This article is the second in a series of seven that will discuss what it takes to reach financial independence. If you have not already read the first step, which covers budgeting, please take a minute to visit that post. This article will outline why you should create a passive income stream.
When I first started my career, it became apparent that I had many working years ahead of me. I had early dreams of becoming a millionaire by age 21 and living the rockstar lifestyle of the rich and famous. I soon discovered that I would have a long wait, if relying solely on my paycheck, before I could afford my desired standard of living. I realized that I needed to create another way to earn money to pay for this dream.
I was very industrious in my younger days—mowing lawns, shoveling snow, doing odd jobs, and running a paper route for a while. I embraced the concept of improving my lifestyle. Of course, I opened up a lemonade stand a couple times during summer vacations. In my early teens, I learned how to drive by working on an 80-acre ranch doing odd jobs, feeding horses, and occasionally plowing a field.
These childhood and teenage experiences had an impact on me. Some of my mentors encouraged me to save and invest, and introduced me to real estate. I did not know then how much impact these early passive income investments would have on the direction of my life.
Retirement from the day job could take some time
Once I discovered that my career “working for the man” could span forty years, I began to think that there had to be a better way to become financially independent. I needed to create a better plan.
It was time to make some changes. I took on roommates and a second job. I began to save even more money for my investments.
I was not afraid of doing hard work. When I was in my mid-teens, a family friend and mentor imparted some sage advice. He told me this:
“The more you use your brain and the less you use your back, the more money you will end up making.”
I was fortunate that I had some great role models in my youth who taught me the concept of working efficiently and thinking creatively, crafting better methods of getting work completed. One told me not to “make a career” out of accomplishing the task at hand, but rather to get it done quickly and efficiently.
We all need to save and invest to retire
I mentioned the importance of monitoring your expenses and saving in Step 1. This is a critical piece to control, that will have a direct impact on your ability to reach financial independence.
There has been a growing community of very frugal-minded people who are attempting to save 50% to 75% of their income. This concept did not really make an impact on my strategy until about six years ago. I discovered blogs like Early Retirement Extreme and read books like Your Money or Your Life that showed me that I didn’t need a six-figure income to retire early. Mr. Money Mustache explains it all quite well here in his “shockingly simple math” post on early retirement.
If you follow this strategy, your focus will be on lowering your actual living costs while saving the difference. It does not take long before you have enough saved to live on for the rest of your life. Speaking of saving…
Some important reasons to save money
My parents taught me the concepts of saving and compound interest, and helped me set up my first retirement account. The need to plan and save became an important focus for me with the birth of my first daughter. It reinforced the notion that I needed to save for her future—as well as our own. Depending on your situation, there are multiple reasons you should save for the future. Here are a few for us:
Funding for repairs, infrequent expenses, and cars
There are good reasons for funding for large and infrequent expenses. This helps the budgeting process by smoothing out the fluctuations on your expenses each month. Those semiannual insurance premiums and property taxes are good examples of expenses that make sense to budget 1/12th the annual cost each month and deposit into a separate account. Saving for your next car is another important reason. This helps build a discipline of anticipating future needs rather than reacting and using credit cards to manage your expenses.
A college fund
We started a college fund for each of my daughters right after they were born. For our oldest daughter, we contributed $200 per month directly into an S&P 500 index fund for fourteen years and then stopped. With only that small savings amount each month, there was enough to pay for her public four-year university, with money left over for her wedding. This was a simple investment approach we did not touch through all the market fluctuations. I am still shocked that we were able to do so much for my daughter. This is a good example of “dollar cost averaging” in practice.
Company-sponsored IRAs or Roths
I can’t say it enough times: take advantage of any company-sponsored retirement accounts regardless of whether they offer a match. For those starting out, it might be hard contributing $18K a year, but I would recommend you invest enough to receive any company match. Those who are over 50 can also contribute an additional catch-up of $6,000 each year. The more and earlier you invest, the less stressful it will be later in life.
Build passive income: Shorten your timeframe
Saving a significant amount of your income will tremendously improve your odds of reaching financial independence early. To turbo-charge your strategy, you may need to think in terms of starting a business or seeking out other forms of investment. I will stick with what I have had experience with in providing a couple of examples.
Start a business
I started my first business at age 18 with my brother and another friend. It was a small, niche company that taught me important lessons quickly—like managing cash flow and expenses while always searching for the next customer. After a few years we sold off the equipment, shut it down, and moved on to other things.
We can all think of people who have done well for themselves by opening their own business.
A former employee of mine comes to my mind. About ten years ago, an IT employee in his early twenties worked his way into a contracting position so he would not have to come in to the office five days a week. He asked to do this because he had recently picked up a couple of contracting work customers of his own. He did this part time customer work in the evenings. It has been nearly a year since we last spoke, but I believe he and his business partner now have over 30 employees. They also own their business’ building free and clear.
If you go this route, don’t underestimate the initial startup costs and cash flow requirements to keep your business solvent. It may take a number of years of dedicated work before the business will make a profit.
In my late teens, I purchased my first rental property. Through some horrible market conditions, the construction company I was working for in the summer was stuck with houses they could not sell with 18% mortgage interest rates. One of the partners of this company was my father; he sold me a house at cost, and taught me how to manage a rental property. I owned that property for ten years before I sold it, relocating with the company I was working for at the time. That was the initial spark and foundation that introduced me to real estate. I have continued investing in real estate ever since.
Early on, I noticed that most wealthy people I knew tended to have built a large portion of their net worth in real estate. These people were friends of the family, doctors, dentists, and local business owners who had a variety of careers and backgrounds. What was amazing to me is that they all had some of their net worth invested in either commercial or residential real estate. In fact, some of the wealthiest people I know made their initial wealth in real estate and development.
This is a great way to leverage Other People’s Money (OPM) when you are just starting out. It is possible to buy properties with very little money out of pocket. The conventional approach with bank financing will require a 25% to 30% down payment for a non-owner occupied rental property. If you are handy and have aptitudes working on houses and their systems, this would be an excellent way to leverage your “sweat equity” by doing the work yourself.
I will get into the details of how to purchase rental properties in a different series of posts. For now, the point is that this is an excellent method to build net worth and a passive income.
The best time to start investing is now
If you are just starting out in the workforce, working forty years may get tiresome unless you truly enjoy your employer and career. For most of us who have worked many years and are closer to retirement age, we are ready to leave our paid jobs and live off a passive income.
There are several ways to reach financial independence early. The first approach is to cut your way to retirement by extreme saving of 50% to 75% of your income. At the 70% rate, in about seven years you can retire.
Another approach is to create the next “dot com” business that becomes successful. Then there are those of us who have company retirement plans where we have saved the maximum each year and have benefited by company matches. Save money for decades and you WILL build a solid retirement account.
Finally, you could jump into rental real estate like many others have done. We followed an approach leveraging a combination of savings, investing, and purchasing real estate for passive income.
The key point to Step 2 is that you need to both save and invest in a business outside of your job if you wish to reach financial independence in an aggressive time-frame.