[Editor's Note: I'm going to get "mathy" with this article. Consider yourself warned.]
For months I've been crushing on Joe Udo's blog, Retire by 40. Perhaps I'm a little jealous as this blog's initial goal was early retirement before I got sidetracked by a number of other interesting financial topics.
One of my favorite topics of Joe's is his financial independence journey. His "mile marker" is his financial independence ratio.
Don't know what a financial independence ratio is? You may remember it from 10th grade math class. It was usually squeezed in the 5 nanoseconds between the discussion of cotangents and the Mr. Rogers' "number" i.
I feel like you could use a refresher. Your financial independence (FI) is your passive income divided by your expenses. If you make $1500/mo. from stock dividends and need $3000/mo. to live, you are half way to financial independence (FI)... an FI ratio of 50%.
I would wager that 95% of the general public just read that as Charlie Brown's teacher talking.
Another 4% fit into my category, how do I begin to calculate numbers? (Maybe it is easier to go back to cotangents and imaginary numbers?) The last 1% are all set and ready to calculate the numbers.
Let me try to help you out.
Calculating Your Financial Independence Ratio
Let's start with passive income... the numerator of the ratio. I think most people don't have any passive income if they stopped working today. That's a FI ratio of "goose egg" (zero).
The Thompson Twins are likely collecting royalties which is a form of passive income. Maybe you have a pension. Maybe you have a huge nest egg in retirement accounts that you are looking to draw down on. Maybe you have investment properties that pay you an income each month. Maybe you have a small business that other people could manage.
Maybe you have all of the above like we do. (Okay, I'm still working on my one-hit wonder.)
The other part of your FI ratio is your expenses... the denominator. If your Ferrari payment is $3000/mo. you are going to need a lot of passive income to cover it.
Most people don't know their expenses. That's a shame because it's as easy as using Personal Capital FREE web app.
Calculating My FI Ratio: Forty-Nine Shades of Grey
As I noted above, we have a few sources of passive income. In reality they are "potential" passive income sources.
My wife is a few years away from her military pension. Our income properties are about 11 years of having the mortgages paid off... when the rental income starts to add to our passive income. We continue stuff our retirement accounts to defer taxes. I don't typically count Social Security, but it is worth noting that it's a source.
My website and dog sitting income can contribute for years even in "retirement", but they aren't passive. They fall into the category of "If you love what you do, it isn't work."
As you can tell, passive income is difficult to quantify when it kicks in a few years. We could refinance the investment properties with 30 year mortgages to have some passive income now, but that's against the long-term goal.
On the other side of the equation is expenses. We still have the mortgages of the investment properties. We have a 2 and 3 year old with daycare commitments. The expense of kids change quite a bit over time. We can plan for them, but it doesn't help for keeping a consistent financial ratio.
We are in the process of paying off the mortgage in our own home (11 years left!). We are in the process of paying off our solar panels which will eliminate our electricity bills. We are half-way through paying off our new cars from a few years ago. Since we tend to drive our cars for 11-12 years, we'll have some time where our expenses are zero.
(Soapbox: I can't anticipate frivolous lawsuits from lawyers. I hope that someday America will be a country where a person can write his opinion or his personal experience to help people.)
In short, there's a lot of ebb and flow on both sides of the equation. We could go from 0% FI to 200% FI very quickly depending on the timeline.
For now, I'll keep it simple... our FI ratio is "goose egg."
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