3 Things the Financial Independence Equation Teaches Us – Huffington Post

Everyone has a particular financial independence datea future date when they can stop working and live off of their savings alone. I know what youre thinking: Not me, Ill be working forever. But thats not necessarily true. It turns out that you can calculate your financial independence date. And, surprisingly, the formula involved contains three hidden insights that can drastically shorten the time itll take you to achieve financial independence. Let me explain.

At its core, financial independence is about accumulating enough savingsa nest eggto pay your yearly expenses. But how large of a nest egg do you need? And how long will it take you to build that up? To answer that we need some assumptions. Here are a few that simplify matters:

You spend the same amount of money each year: E dollars. (Importantly, E should include all yearly expenses, like taxes, utilities, etc.)

You save the same amount of money each year: S dollars

You deposit your savings into an account that earns r% interest each year

You currently have no savings

You have no other assets you can sellno home, no caror future sources of income (no retirement account, no Social Security, etc.)

With these assumptions we can calculate how many years itll take you to achieve financial independence (in a minute Ill indicate where you can find the derivation of this equation):

Here log is the base ten logarithm. You probably havent thought about that since high school. Thats okay, because at the end of this article Ill give you a link to an interactive calculator I created which calculates t for you. The formulas real insights come from understanding the new kid on the block: STE.

STE is the savings to expenses ratio: STE = S/E. As an example, if you save $1,000 each year and spend $10,000 each year, then STE = $1,000/$10,000 = 1/10 = 0.1. (This says that each year you save one-tenth what you spend.)

Now on to the formulas insights. The table below shows various combinations of STE and r (the return rate on the accumulated savings).

Here are the three key insights:

Youll likely be working forever if you spend 10 times (or more) what you save each year. In these cases STE is at most 0.10, and according to the first row of the table, even with a 6% return it would still take 48 years of saving to replace your yearly expenses.

Even small improvements in your STE ratio can make a big difference. Check out what happens when you go from an STE of 0.10 to 0.25the financial independence date decreases regardless of the return, and it also occurs at least 15 years sooner!

Once you save at least what you spend each year (STE of 1 or larger), the rate of return doesnt matter much. These cases are illustrated by the last 5 rows of the table. Notice how the years until financial independence dont change much as the return rate increases. Even at an STE of 1, the difference is 4 years between a measly return of 2% and a 6% return.

The major takeaway from these insights is this: the fastest way to reach financial independence is to increase your STE ratio! Moreover, if you manage to reach an STE ratio of 1, mathematics rewards you: you can invest your savings in relatively safe but low-returning securities (like bank CDs) and still reach financial independence in about the same time as investing in higher-returning, generally more risky securities (like stocks). Finally, here is the link to the interactive tool I had mentioned I created to help you calculate your own financial independence date.

I hope the equation aboveand its insightshas empowered you to take control of your finances and move up your own financial independence date. Youll have to increase your STE ratio, which is no easy task, but there again math has much to say. In fact, the same math I used to derive the financial independence equation yields similarly useful insights into other parts of your life, including health and even relationships (see The Calculus of Happiness, which also includes the derivation of the financial independence equation). The final takeaway, then, is this: math is empowering. Learn it, implement it, and it can change your life for the better.

Read this article:

3 Things the Financial Independence Equation Teaches Us - Huffington Post