Top 10 Terms You Should Know About The Basics of FI

The Basics of FI

Welcome to my FI Top Ten series of posts.  I came up with this idea because I believe one of the keys to pursuing financial independence (FI) is increasing financial literacy.  I believe a large part of the reason why so many people’s finances are a mess and they don’t make efforts to fix it is because they don’t have the vocabulary.  If you don’t understand what advisors, bankers, accountants, real estate agents, loan officers, and salesman are telling you about your money, it is overwhelming and confusing.  This leads to poor decisions and a culture of ignorance. It is easier to pretend money doesn’t matter and stick your head in the sand than it is to educate yourself and take control of your financial destiny.  Well, it’s time for things to change.  In this series of posts I try to select what I believe are the top ten terms for a given area of personal finance and define them in a simple and understandable way.  Some definitions are shorter than others and in some I will give my opinion about something.

This first list contains 10 terms that I think are crucial to understanding the concepts of FI.  If you are going to learn more about FI, you need to have a very good grasp on these 10 concepts.  Most blogs, podcasts, and books on FI will use these terms regularly, so if you want to be a part of the club, its time to learn the lingo.  

Money 

Have you ever asked yourself the question: What is money?  Really, I’m being serious here, what is money?  If you think about it, in today’s society we rarely see actual physical money.  Our paychecks come via direct deposit or a check we take to the bank.  Then we transfer that money to others by paying our bills online or sending a check in the mail.  Most of us buy things with a credit card, debit card, or Apple Pay.  We never actually see or handle this money most of the time; it is all handled electronically, a long stream of 0’s and 1’s.  It is now the exception, not the rule, to use cash to purchase things.  Yet, even though we rarely see this enigmatic thing called money, it is at the center of our lives.  

Most people will say that money is a means of exchange, or stored value of some type of good, or legal tender backed by a government entity.  While all these definitions may be accurate, I am more interested in what money represents to each of us in our lives.  In what I consider to be one of the best books on personal finance, Your Money or Your Life, Vicki Robin shares how her late co-author Joe Domingez would describe money.  In his presentations to large audiences, Joe would ask what was the one thing you could say about money that is always true?  Audiences would give all types of responses such as money is a store of value, it is a status symbol, it is a form of power, it is a tool of repression, it is the root of all evil.  But no matter what they would say, he would demonstrate some way in which that definition wouldn’t stick.  Then he would reveal the one absolute truth about money:  Money is something you trade your life energy for.  Now just let that sink in for a minute.  The only real asset you and I have is our time, which is finite and irreplaceable.  It represents our life energy.  When we trade our time working for money, we are selling this limited asset and we can never get it back.  Whether you work for $10/hr or $500/hr we all trade our life energy for money to some degree.

Once you come to understand that money is what we trade our life energy for, it changes your perspective on nearly everything involving money.  For example, lets say you make $60,000 a year, about the median U.S. annual income in 2019.  After subtracting taxes that number drops to some degree, lets just say to $48,000 to make the math easier.  That would break down to approximately $4,000 a month, $1,000 a week, and $25 per hour for a standard 40 hour work week (I know it’s not exact, but work with me here).  Now let’s say you want to buy a car.  You are looking at a used vehicle for $8,000 vs. a new one with some extras for $28,000; that’s a difference of $20,000.  Before increasing your financial literacy, you may have looked at the monthly payment for the new car and said: I can afford this no problem.  But now that you understand that money really represents your time/life energy, you need to ask yourself if this new car is really worth working for 5 extra months, or 20 extra weeks, or 800 extra hours of your life compared to the used vehicle.  Is it worth giving up that amount of freedom?  If it is, then go ahead and buy the new car.  But if you are more interested in becoming financially free, the used car starts to make a lot more sense.  With this line of thinking (assuming the same level of income), the $800 cell phone (32 hours of your life), the $5,000 vacation (5 weeks of your life), and the $300,000 house (more than 6 years of your life if you could sink every penny into it which is obviously not realistic, and does not include mortgage interest) all take on an entirely new meaning.  

So remember: Money is something we trade our life energy for.

