The stages of financial freedom: The road to financial independence

Today we’re going to explore the six stages of financial freedom. First, though, I want to introduce you to my friends Mac and Pam.

Pam is a pathologist and an elite ultra-runner. Mac is a former high-school science teacher and current stay-at-home dad. Together, they form a formidable financial team.

They’re also a couple of nerds. I mean, look at them!

[Pam and Mac]

Maybe because they’re such nerds, Mac and Pam have always put an emphasis on saving. But they don’t just pinch pennies. They’ve optimized their lives to boost their income and their happiness. They’re well on their way to financial independence. In many ways, they epitomize the ideals espoused by my Money Boss philosophy.

The Money Boss Method in Real Life

When Pam was in her final year of med school, for instance, Mac worked as a research tech at a neuroscience lab. He brought home only $18,000 but they were careful to avoid living paycheck to paycheck.

“We would pay the rent,” Mac says, “we would put money into savings, and we’d still have money left over at the end of the month. We made choices not to buy the little things that could have killed our future.

After med school, Mac and Pam moved to Portland. While Pam did her pathology residency at Oregon Health & Science University, Mac taught high-school science. At that time, their salaries were similar.

When their first child was born in January 2005, Pam took maternity leave until Spring Break. From Spring Break until the end of the school year, Mac brought the baby with him to work and placed her in the student-run daycare.

“Counting the cost of daycare, my teacher’s salary went down to minimum wage,” Mac says. At the end of the school year, he asked for a year off. That year turned into forever. “It came down to whether I wanted to raise other people’s kids or whether I wanted to raise my own.”

The traditional choice is for the mother to stay home with the kids, but that seemed silly in their situation. With her residency completed, Pam could earn four or five times what Mac could make as a teacher. “It didn’t make sense to throw away the money we spent on Pam’s education to not reap the benefits of that education.”

For the past decade, Mac and Pam have worked in tandem toward family and financial goals. Pam makes the money. Mac takes care of two kids and day-to-day household operations while also managing their investments. They’re both careful with spending.

“We spend a lot less than all of our friends who earn similar amounts,” Mac says. “Lots of our doctor friends have multiple houses. They own fancy cars. They spend lots of money and we don’t. Neither of us wants a second home. I drive a 2007 minivan and Pam drives a 2004 Avalon. Our only debt is our house. We pay off our credit cards every month and we have no car payments.”

From the beginning, saving has been a priority for Mac and Pam. And as they earned more, they saved more. It’s true their spending increased too, but at nowhere near the same rate. A higher income meant they could put more in the bank — not buy more stuff.

Because they’ve been so diligent for so long, Mac and Pam will be able to retire in their forties. They’ve made the choices and done the work necessary to achieve Financial Independence at a young age.

“We’d rather accumulate our wealth, to live how we want later in life than spend on things now,” Mac says. Yes, they could afford to buy things today, but doing so would require sacrificing more important opportunities tomorrow.

These two are money bosses! They’ve been climbing the ladder of financial freedom for a long time.

[The Smith Family]

The Six Stages of Financial Freedom

I used to believe that financial freedom meant just one thing: Having enough money that you never had to work again. Over the years, people like Mac and Pam have taught me that financial independence exists on a continuum. It’s not “all or nothing”, but an ever-increasing range of options. It’s a process.

Each stage of financial freedom allows you greater autonomy and self-expression, and these are qualities that lead to happiness.

Nearly a decade ago, I came up with what I called the three stages of personal finance. Later, I expanded this to four or five stages. Today, I recognize there are many degrees of financial independence.

For our purposes, we’re going to keep things simple.

After blending my ideas with those of Joshua Sheats at Radical Personal Finance, I’ve come up with a model that tracks six stages from financial dependence to financial abundance.

But before you can begin progressing through the six stages of financial freedom, there’s a preliminary hurdle you have to clear. You’re in this “zeroeth stage” if your expenses exceed your income.

Stage 0 – Dependence

In this stage, your lifestyle depends on others for financial support. We all start here. We’re born this way. How long it takes to break free varies from person to person. You’re in this stage if you rely on financial support from your parents. You’re in this stage if you spend more than you earn. You’re in this stage if your debt payments exceed your income.

After you begin to earn a profit, you begin to progress through the six stages of financial freedom. The first three are the “surviving” stages.

Stage 1 – Solvency

Solvency is the ability to meet your financial commitments. You reach this stage when you no longer rely on anyone else for financial support — when your income exceeds your expenses, when you are no longer accumulating debt. When you are earning a profit, you have achieved solvency. Some people reach this stage in their teens. Some never reach it. (I reached it at age 35 in October 2004, when I stopped debting and began to repay what I owed.)

