in a year between all expenses (energy, rent, food, leisure, etc.) you spend approximately €20,000. This means that your savings target is €500,000 over the course of your working life.
To follow the FIRE method and to be able to achieve financial independence, there are some fundamental investment bases that you have to take into account:
- You should invest your savings periodically. Time is key in investments. The FIRE method proposes a long-term investment, which makes it possible to assume more risks since the type of investment itself involves less.
- It invests in index funds or low-cost EFTs. Above all, the FIRE method focuses on frugality and efficiency. For this reason, all those who follow the method are big fans of indexing, because by holding a portfolio over the long term, you can achieve 7% annual returns.
This financial independence you are looking for translates into a final result of passive returns of 7% per year on what you have saved and accumulated, which allows you to devote 4% to your real expenses. In other words, you will only be able to enjoy 4% of everything saved once you have acquired financial independence. In order for the method to be effective, restraint in spending is vital.
It’s all about your savings rate
The FIRE method states that the way to move towards financial independence is through your savings rate, or the percentage of income you can devote to savings. If you are able to save 50% of your annual income, you will be able to reach financial independence faster than if you only save 20% of your income.
One of the big doubts is whether you consider home ownership as part of that savings. The truth is that buying a home greatly limits your financial freedom, since people, on average, take out a 20-year mortgage. During those years of mortgage it is difficult to think about becoming financially independent. But when we exceed those years, we are much closer to it, because we have an asset that can later be translated into a reverse mortgage or a rental.
Thus, those who buy a home as an investment may be buying financial independence in the long term, at the cost of not having it in the short and medium term.
If we prefer to live renting in order to enjoy more financial independence now, we must evaluate to what extent we convert the difference between a letter and a rent into savings so that it does not hinder our future financial independence.
In conclusion, the FIRE method allows you to consider financial independence (FI) as a short-term protection or as the option of being able to make a change in your life whenever you want. Or, as a way to be able to retire earlier (RE) with a better quality of life if you do it when it is your turn.