Opportunity Cost

Opportunity cost is closely tied to this new definition of money.  Basically it is the value or profit that must be given up when choosing one alternative over another.  Let’s put this into financial terms.  Going back to our car example, if you chose to buy the new car, then the obvious opportunity cost would have been $20,000, the difference in the prices.  But now that you understand that money is what you trade your time/life energy for, then the opportunity cost could also be viewed as the 5 extra months you would have to work to pay for it (assuming the same parameters as listed above).  However, if you want to really think like someone on the path to FI, lets take this a step further.  What if you were to invest this $20,000 in a low cost index fund that averages an 8% annual return on investment (an optimistic but realistic estimate).  If you let it grow in a tax sheltered account (we’ll discuss what these are later) for the next 40 years, it would grow to a value of $434,490!!!  Now you can start to understand the real opportunity cost of buying that new car.  

As you move forward and consider various purchases, I believe it is important to consider opportunity cost with this frame of reference.  Now, I don’t think you should figure out how much of your life energy you are losing or what your money could have earned through investments for every single little purchase every day, like the cost of a meal or groceries at the store.  That would be a little silly and a waste of time in my opinion.  But for major purchases such as a new home, a vehicle, a large vacation, a recreational vehicle, etc. I think it is very important to think about the real opportunity cost of that purchase before making it, because what you ultimately choose when making these decisions will have a major effect on how long it takes you to reach FI.

Compound Interest

The miracle of compound interest is one of the factors that ultimately makes financial independence possible.  It is so powerful, that Albert Einstein said, “Compound interest is the eighth wonder of the world.  He who understands it, earns it . . . he who doesn’t . . . pays it.”  We have all heard that if you invest your money, it will earn interest.  That’s part of this, but compound interest means that the money you receive in interest will also earn interest in addition to the initial amount you invested, and this will continue on indefinitely if the money is left untouched (which is the key).  Let’s take a look at how powerful this is.  

First, let’s consider an example of interest without this magical compounding effect.  Let’s say you have $10,000 and you invest it in a low cost index fund (don’t worry about what that is, I will define it later, but I want you to get used to hearing these key terms).  And let’s say that it averages a 7% annual return, adjusted for inflation.  This means that every year (annually) your money will earn 7% of the invested amount (the principal) and we are using this value of 7% after taking into account how the spending power of money historically goes down over time (adjusting for inflation).  So, after 1 year, your money should earn $700, and you now have $10,700.  If you withdrew your $700 and left the initial $10,000 (the principal) in place, after another year you would again have $10,700.  If you continued to withdraw the $700 each year and your return on investment remained constant, this could continue indefinitely.  Pretty nice, huh?  If this continued for the next 40 years, then you would have made 40 years x $700 per year in interest = $28,000.  While this is not a bad way to make some money, we can do better!!!

Now let’s consider the power of compounding.  Assuming the same initial investment of $10,000 and the same annual return of 7%, you would again have $10,700 after one year.  But instead of withdrawing and spending the interest, let’s assume you leave it in your account and it becomes part of the new principal when calculating the return in year two.  So, at the start of year two we have $10,700, and after it gives us a return of 7% again, at the end of the year we now earn $749 in interest.  Again, we won’t withdraw this money and will let it become part of the new principal or COMPOUND, so our new initial investement in year three is $10,000 (initial investment) + $700 (interest earned in year one) + $749 (compound interest earned in year two) = $11,449.  If we let this continue for a total of 40 years, our total in the account will become . . . $149,745!!!  That is $111,745 more that we have at the end of 40 years compared to the first example in which we withdrew the interest on our initial investment every year. 

As you can see, this is powerful stuff.  And this is what would happen if we just left the money in place and forgot about it.  Imagine what could happen if we continued to add to the account on a regular basis over 40 years.  Let’s say you added $1,000 each month to the initial investment and you never touched the money (I know that may seem like a lot of money to most, but let’s just have a little fun here).  After 40 years you would have . . .  $2,636,200!!!!!  This is the miracle of compound interest, and it is at the very heart of becoming financially independent.

Asset

These next 2 definitions are a key part of calculating your net worth, which is critical to measuring your progress on the path to FI, so we will define these first.  An asset is basically something of value that could be traded for money.  I also like Robert Kiyosaki’s definition that he uses in his book Rich Dad, Poor Dad.  He defines an asset as “anything that puts money in your pocket,” which looks more at cash flow.  There is a fair amount of debate in the personal finance world on what should be considered an asset.  Most financial experts will agree that the money in your bank accounts, retirement accounts, and taxable investment accounts are assets.  However, for other commonly owned items such as your primary residence and vehicles, this is less clear.   Many believe that your home is an asset given the large amount of money you have invested in it.  The argument to this however, is that while your home certainly has value, it does NOT put money in your pocket; in fact, it takes money out of your pocket every year in the form of property taxes, home insurance, and maintenance.  Similarly, vehicles are considered by many to be an asset given their significant value.  However, the argument here is that they depreciate (lose value) over time and again take money out of your pocket in the form of auto insurance, annual registration fees, and maintenance.  

