How To Win Financial Freedom

You can think of financial freedom like a video game. You’ve got to get through 7 levels to make it to financial freedom. What does financial freedom mean? It’s when your income is higher than your expenses. When you can get your money to make enough money to cover your expenses, you’ve reached financial freedom. It’s like running a gauntlet, but it can be accomplished! So let’s first outlay what the seven levels are and how to make it to your goal of financial freedom.

The 7 levels of financial health and freedom:

1. Level I – Handle all bad debt

Bad debt is distinguished by it being used for consumption rather than production. Bad debt typically does not have beneficial tax treatment like good debt does. By getting rid of all bad debt, you’ve established you can budget and you can produce more than you consume. These habits are critical to achieve financial success. In addition, these habits must be learned before anything else can be accomplished.

2. Level II – Start a Retirement Account and add 10% per year

Retirement is the first goal you should tackle after handling your bad debt because you want to add small amounts of money over a long period of time. You need your money to have a chance to compound over time. So, you need to start a retirement account as early as you can, preferably in your 20’s. I like the automatic investing approach provided by “robo-advisors” such as Wealthfront, Betterment and Personal Capital. The earlier you start, the more time your money has to compound and the easier it will be to retire with enough money.

3. Level III – Create a Savings Account with three months of expenses

This is an important step and many people try and skip this step. I did. Everything goes fine with your investment account (#4) until it doesn’t. Inevitably, something comes up in life. If you don’t have a cushion built up, all your investments come crashing down at the worst time possible when you have to cash out. Needing to cash out investments early, with bad timing and losses, destroys wealth. Before you can invest, you need a savings cushion of ~three months of expenses, minimum.

4. Level IV – Start an Investment account (taxable brokerage account)

Your first goal may be to build income for a home payment. Setting up an investment account could go several ways. You could set up a Wealthfront account and use passive index investments like retirement. Or you could open a TD Ameritrade account and invest in particular stocks or ETFs that usually generate a higher return. What determines this is how much time you’re willing to spend on active investment. It’s important to be able to generate consistent returns based on outlined risk.

5. Level V – Buy a house

Once you are able to generate some return from your investment account and you saved up enough money, the next goal is to buy a house. Buying a house allows anybody to fix the second highest expense, rent as well as creating a forced savings plan. The house is an asset and has the chance for capital appreciation. An additional benefit of real estate is that you can use leverage, in the form of a mortgage, to help boost your returns. Mortgage interest can also be tax-deductible, which makes it favored tax treatment and a good path to increasing annual net income by reducing taxes. A home is an important part of successful financial plans.

6. Level VI – Build multiple streams of income

Start building income-generating assets. These could include REITs (real estate investment trusts), LPs (limited partnerships), Equity Income Accounts and Fixed Income Accounts, such as municipal bonds and annuities. Now that you’ve finished Level 5 and you’re on Level 6, you’re onto the more advanced aspects of the game. Deferred annuities can be one method. Real estate, in the form of REITs, can be another method. The goal is to invest in income generating assets and start to pay attention to the income and cash flow they generate more than the principal value. There is an investing shift that’s going on where you are less interested in capital appreciation and more interested in cash flow. Buying partial businesses in the form of stocks for equity income, or REITs to invest in real estate, and generate yield, all represent early stage vehicles for cash flow investing. The goal is to build this up to a semi significant amount so that a portion of your expenses are now offset by your newly found cash flow income.

7. Level VII – Buy cash flow businesses or income-generating real estate

This is the critical level to work on until you can passively produce more income than expenses. OR, build your own growth start-up company you can sell for millions. I distinguish this final stage from the previous stage in that you’re buying “whole” businesses or real estate investments. At the previous stage, you’re buying “portions” of investments in the form of stocks, units of companies or limited partnerships. The final step in the financial game of life is to be able to buy cash flow businesses or income generating real estate in enough quantity that your income is higher than your monthly living expenses. Once you can do that you have won the financial game of life. You are financially free.

This is the basic financial life plan. For me, I’ve made it to Level VII, but was cast back down to Level V, where I’m currently playing the game of Financial Freedom. Where are you in the current Financial Game of Life? What are your next moves?