To many, the most important aspect of financial freedom is simply being able to pay bills each month, with some money left over at the end. From an accounting standpoint, that's a goal of being cash flow positive. To measure cash flow, we look at monthly income and subtract monthly expenses. So if I take home $3,000 a month after tax, and average spending of $2,800, that's positive cash flow of $200 a month. And of course, if I instead spend an average of $3,200 a month on the same income, then I have negative cash flow of $200 a month. Obviously, the goal is to have positive, or at least improving cash flow. Realistically though, most of us are cash flow negative during some months or during certain periods of life, depending on family or personal circumstances or period of life.
Historically, the most important factor affecting cash flow, savings, is age. We tend to save less as younger adults and increase our savings as we approach retirement (see chart below). Younger adults often have student loans, new cars or home purchases and usually, lower incomes. As debts are paid off in later years, with higher incomes, and as potential retirement lies on the horizon, saving more usually becomes easier, and often more necessary.
When analyzing spending, it's useful to look at the proportion that fixed or nondiscretionary spending to total spending. Non-discretionary, or fixed spending, includes things like a mortgage, rent, car payments, student loan payments, credit card payments, insurance, and taxes. Things like utilities, clothing and groceries tend to be in the semi-fixed category. We have some control in reducing those expenses. We have the most control over discretionary spending, things like eating out, alcohol, tobacco, vacations, hobbies, gifts, and entertainment spending.
While we might think that the primary problem with most people's overspending is that they spend too much on discretionary expenses, it is just as likely that they are spending too much on fixed expenses. The degree of financial freedom in the area of cash flow can be greatly affected by the percentage of monthly spending made up of fixed expenses. So for example, an individual might have $3,000 of monthly income and spending, but if $2,500 of that spending are fixed expenses, he or she will likely feel much more cramped financially than someone spending $3,000 a month, but where just $1,500 of it are fixed expenses. The same monthly spending, but with more flexibility, will likely lead to a greater sense of financial freedom in one's life. This is something to remember when it seems that nearly every product or service we buy comes with either a long-term loan or monthly service subscription.
“Financial freedom is not having any debt”
In general, the more debt one holds, the less financial freedom. But that varies depending on many factors, such as whether assets underlie that debt, the interest rates on debts, cash flow and other personal circumstances. An important consideration is what the debts are used for. For example, most Americans (and financial advisers) believe that taking on mortgage debt is generally necessary and appropriate for buying a new home. That's because of the time needed to save for such an asset as well as the fact that real estate tends to generally hold its value, or appreciate, over the long term. The next level down would be things like auto loans, also expensive purchases, but ones that generally depreciate. The general goal with borrowing for such purchases is to keep the interest rate as low as possible and pay off the loan as quickly as possible. Unfortunately, auto loan terms have been getting longer, and hitting record highs. See chart below. That's good for auto makers and lender; bad for borrowers.
Borrowing for college was once thought of as an “investment” in the future, but changing realities over the last couple decades have upended that equation, as millions of student loan borrowers have not seen college pay off the way they expected. A study of students starting college in 2003 found that by 2015, 38% of students taking on federal loans had not paid down any principal on their loans. And in fact, because of accrued interest, they owed more than when they graduated (or didn't graduate, as in many cases). With average student loan amounts now much higher than in a decade ago, borrowers should be especially cautious about taking on big loans. The 2003 study found that of those who borrowed more than $50,000, nearly three-quarters (72%) had not paid down any principal 12 years later (see graph below). That compares to just 26% of those who hadn't paid down their loans when those loans were under $10,000. The new reality of college is that a degree by itself isn't a ticket to financial freedom, especially when it's wrapped with a large student loan.
A survey by AICPA in 2013 found that 60% of student loan borrowers have at least some choice over the way they financed college and only 39% said they fully understood the burden of their student loan debt would have in the future. Those impacts include lower retirement contributions (41%), delayed auto purchases (40%), delayed home purchased (29%), and even delayed marriage (15%). According to the Consumer Financial Protection Bureau, half of student loan borrowers will not begin to pay student loans before age 34, a doubling of the 25% of borrowers doing so in 2003. Except for real estate debt, student loans now exceed all other forms of personal debt in the U.S. Increasingly, those with financial freedom, especially younger and middle-age Americans, are those who are successful keeping student loan debt modest and for those who have it, are successful in paying it down.