Where do I fall on this?  I can understand the arguments for both.  I guess it depends on what definition you use and what you are doing with this information.  If you do decide to use the equity in your home and the value of your vehicles when adding up your assets, I think there are three important points to keep in mind.  First, these are relatively illiquid assets, which means they can’t be exchanged for cash as easily as say, selling a share of stock.  It will take time to find a buyer and complete the transaction to turn these assets into money you can use to pay for expenses.  Accordingly, if you are trying to determine how much money you have for your expenses in retirement, I would not recommend counting the value of your primary residence; you most likely aren’t going to sell your house to help pay for groceries.  However, if you are simply trying to get a sense of the value of all your assets, I believe there is utility in including these items.  Second, as you track the value of your total assets over time, make sure you are consistent from year to year.  Don’t include your home and/or vehicles one year and not do it other years.  Finally, the value of these assets changes from year to year.  Your house will hopefully appreciate (go up in value) and your vehicles will most likely depreciate (go down in value).  Make sure you use updated numbers for your calculations.  I use the assessed value of our property from which property taxes are calculated each year for our home, and a recent Kelley Blue Book estimate for the value of our vehicles.

Liability

In terms of personal finance, a liability is a debt owed to someone else.  According to Robert Kiyosaki, it is “something that takes money out of your pocket.”  As you would suspect, liabilities are bad, you don’t want to have them.  Some are worse than others.  High interest consumer debt, specifically credit card debt, is especially bad.  Other liabilities include car loans, student loans, and your home mortgage.  Some personal finance experts also consider your home a liability because over time it takes money out of your pocket, as described above.  While I would consider your home mortgage a liability, I personally don’t go so far as to lump your home itself in with other liabilities.  Liabilities typically don’t include other expenses or payments beyond debts.  For example, your monthly electric bill, how much you spend on food, and the gas you purchase for your vehicle are not typically included in your list of liabilities.  Those would typically fall under your regular expenses.

Net Worth

Your net worth is the sum total of all your assets minus all of your liabilities.  I believe this is the best measure of your financial health.  The media would have you believe that income is what defines the rich, but those that understand personal finance understand that net worth is really what defines wealth.  We all know of plenty of people that have high incomes, but spend all of their money.  We also all know people who “look rich” based on the cars they drive, homes they live in, clothes they wear, or the vacations they take.  But this is not wealth either; consumption does not equal wealth.  How much you earn or consume doesn’t maken you rich, it is how much you save.  Your net worth is a measure of this and an excellent tool to use along your path to FI.  

In my series of posts, FI Step by Step, I outline 12 steps that will lead you to financial independence.  Step 2 is to determine your net worth.  I will go through the specifics of how to go about this process, but it basically consists of adding up all of your assets and subtracting all of your liabilities.  For some this will be a rude awakening.  You may discover you have a negative net worth, meaning you owe more than you have.  If that is the case, don’t despair.  The important thing is to know where you are now and begin turning things around.  From now on, your net worth should be something you calculate on a regular basis and track to make sure you are progressing toward your goals.  

Side Hustle

This is a common term used in the the FI blogosphere and community, and I believe a key component of the FI mindset and philosophy.  A side hustle is a way to make money outside of your normal career or job.  But it’s more than just a second job or moonlighting.  Typically a side hustle is more of a creative or entrepreuneurial endeavor, not flipping burgers or a paper route.  It is usually something you are interested in or passionate about.  But rather than costing money like a typical hobby, a side hustle earns money.  The overall idea here is that you turn something that you really enjoy doing into a source of income that brings you closer to financial independence.  Examples of side hustles include designing web pages for businesses, selling your travel photographs, or starting a blog.