Stage 2 – Stability

You achieve stability once you’ve repaid your consumer debt, established some emergency savings, and continue to earn a personal profit. You may still possess some “good debt” — college loans, a mortgage — but you’ve eliminated other obligations and built a buffer of savings to protect you from unfortunate events. (I reached this stage at age 38 in December 2007, when I made my final debt payment.)

Stage 3 – Agency

The final “surviving” stage is free agency, the ability to work and live how and where you want. In this stage, you’ve eliminated all debt (including student loans and mortgage) and you have enough banked that you could quit your job at a moment’s notice without hesitation. This is commonly called “screw-you money”. (I achieved agency in March 2008.)

Note: I know first-hand there are times you might prefer to carry a mortgage even if you don’t have to. For the purposes of this stage, if you have enough saved and invested to pay off your mortgage, it’s the same thing as not having one.

In the final three stages, you move from surviving to thriving. Money is no longer a safety net, but a tool to help you build the life you envision for yourself and your family. Remember our discussion of the “crossover point” earlier this week? That concept is key to defining where you are in these latter stages of financial freedom. (Each of these stages assumes no debt. Or, as explained in the note above, enough cash on hand to instantly repay your debt.)

Stage 4 – Security

You achieve financial security when your investment income can cover your basic needs. That is, based on how much you have saved and invested, you could live a meager existence for the rest of your life. Even if you never worked another day in your life, you have enough to afford simple housing, basic food, essential clothing, and insurance.

Stage 5 – Independence

Financial independence is the ultimate goal for most folks. At this stage, your investment income is sufficient to fund your current standard of living for the rest of your life. You can afford the basics, but you can afford some comforts too. You have Enough. (I leaped from agency to independence in April 2009. This is the stage I’m in today.)

Stage 6 – Abundance

In the final stage of financial freedom, you have “enough — and then some”. Your passive income from all sources will not only fund your lifestyle indefinitely, but grant you the freedom to do whatever you want. You can share your wealth with others. You can indulge in luxury, explore the world. You can build a business empire.

Note: Where am I on this scale? I’ve definitely achieved Financial Security. If you’d have asked me a year ago, I would have told you that I was solidly in stage five, Financial Independence. Honestly, that’s probably still accurate — but a lot about my financial situation seems less certain than it did a few months ago. That’s a topic for another conversation…

The more money you save, the more freedom you have, and the greater risks you can take. As your financial independence increases, you chip away at the wall of worry. You’re able to make decisions based on happiness and not on dollars.

And here’s the thing: As you develop smart money habits and skills, these will not only help you obtain whatever immediate level of financial freedom you’re working toward, but also progress toward future levels of freedom.

If you’re working toward debt freedom, for instance, as you learn to spend less and earn more, this profitability will continue to help you once you’ve achieved solvency. You can apply the same ideas as you work to obtain stability, and then agency.

I spent far too long this morning playing in Photoshop to create the summary below. I am not a graphic artist…but I try.

[The Stages of Financial Freedom]

Summing Up

That’s it for migrating the Money Boss crash course to Get Rich Slowly!

Over the past few weeks, I’ve shared the nuts and bolts of my financial methodology. To summarize:

  • You are the boss of you. Nobody cares more about your money than you do, so assume responsibility for your financial future. Run your life like a business.
  • The best way to get what you really want is to become clear on your goals and values. That’s why everyone should craft a personal mission statement.
  • Your saving rate is the most important number in personal finance. Savings — which I like to think of as “profit” — gives you the power to do what you want in life.
  • Frugality is the cornerstone of wealth-building, but the best way to spend less is to cut back on the big stuff.
  • You are 100% responsible for your income. To earn more, learn more. Work more and work better. Sell yourself. If you take the time to supercharge your income, your profits will soar.
  • Think like a billionaire by carefully guarding each dollar you earn. Recognize that every time you spend today, you’re sacrificing a piece of tomorrow. Be wary of opportunity costs. Practice mindful spending.
  • Invest wisely. Don’t try to get rich quick. Develop an investment philosophy and develop an investment strategy that supports this philosophy.
  • Use barriers and pre-commitment to automatically do the right thing — every time.
  • As you adopt this philosophy, your wealth snowball will begin to grow. The more you work at it, the bigger it’ll get. Protect it. Your wealth snowball is the key to your financial future. Eventually, you’ll reach the crossover point, that place where your investment income exceeds your day-to-day spending. You’ll have achieved Financial Independence.

It was a lot of work to put this together, but it was also a lot of fun. I’d love feedback if you have it. I want this info to be as useful as possible to future readers, so drop me a line to let me know what you liked — and what you didn’t. Constructive criticism will not offend me.

I’ve collated this series of articles into a free ebook called A Brief Guide to Financial Freedom. Like much of this material, it’s still branded for Money Boss, but soon I’ll revise everything to be GRS-specific.

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