“Financial freedom is having a lot of money in investments or in the bank”
The flip side to debt are assets. The two can of course, coexist, but financial freedom tends to grow as the balance tips to the savings side of the asset-debt scale. Lately, there have been news stories bemoaning the fact that a high percentage of Americans have very little or no money in a savings account. Similarly, despite the long held adage from financial planners that individuals should maintain an emergency fund for three to six months living expenses, fewer than 20% of Americans report having one. However, as opposed to showing American's dire financial straits, keeping little money in the bank or for emergencies simply reflects the increasing ease of credit that most Americans have. A higher percentage of Americans without much in savings would have little trouble tapping a credit card or home equity line of credit to pay an expected $1,000 medical bill, and many would get by liquidating financial assets for an extended period of time between jobs. The access to credit, combined with the nearly 0% interest rates on bank savings, explains much of the reasons behind the “dearth of savings” commented on. What would be a problem is if one has low savings, low ability to access credit and low levels of financial assets to tap in case of an emergency.
When looking at savings, the relevant aspect is how total financial assets compares to total financial debt. Netting those out will give a picture of either a positive (financial) net worth or a negative one. Just as with debt, looking at money in the bank doesn't mean much without looking at the other. It's fine to have $50,000 of investments or in the bank, but if it's more than offset with $100,000 of debt (independent of any real estate debt, that is typically offset by the value of the home), from a net worth standpoint, it's no different than having $0 in the bank, but only $50,000 of debt.
“Financial freedom is having enough to retire”
Among individuals seeking out professional financial advice, probably the goal most often mentioned is that of being able to retire. And for many, a comfortable retirement at a comfortable age is the very definition of financial freedom. It has been well noted by many in recent years the increasing number of Americans who expect to retire later or work during retirement (the latter of which always sounds like an oxymoron to me). Gallup reported in 2016 that 37% of those surveyed said they expected to retire after age 65, compared to just 14% saying the same in 1995. (However, it should also be noted that a high percentage of Americans don't retire when they expect, usually earlier than expected, due to layoff or buyout, health, disability or some other personal issue.)
However, nearly all of those who expect to work at an advanced age, would also like the freedom to not have to work. A financially free individual has the freedom to work or to not work, to the extent he or she desires. Financial freedom in retirement comes down to three primary factors. The first of these are the amount of fixed income streams, such as Social Security, pension or annuities. The second factor is the yearly cost of living, the standard of living, one requires or desires during retirement. The third is having enough financial assets to be able to take either an income stream off those assets or liquidate them over time to ensure enough income each year, as well as a potentially long retirement. A high percentage of today's retirees will live beyond age 90 and even 100, but such a lifespan would be a blessing, not a burden, for those who are financially free in retirement.
Financial freedom is the weaving of financial assets, debts, income and expenses with our emotions and desire for comfort, flexibility, and freedom of worry. We are human creatures with emotions that often override accounting equations. In the end, it comes down to personal preferences. For example, for a multitude of reasons, some of us may simply feel more comfortable with having lots of money in a non-interest earning savings account, even while having auto loans or other personal debts. Some of us are more bothered by debts or more pleased by having a large amount of financial assets.
Research indicates that financial assets, debts and money in the bank are more influential in our life happiness and reported financial well-being than income or spending. In other words, earning a lot of spending a lot isn't highly associated with having a satisfying life. A 2016 U.K. survey by Ruberton, Gladstone & Lyubomirsky found that there was only about a .10 positive correlation between either average monthly income and average monthly spending and reported life satisfaction. The amount of the participants' total investments was more highly correlated with both life satisfaction and financial well-being, with about a .20 correlation to both. On the other side, indebtedness had about a .25 negative correlation with reported financial well-being, indicating that keeping control of debts does matter to life happiness and financial well-being, at least to a degree. The highest correlation of the variables measured, with both life satisfaction and reported financial well-being, was with average monthly “liquid wealth”. There was a rather strong correlation (more than +.40) with liquid financial assets (checking and savings accounts) and financial well-being. Apparently, having money in the bank, even when it earns virtually nothing, does make us happy. Or at least, happier than having the same amount in debts.
In the end, we all want to be happy, and we want to feel freedom with our finances. The amount of financial assets, debts, money in the bank, and retirements associated with these factors, aren't the only things in life that matter, but they do matter to our finances and to our life satisfaction. Having the patience and persistence to save, spend wisely and restrain debt does tend to pay off on the path to long-term financial freedom.