- Why a $1,000,000 net worth is a poor measure of financial health
- What the Financial Independence Ratio is, why it’s a better measure, and how to calculate it
- Ways to improve your Financial Independence Ratio
For 3 years, Regis Philbin charmed us with his pearly whites and a famous question—“Who Wants to Be a Millionaire?” But Regis and his producers already knew the answer, that we’re obsessed with the 7-digit number. Everyone wants a million dollars, as it’s become a symbol of status, success, and financial security. Still, the question begs to be asked: is our quest for $1 million really a smart financial goal?
The first known American millionaire was John Jacob Astor, who, in the 1790s, made his fortune trading fur and real estate. That’s back when calling someone a millionaire also meant they had over $25 million in today’s dollars. Fast forward to 2017, and anyone who bought a house in Vancouver or Toronto 10 years ago is close to being a millionaire. Just last year, with the help of inflation and soaring real-estate prices, Vancouver was named Canada’s first millionaire city with an average household net worth of $1.036 million. But having $1 million is no longer, and maybe never was, a proper measure of financial health. There’s a much better indicator—the Financial Independence Ratio.
What is a Financial Independence Ratio?
What’s at the root of this $1 million pursuit? For some it’s prestige, but for many, it’s the belief that $1 million equates to financial independence—the ability to ride into the sunset knowing your expenses are covered and that you don’t have to rely on traditional income like wages or salary. Jonathan Chevreau calls it Findependence, while other personal finance gurus call it FIRE—financial independence, retire early. And it’s this interpretation of financial health that the Financial Independence Ratio aims to calculate.
To determine your Financial Independence Ratio take your monthly passive income—income earned without being actively involved, think bond interest, not work wages—and divide it by your monthly expenses.
Financial independence ratio (FIR) = passive income / expenses
You’ll be left with a number somewhere between 0 and 1.0 (in other words, 0% or 100%) which is to say you are X% of the way to financial independence. For example, say your ratio is 0.5 (50%), you are halfway to financial freedom. This simple, yet insightful formula can tell you exactly where you are on your journey to financial independence.
Why it's a better indicator of wealth than $1 million
A net worth of $1 million is an impressive financial milestone and we don’t want to turn our noses up at it, but what good is having $1 million to your name if you spend like a Kardashian and your income depends on the hours you put in at the office? $1 million is a milestone, but not a mark of financial independence. Napkin math can tell us that if you have $1 million coming in and $2 million going out, it’s not sustainable nor is it financial freedom.
Financial Independence example
Karen and her partner are a couple of decades from traditional retirement. They own a small duplex and rent out the other unit, they share a car and love to travel. They don’t have employer-sponsored plans, but have maxed out their TFSAs, contributed to their RRSPs, and focussed on dividend-paying stocks. Karen loves photography and actually makes some residual income selling her images online.
Here’s a snapshot of their expected passive income, expenditures, and financial independence ratio.
|Passive income sources||Monthly amount|
|Bonds and GICs interest||$115|
|Car fuel, repairs||$125|
|Home and car insurance||$235|
|Utilities, phone, internet||$260|
|Groceries, eating out||$467|
|Cat food, litter, toys, etc.||$73|
Note: passive income and expense figures are for illustrative purposes only.
Karen's financial independence ratio
Karen and her partner make a combined $2,494/mo. in passive income and pay $4,703/mo. in expenses.
Monthly financial independence ratio = $2,494 / $4,703 = 0.53 or 53%
These two are well on their way towards financial freedom. The ideal ratio is above 100% with some buffer room, because life happens and it’s important to prepare for possible cash flow interruptions. Nevertheless, 53% is a great start and there are plenty of ways Karen and her partner can improve their ratio.
Ways to improve it
Increase passive income
- Dividends are a payment (often in cash or additional shares) made by a corporation to its shareholders. Dividends have long been a favourite source of passive income for the retirement crowd due to the predictability of the payments, which are often paid on a quarterly or monthly schedule. There are multiple ways to earn dividends whether they be dividend-paying stocks, REITs, ETFs, mutual funds, and some robo-advisors.
- Timing your pension is often overlooked as a way to increase your passive income payments, as the age you decide to dip into your pension can have a dramatic effect on how much you get. Take for instance Canadian Pension Plan payments, which can be taken at different ages with varying payouts. Here’s a great article on the most lucrative time to take CPP.
- Royalties are an enjoyable source of passive income for those who want to monetize their passion, be it photography, graphic design, writing, music, or anything people are willing to pay for.
- Rental properties require a large upfront investment but are one of the most recognized techniques for generating income. Everyone needs a place to live and payments are predictable as long as the property is occupied. However, it’s important to make sure the incoming rent payments are sufficiently more than the associated costs of owning and maintaining a property. Otherwise, you run the risk of it being a cash drain and not an income generator.
- Owning a business may require more supervision than the other methods, but if other people are managing the day-to-day it could prove a lucrative and passive source of income.
- Peer-to-peer lending (or P2P lending), already popular in the U.S., is starting to gain momentum in Canada as a way to diversify investment income. P2P lending allows businesses or individuals to access financing from a marketplace of individual online lenders. Lending Loop is Canada’s first fully-regulated lending marketplace, and focuses on small business loans.
- Reduce or pay off your mortgage. For many Canadians, their biggest asset is their home, but it’s also usually also their biggest expense. Once you pay off your mortgage your financial independence ratio should experience a considerable bump. Downsizing is another common option, especially for empty nesters, as it lowers housing costs and frees up assets to invest in other opportunities.
- Eliminate other recurring payments, similar to paying off your mortgage, Netflix, Spotify, Vogue magazine, the Economist, car leases, they add up and undercut your financial independence ratio.
- Get creative with solar panels, wind mills, weatherproofing, or other out-of-the-box green improvements that help reduce, or even eliminate, your utility bills. These upgrades require an upfront investment, but can certainly pay off in the long-term. There are even some individuals who generate more electricity than they use themselves and can sell it back to the grid, so lowering their expenses actually turns into a form of passive income.
- Consolidate high-interest debts into one easy payment at a lower rate. Debt is the opposite of passive income, and fortunately, there are plenty of free services out there that can help you with your debt repayment. Check out Credit Counselling Canada, a non-profit association that “serves anyone who needs help managing money and credit as well as reducing or eliminating debts.”
Not all goals are good goals
It’s always prudent to get to the core of why you’re setting a goal. It could be that your target doesn’t get you to where you really want to be and that there’s a better way. Such as the case of wanting financial independence but saving for an arbitrary fixed number like $1 million.
Money means different things to different people, but no one will argue that financial independence is liberating and a worthy goal. And no matter where you are on your journey to financial freedom, the FI ratio can serve as your guiding star.
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