Q&A: What are the different stages of financial independence?

​Hi Heather,
 
My name’s Sam. Can you talk about financial independence and the steps one has to move through to get there?
 
Thanks

The Money Spot™ - UK Personal Finance · #15 What are the different stages of financial independence?

Thanks for this question, Sam.

​In the past, I used to think about financial independence in a one-dimensional way: you were financially independent if your income from passive investments exceeded what you need to maintain the lifestyle you want indefinitely.
 
It wasn’t until I heard JD Roth the founder of Get Rich Slowly on Paula Pant’s Afford Anything podcast that I started thinking about financial independence as something that can be broken down into stages. I like his idea so rather than re-invent the wheel, I’ll share his wisdom with you and you can decide where you are on this continuum:
 
Stage 0 – Dependence
 
In the dependence stage, your lifestyle depends on other people for financial support. Absolutely everyone starts here, we are born fully dependent on our parents and people break out of parental dependence at different stage. I dare say you can break out of being dependent from parents and fall back into dependence in your 40s and 50s because of a life incident or poor planning.
 
However, if even if you don’t live at home with family you would still be in the dependence stage if your spending exceeds your income.
 
Following the dependence stage, stage 0, there are six stages to full financial independence in JD Roth’s model. The first three stages of the journey are the “surviving” stages.
 
Stage 1 – Solvency
 
You’re solvent if you can meet your financial commitments, that is, you have enough earnings to pay your bills. You will have reached this stage when you no longer rely on anyone else or on credit for financial support.
 
You are a solvent person if your income exceeds expenses, and you are no longer accumulating debt. I reached this stage when I was 18 thanks to an academic scholarship. My scholarship paid for all fees and gave me a lump sum to cover accommodation, food and a plane ticket home every year. In December 2002 when my dad sent me a gift of money with my mother who was visiting me at school, I told her that from here on out I don’t need money from you and dad; I will survive within the means of my scholarship – I asked that they saved the money for my sisters’ education and I haven’t looked back since.
 
My dad took that thanks and ran!
 
While some people will reach this stage in their teens, as I did, most people reach this stage when they start the first job that allows them to leave home. Some never reach it and are dependent on others for survival from cradle to grave.
 
Stage 2 – Stability
 
You have achieved financial stability once you've repaid all your consumer debt and have some money set aside for emergencies, and continue to earn enough to save – you can think of your savings as your profits.
 
You may still possess some “good debt” — student loans, a mortgage — but you've eliminated other obligations and built a buffer of savings to protect you from unfortunate events. Dave Ramsey suggests a buffer of £1,000 and I would agree with that as being adequate to cover most emergencies. I would recommend buying insurance cover for things that could cost more than this, e.g. buildings and contents insurance to cover damage to your home and your personal possessions.
 
As I have never been in debt, again thanks to my scholarship, I could say I reached this stage at 18 as well. As a Malawian student living in Britain I had no credit history so no bank would give me access to a credit card or even an overdraft facility and no store would allow me store credit.
 
You know how you get to stores and they ask you if you want to get 10% off by signing up to a store card? Well, I said yes and I got rejected with the net result that I always said no after that because I felt so ashamed when she walked back to the counter to tell me I didn’t qualify in front of other customers.
 
Thank God for small mercies. I was an unsuspecting teenager in a foreign country and I don’t know what debt I could have landed myself in had that request for store credit gone through.
 
Stage 3 – Agency
 
The final “surviving” stage in JD Roth’s model is free agency. He describes this as the ability to work and live how and where you want. In the free agency stage, you've cleared all debt (including student loans and your home mortgage) and you have enough banked that you could quit your job at a moment's notice without hesitation. Apparently, some call this “screw-you money”.
 
I was about to disagree with the free agency stage until I saw JD’s note that: “he knows first-hand there are times when you might prefer to carry a mortgage even if you don't have to. So, 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.
 
Technically, I would say I initially reached this stage when I was about 30 because I had enough equity in a home I bought when I was 23 to pay off our home mortgage free and clear and I had enough passive income from a small business I set up at when I was 26 (but spent only 10 minutes a month on) to meet the other financial needs that I had at the time. I say technically because in practice, I would never have done that as even then, I knew I would probably want kids and I would need more money to give them the life I wanted them to have, essentially, even if you are in the agency stage but you know your future financial needs will be greater, you’re probably not fully there yet.
 
In JD’s six-stage model to financial independence, you move from surviving to thriving in stages 4 to 6. As you work your way through these stages, money is no longer a safety net, but a tool to help you build the life you imagined for yourself and for your family.
 
Each of the next series of stages assumes no debt or enough cash on hand to instantly repay all debts.
 
Stage 4 – Security
 
You have achieved financial security when your investment income can cover your basic needs. Investment income is money that you don’t need to actively work for; it arrives like clock work without any further input from you.
 
So, in the security stage, based on how much you have saved and invested, you could live a meagre 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.
 
I would say we are currently working towards stage 4.
 
If we both quit our jobs and took our children out of a fee-paying school, rental income would cover our cost of living and we have some decent savings to cover tenancy gaps BUT our whole life would come tumbling down if interest rates rose because of the buy-to-let mortgages and our mortgage so we are not here yet.
 
In the security stage you should be able to cover all basics regardless what interests and other economic indicators are doing.
 
Stage 5 – Independence
 
Financial independence is the ultimate goal for most people. At this stage, your investment income is enough to fund your current standard of living for the rest of your life. You cannot only afford the basics, but you can afford some comforts such as holidays abroad too. You have “Enough” with a capital E.
 
Stage 6 – Abundance
 
In JD Roth’s sixth and final stage of financial freedom, you have “enough — and then some”. At the abundance stage your passive income from all sources not only funds your lifestyle indefinitely, but it grants you the freedom to do whatever you want. Besides sharing your wealth with others – which you should be doing whatever your stage of wealth but can really ramp up once you’re in the abundance stage – you can indulge in luxuries, explore the world.
 
When you see me wearing a Patek Philippe, we have arrived here. Both children will be in university at this stage (think early 50s) and I will spend a full year of school fees on one watch! Okay, so in a world with starving children, even writing that doesn’t feel quite right – I’ll downgrade that aspiration to a Rolex which I could buy now but that will be my gift to myself for getting to Abundance!
 
Jokes aside, the more money you can save either by clearing mortgages on your home or rental properties or by investing in stocks and shares and shares, the more your financial independence increases. As you become more financially independent your happiness levels are likely to increase because you can make decisions based on life fulfilment rather than what makes financial sense.
 
Being financially independent doesn’t mean you will quit working, it just means that you can if you wanted to!
 
Now, I can’t talk about financial independence without talking about the FIRE movement. FIRE stands for Financial Independence, Retire Early. The movement is a lifestyle movement whose goal is financial independence and retiring early. Most people agree on the financial independence bit of the equation but RE means different things to different people.
 
To some, retire early actually means quitting work and living a hobby life of travel and blogging, to others it’s simply a reference to reaching the ‘Abundance’ stage of financial freedom.
 
I am totally into the FIRE movement because I love how they’ve changed the meaning of what it means to live rich, many in the community live humble lifestyles in the secure knowledge that they are building real wealth. FIRE is not about conspicuous consumption it’s about real wealth and achieving meaning in your day to day life.
 
Let’s wrap up with some key takeaways on what you can do to move towards financial independence?

1. Earn more
2. Spend less and
3. Invest the difference – don’t just save it!

 
The philosophy is simple and as you put ‘spend less’ principles into practice, it gets easier and easier not to spend over time.
 
I hope this helps!
Heather

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