Personal Finance

How to Calculate Your Freedom Number by Learning Your “Real” Net Worth

Expertise: Personal Finance, Personal Development, Real Estate Investing Basics, Landlording & Rental Properties
58 Articles Written
real-net-worth

What’s your number? No. I do not want your phone number. I’m talking about your freedom number.

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Freedom number—what is that, you ask? If you don’t know, you’ve been thinking about your finances all wrong. Let me explain.

Your freedom number is the amount of passive income you need to fully satisfy your living expenses. Once you achieve this amount of passive income, you no longer need a full-time job. You will be living off of your passive investments and will be able to fully enjoy the life given to you.

So, what is that number for you? If you don’t know, don’t worry. Just keep reading.

This article is going to explain how to calculate and measure your freedom number—because, as we all know, you can’t manage what you can’t measure. 

Calculating YOUR Freedom Number

Calculating your freedom number is easy. It is the average amount you spend on a monthly basis. If you are organized, this will take as little as 10 minutes. If not, you may need to spend a couple of hours pulling together records of your various spending outlets. Either way, the time invested here is well worth it. Here are the steps to calculate:

  1. Figure out how much you spend on a monthly basis. Look back at all of your spending mediums for the last 12 months—including bank statements, credit card statements, debt payments, charity donations, etc.—and try to remember any cash transactions as well. Note: This is why I try to never use cash. It is untraceable!
  2. Put them all into a single spreadsheet. Aggregate all of the transactions you have made in the last 12 months into a single Excel spreadsheet.
  3. Divide by 12. Take the sum of all of the transactions you have made in the past 12 months and divide it by 12. Assuming no drastic life changes, this is your average monthly spending, otherwise known as your freedom number. Once your passive income surpasses this amount, you are free!

Let me give you an example. Let’s assume John Smith looks back at all of his transactions over the past year and determines that he spends approximately $5,000 each month. Once his passive investments generate $5,000 per month, he is “free.”

short-sale

Related: How to Achieve Financial Freedom By Calculating Your “Rat Race Number”

Why did I put “free” in quotations marks? Because being free does NOT mean you should quit your job and move to a tropical island with bottomless piña coladas—well, at least not yet!

Being “free” means you can live your current lifestyle, exactly how it is, without working. Before elevating your lifestyle, you need to increase your passive income by the amount you desire. If you want to live a lavish lifestyle spending $10,000 a month without working, then you will need to increase your passive income to that amount prior to living that life.

Keeping your full-time job will likely help you attain this goal quicker by providing a steady paycheck that can be used to invest while also making it easier to obtain a loan.

Annual Income is Irrelevant

Most Americans use “annual income” as a barometer of how successful someone is. Let me break the news to you: Annual income by itself is irrelevant.

Why? Because annual income is solely an indicator of how much your time is worth. If you are financially free, you do not need to work, and your time is therefore worth an infinite amount.

The only thing that annual income is good for is giving you additional cash on a regular basis that can be used to invest and increase your passive investments.

While passive income is the underlying metric to determine freedom, it is driven directly by one's net worth—though net worth is a misnomer. Real net worth is the true metric that should be monitored when considering financial freedom.

Net Worth vs. Real Net Worth

Your net worth is the amount you own (assets) minus the amount you owe (debt and other liabilities). Why is this so important?  Because you have the ability to earn passive income on your assets while still having to pay your debts.

As Scott Trench pointed out in his book Set for Life, many Americans’ net worth is tied up in their personal residence, personal vehicle, retirement accounts, etc. These are called “false assets.”

They do not provide you a return that can be deployed in a reasonable amount of time to generate passive income. Since our goal is to have cash-flowing assets and the ability to access this capital well before the age of 60, we will be excluding all “false assets” from our calculation.

And yes, we will be retaining the debt. You are still obligated to pay your debts even if you did not buy real assets for it.

This will give you your “real net worth” number.

Here is an example of John Smith’s “net worth” versus a “real net worth” calculation.

As you can see, John Smith received a metaphorical slap in the face after calculating his real net worth. The majority of his assets are “false assets.” His 401k and Roth IRA cannot be accessed without penalty until he is 60+.

He pays insurance, maintenance, and repairs on his personal residence and vehicle while both generate $0 of income. For that reason, these are all removed as assets from his “real net worth” calculation.

Now that we know the importance of and how to calculate your real net worth. What do we need that number to be to be considered “free”?

4% Rule

A common rule of thumb is the 4% rule. This assumes that, on average, you are able to make a 4% annual return on your investments. Now, of course, some years will be lower, and others will be higher. But the average rate of return is a conservative 4%.

Related: Are Your Children Stopping You From Achieving Financial Freedom?

Let’s revert back to the John Smith example above. If we take his monthly expenses that we calculated above and multiply it by 12, we will get his annual spending of $60,000. To get to that real net worth number, he divides his annual spend of $60,000 by 4% (or multiply by 25) to discover that with $1.5 million of real net worth, he will be financially free.

Now, if you are generating more than a 4% return or spend less than $60,000 per year, you may be financially free even before you hit this target. The 4% is just a rule of thumb that takes into consideration fluctuations in the market on a year-over-year basis.

productive-2017

Conclusion

I can hear everyone now: “One-point-five million dollars?! I’ll never get there.”

You’re right—with that attitude, you won’t. You need to shift your thinking. Rather than saying, “I’ll never get there,” you need to say, “How can I get there?” This allows you to think of a means to get there.

As Set for Life points out, you can do this by making more, spending less, and investing the difference wisely. I know I’m touting this book a lot, and I promise, I’m not paid to do so. It’s just a great book. If you haven’t already, the first step would be to read this book!

See you on the beach!

Where are you on your journey to reach your freedom number?

Leave your questions and comments below!

Craig Curelop, aka thefiguy, is the author of The House Hacking Strategy and a driven pursuer of financial independence. Sta...
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    Derin White from Bremerton, Washington
    Replied about 3 years ago
    Craig, Your misrepresentation of retirement accounts, and the ability to access them before retirement age is well documented by other commenters. I’ll add this: investing in stocks is the most passive way someone can invest, as income generated by stock appreciation and dividends certainly add real dollars to your account with zero involvement (unlike RE investing) on your part. Seeing as how tax advantaged retirement accounts are the most efficient vehicle for stock investing, not including them in net worth calculations is pretty silly. Your understanding of the 4% rule is completely wrong. This rule is based on historical stock market returns, and predicts a safe withdrawal rate based on the probability that your account will not run out of money for a given period of time. 4% is not the expected rate of return as you stated. If 4% is simply the conservative rate of return that you use in your personal planning, that’s fine, but don’t call it the “4% rule” and explain it as something it’s not.
    David Rogers
    Replied 29 days ago
    This is a very good article because it touches on the main subject of true financial freedom. It lays out the basis for not having to work for a living verses living off of what assets you currently have to live off of. This passive income stream from your individual assets, not locked up from tangible use, is what really gives you the opportunity to provide your own paycheck to live off without assistance from a typical job. It is what is accessible for tapping into and providing money to use now. You can’t tap a retirement account until you 59 1/2. And, you use your house asset to live in live in and you can’t use that equity to provide you with an income. So, you have to have other assets to rely on for making you enough money to live off of in order to replace what you make at your conventional place of work.