Thursday, August 2, 2007

Calculating how long you need to achieve financial freedom

This article was submited to the #112 Carnival of Personal Finance. Complete list of entrants can be found here

Financial freedom may be the dream of most people. What is financial freedom?

In my opinion, it is the freedom to do whatever you want, financial-wise. Great… How do we get there?

Crossover Point

Let’s assume you have a steady job with generates income, you spend part of your income and invest the rest. Someday your investments will be so big that they will generate more income than your full time job. When that happens, you have reached the Crossover point (a.k.a financial freedom).

It is easy to calculate when, approximately, you will reach your crossover point. Open up MS Excel (or similar) and reproduce the following spreadsheet on it with your own parameters such as your income (in my example $60k per year) and your current age. (click to enlarge the image)

When placing the cells with formulas, such as Savings column or Investment Interest, make sure to place “=” before the values you see in the image (i.e. =C8*$E$2 should be placed in the first row of Savings column). The spreadsheet on excel should look like this: (click to enlarge the image)

Now select the row of age 31 (or your own personal age) and then drag it down 20-30 lines. (click to enlarge the image)

You should have a table similar to this. Using that table you will be able to make graphs on excel, such as Income and Interest vs age.

The red circle in the graph below indicates the Crossover point, somewhere between 55 and 56 years in this example. This means that, after 56 years old you can simply walk away from work and you will keep the same income you had with zero effort. You could focus your time into activities that you enjoy more or simply go spend your money.

One thing that is important to note is that the income from your job grows 5% per year, part of it is due to inflation and the other part is because of promotions or other bonuses you eventually get along your life. So this calculation takes into account potential increases in lifestyle. (click to enlarge the image)

You are welcome to play with the Savings (%) and check the impact it has in the crossover age and then leave a comment with your findings.


dong said...

I think your investment income crossover point is solid concept, but I think it's also worthwhile to look at expenses. I mean why work if your investment income covers your expenses even if it doesn't cover your income?

P said...

dong, thanks for the comment !

I think you should continue working until your investment covers income because then it will have a "snow ball" effect. If your investment covers your income and you quit working I assume you can continue saving the same way you usually did, and therefore your investment will continue to grow exponentially.

Since there is always inflation, your expenses are always growing and it is important to keep the investment interest growing as well. If your investment only covered expenses, your investment interest would be same every month (not growing), and would eventually be not enough to cover your new expenses (adjusted by inflation).

I hope this helps.

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