When you are trying to reach Financial Independence (FI), the best way to do it is to increase your savings rate. Your savings rate is the amount of your net income that you are able to save. For this, you have two options. You can either spend less or grow your income. These two options will directly increase your savings rate. And as result, they will speed up your road to Financial Independence and make you reach FI faster.
So which should you focus on if you want to reach Financial Independence ? There are some advantages and disadvantages to each of them. They do not accelerate your path to FI at the same rate. Find out what you should do to become financially independent.
Growing your Income
Growing your income can be achieved in several ways. The most common way is to get a raise or a promotion at your main job. You can often grow your career a lot more than people think. You could also change company or even change job to grow your income. But it may not be easy to do grow your income career. It may take a lot of motivation and work on your side to get a bigger salary.
Another way to increase your income is to invest in real estate. Depending on how you invest, this could be passive income. This new income is simply added to your own income. Or you could start a side hustle. There are many of them. I am not a big fan of side hustle. Generally, they take a lot of time and some of them do not pay that much when you consider the time you spent. Personally, I do not consider Airbnb as a side hustle, it is just real estate investing.
Some people also consider dividend income as a good source of passive income. There are many people who want to cover their expenses with dividends. Or simply reach FI by accumulating money by reinvesting the dividends. Some people also use their blog to reach FI. A blog is somewhat passive income. But it is probably closer to entrepreneurship than real passive income. It takes a lot of time. For me, I do not think I will ever make enough from this blog to help towards FI. But this can work for some people.
Finally, you can also grow your income by becoming an entrepreneur. You can start your own company. If you are successful, you can make a load of money with your own company. Of course, this is also a risky course and it may well end up without money.
Let’s see how this work with an example to reach FI. Let’s say you are spending 4000 per month and getting 5000 per month. You have a savings rate of 20%. For simplicity, you have no net worth to start with. If we assume a Withdrawal Rate of 4% and an annual Return on Investment (ROI) of 8%, you will need 28.5 years to reach Financial Independence.
So, if you manage to grow your income to 5500, you will reach FI in 23.6 years. If you grow it even higher to 6000, you will only need 20.6. And if you go to 7000 monthly income, you will be FI in 17.2 years. As you can see, the first 1000 will save you more years than the next 1000. This is called diminishing returns. The years you save are getting lower and lower the more money you manage to grow your income. It should not prevent you for growing your income. You just need to be aware of this important fact.
Problems with growing your income
There is a risk when you are growing your income. It is lifestyle inflation. Very often when people have more money each month, they spend more money. This is somewhat logical. But if your goal is to reach FI and to retire early, you should be very careful about lifestyle inflation. If you grow your income and grow your expenses at the same time, you will not reach FI faster. You may even not be able to reach it.
There is one other thing that is important when growing your income. It will help you reach Financial Independence faster. But it will not help you once you are financially independent if you retire. Indeed, you will not have this increased income anymore.
And do not forget about taxes. The more you grow your income, the higher your taxes will be. If your marginal tax rate increases, every extra money that you will get will be worth less than before. I do not say that this should prevent you from earning more. But this is something you should be aware of.
Spend less – Be more frugal
The other thing you can do is reduce your expenses. By spending less money each month, you will increase your savings rate. Moreover, this will also reduce the total amount you need to reach Financial Independence. This has two advantages. You will reach FI faster since you need less money and you will also reach it faster since you will save more money each month.
There are many things you can do to spend less money. You can cut back on the bills you do not need. Or you also be more frugal with your food budget. You even can change for a small apartment or smaller house. You can focus on every single expense on your budget and check if they are really necessary.
Let’s take the same example as before with 4000 monthly expense and 5000 income and 28.5 years to reach FI. If you manage to reduce your expenses by 500 per month, you will need 22.5 years. If you reduce it to 3000 per month, you will only need 18 years. So reducing your spending can make a very large difference. You can see the same phenomenon of diminishing returns in reducing your spending. However, you can also see that reducing your spending by 500 has more impact than growing your income. Mathematically, it is better to spend less than growing your income.
Limits to reducing your expenses
However, there is something important about reducing your expenses. There is only so much you can do. If you are really putting a lot of effort on it, you can reduce it a lot. But some people will start to get stuck at some point when you cannot spend less without reducing your quality of life. This point is different for each person. Some people are willing to live with very little to retire. On the other hand, some people are not willing to go very far. But once you reach that point, the only way to reach FI faster is to grow your income. On the other hand, growing your income is almost limitless. Of course, it will not necessarily be easy.
Finally, there is something that not everybody is thinking about. First, the reductions that you make to your expenses should last through retirement. That means that if you cut your expenses really low, you need to be ready to live at this low-level of expenses. And do not forget about something very important. You will have much more free time after retirement. If you plan to travel more or if you plan to do new things, it is quite possible that you end up spending more in retirement than when you are working.
Doing both to reach FI
In fact, if you are really motivated to reach Financial Independence, you should not only focus on one. You should grow your income while reducing your expenses. This is the fastest way to reach FI.
Once you have reached the limits of reducing your expenses, you need to work on increasing your income. At this point, you should make sure of not increasing your expenses to avoid lifestyle inflation. That way, you will reach FI as fast as possible.
Let’s take our example one final time. You spend 4000 each and get 5000 of monthly income and 28.5 years to reach FI. If you manage to increase your income by 500 and reduce your expenses by 500 as well, you will only need 19.7 years. You just saved yourself almost nine years! If you manage to grow your income to 7000 with 3500 of monthly expense, you will only need 14.3. You just cut your road to FI in half!
There is no reason not to try to do both of these things together. They both have their limits. But together they work better than only one of them at once.
The easy answer to the question should you spend less or grow your income is that you should do both!
To summarize, growing your income is an excellent way to speed up your path to Financial Independence. You just need to be careful to not increase your expenses as well. Spending less will also speed up your path to FI. Moreover, it will also make your life easier once you are retired. Mathematically, reducing your expenses is better to reach F than growing your income. However, there is a limit in how low you can get your monthly expenses.
Personally, I think you should first focus on having a sound budget. Once you feel, you have your budget in control, you should focus on growing your income. But both are important. Do not consider your expenses at a perfect level. There is always something you can do to improve your budget. And do not consider your income at its peak. It is also unlikely to be true.
What do you think ? What do you focus on ? You prefer growing your income or reducing your spending ?