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When you are trying to reach Financial Independence (FI), the best way to reach FI faster is to increase your savings rate. Your savings rate is the amount of your net income that you can save.
For increasing your savings rate, you have two options. You can either spend less or grow your income. These two options will directly increase your savings rate. And as a result, they will speed up your road to Financial Independence and make you reach FI faster.
If you spend less, you need to accumulate less money to be financially independent. And if you earn more, you will reach your goal faster.
So which of these two options 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.
Reach Financial Independence
Being financially independent means, you do not have to rely on your job to live. There are several ways to reach Financial Independence. But basically, it boils down to either:
- Have enough side income to cover your expenses
- Have enough net worth to be able to withdraw money for your expenses
The second case is the most common one. You will have to reach a specific target net worth (your FI number) to become Financially Independent. And once you have reached this number, you can withdraw money regularly to pay for your expenses.
Your target net worth is based on your current expenses. So, if you reduce your expenses, you will directly reduce the amount of money you have to accumulate.
And if you increase your income, you will reach faster your target net worth. So, both options will have the same effect in the end. So, what should you focus on?
Growing your Income
The first option is to increase your income to reach your goals faster.
There are several ways to grow your income. The most common way is to get a raise or a promotion at your primary job. You can often grow your career a lot more than people think. You could also change the company or even change your job to grow your income. But it may not be easy to do increase your income career. It may take a lot of motivation and work on your side to get a bigger salary. And some jobs have a higher potential for income appreciation than others.
Another way to increase your income is to invest in real estate. Depending on how you invest, this could be some passive income. This new income is simply added to your income.
Or you could start a side hustle. There are many of them. I am not a big fan of side hustles. Generally, they take a lot of time, and some of them do not pay that much when you consider the time you spent. I do not consider Airbnb as a side hustle. It is just real estate investing. You just need to make sure you are side hustling legally.
Some people also consider dividend income as a good source of passive income. Many people want to cover their expenses with dividends. Or simply reach FI by accumulating money by reinvesting the dividends.
Some people also use their blogs to reach FI. A blog is a 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.
Even though having a significant income helps, it is not necessary to earn a considerable amount of money to retire early. I found a nice example of people financially independent on a modest income. Retiring early without very high income is possible!
Extra income is different from your primary salary. Your main income will not be available after retirement. On the other hand, if you are generating some extra income, you may still generate it after retirement. Such extra income can go a long way into helping you retire early.
Example of increased income
Let’s see how this works 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 extra income will save you more years than the next 1000. This phenomenon 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 from 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 fact 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 career 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. It is an essential limitation of increasing your primary income.
On the other hand, this limitation is not there with extra income. If you can keep some income for after your retirement, you can cover some of your expenses with this income. You will have less money to accumulate.
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. Doing so 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 essential.
Example of saving less
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 cut it to 3000 per month, you will only need 18 years. So reducing your spending can make a huge 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 by the same amount. Mathematically, it is better to spend less than increasing your income.
Limits to reducing your expenses
However, there is something important about lowering your expenses.
There is only so much you can do. If you are putting a lot of effort into 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 low, you need to be ready to live at this low-level of expenses. And do not forget about something fundamental. You will have much more free time after retirement. If you plan to travel more or if you plan to do new things, you may end up spending more in retirement than when you are working.
Doing both to reach FI
If you are motivated to reach Financial Independence, you should not only focus on one. You should grow your income while reducing your expenses. Doing both 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 growing 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 revenue 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 expenses, you will only need 14.3 years. 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.
And I would also like to emphasize that being able to generate some income while retired can be of great help. Dividends will help, but you should have more than dividends. If you have some real estate properties or some online business, you can improve your Financial Independence state.
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 not to 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 FI than to grow your income. However, there is a limit to how low you can get your monthly expenses. After this limit, increasing your income makes more sense.
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.
It is also important to note that your expenses and your income are only two of the three axes of personal finance. You should not forget about investing.
What do you think? What do you focus on? Do you prefer growing your income or reducing your spending?