Passive Income

Sources of passive income are the holy grail of those seeking FI.  The more sources of passive income you have, the more easily or quickly you can achieve financial independence.  As you’d expect, income is something that brings in money.  The word passive means you aren’t trading your time or direct efforts for this income, like in a typical 9 to 5 job.  Developing a source of passive income usually takes a large amount of timue and effort up front.  But after it is established, it can continue to put money in your pocket for years.  Examples of passive income could include writing a book and then receiving royalties from its sales, regular dividends on stocks you hold, and rental from real estate investment properties.  Ideally, side hustles could also be transitioned to streams of passive income.  While the degree of passivity can vary, the key principle is that you aren’t trading your own time directly for money.  Each stream of passive income you develop can be part of your own formula for financial independence.  

Financial Independence

If FI is the goal, then we better know exactly what we are shooting for.  The term financial independence gained popularity with the birth of the F.I.R.E. movement, which stands for Financial Independence, Retire Early.  While many people embrace both the concepts of becoming financial independent AND retiring early, many people don’t believe in the latter half, early retirement.  Some people just like their jobs and don’t want to quit.  Others want to pursue another career or passion and don’t consider that transition “retirement.”  Still others feel “retire early” has a negative connotation and just don’t embrace it.  As a result, many people, including myself, choose to make financial independence alone the primary goal, which will ultimately give you the freedom to choose whatever and whenever is right for you regarding retirement.  

When your assets generate enough passive income to cover your living expenses, you are financially independent.  This means you no longer have to trade your time for money and you have much more freedom to make lifestyle choices based on what brings you value.  Financial independence can be achieved in many different ways.  The most commonly discussed method is when the value of your stock and bond portfolio is 25 times your annual expenses, a value derived from the 4% rule as listed below.  Another common method is through developing passive streams of income, such as through rental properties or side hustles.  When the positive cash flow is greater than your expenses, you have achieved financial independence.  Other factors such as social security or a pension could also play a role.  Most people that achieve FI have done so through some combination of these income sources.  

The 4% Rule

This rule, also known as the safe withdrawal rate, is at the core of FI doctrine.  In the future I will write an entire post on the 4% rule, breaking down the details of the original study upon which it is based.  But for now, I will simply summarize the 4% rule so you have a basic understanding of how it relates to financial independence.  The 4% rule, perhaps better stated as the 4% rule of thumb or guideline, refers to the amount you can withdraw from your portfolio of stocks and bonds each year to pay for your expenses.  The rule states that if you withdraw 4% or less from your portfolio the first year of retirement, and then the same amount adjusted for inflation each year thereafter, you will not run out of money.  This is based on an analysis of historical returns in the stock and bond markets.

While there are many specifics that need to be considered in more detail, such as asset allocation, adjustments for inflation, investing in index funds vs individual stocks, length of retirement, and sequence of returns risk (all items I will write about later), the basics of the 4% rule provide an excellent framework from which to build a plan to reach FI.  Let’s break this down.  The 4% rule gives us a safe withdrawal rate in retirement; this could also be interpreted as the amount of money your portfolio could generate each year to live on.  If this amount was greater than your expenses, you would be financially independent.  Pretty awesome, right?  Now we need to determine how much you would need to save and invest in order to create this money making machine.  To do this, we need to take into account your actual annual expenses.  For example, if you have a retirement portfolio of $500,000.  The 4% rule states you could safely withdraw $20,000 the first year and that same amount adjusted for inflation each year thereafter.  If your annual expenses are $50,000, you would NOT have enough money to cover your expenses in retirement by the 4% rule.  So how do we calculate the amount you would need to save to live by the 4% rule when considering your actual annual expenses?  Here’s how it works.  Because 25 is the reciprocal of 4% (which is 1/0.04), and this 4% withdrawal is covering annual expenses, we can deduce that you would need to save 25 times your annual expenses to have enough money to live by the 4% rule.  This is also called the 25 times expenses rule.  Back to our example: if your annual expenses are $50,000, you would need to save 25 times $50,000 to have enough in your portfolio to live on by the 4% rule.  This means you would need to save $1,250,000 to reach financial independence.  

In the FI world, this savings goal is known as your FI number, which again is 25 times your annual expenses.  Once you hit your FI number, you have achieved financial independence!  While FI is often achieved by combining your stock and bond portfolio with other sources of passive income, the 4% rule and its derivative, the 25 times expenses rule, give you a starting point for your actual savings and investing goal.  

This concludes The Basics of FI.  These terms should become second nature to you and will be referenced over and over again in future posts.  They form the foundation from which other financial principles will be based.  Please continue to increase your financial literacy and read some of my other posts in FI Top Tens.