So you have managed to start saving and increase your monthly savings ratio to a satisfactory level.
Now you can use your savings to apply the FILIP formula, a simple formula which will hopefully help you achieve your financial goals and life goals easier and faster and ultimately reach financial independence.
Financial Goal No.1 – Use any savings to pay back in full all high interest debt such as credit card or personal loan debt.
Take a good honest look to all your existing accounts, credit cards and loans. Hard as it may be put together a list of all your outstanding debt in order to be able to track it better.
The first step FILIP applies is to attack and pay back all high interest debt as fast as possible. This would be any debt with an interest rate of 6% or above.
This debt exists because for some time you probably lived above your means and is mainly linked to consumer products you bought when in reality you could not afford these such as an expensive car or an expensive pair of shoes.
When you change your financial habits and start saving each month not only are you able to stop increasing the amount owed in credit cards and personal loans but you are able to reduce any outstanding debt.
The faster you pay back this debt the more money you will be able to save and the faster you will apply the next steps and reach financial independence.
Financial Goal No.2 – Set aside enough money for an emergency.
After you repay in full all high interest debt, you need to set aside an amount sufficient to cover your necessary expenses for a period of 3 months.
Open an easy access account and keep this money separate to all your other accounts.
This account should only be used in an emergency or in case you lose your job in order to temporarily cover your necessary monthly expenses such as rent, food and transportation.
Financial Goal No.3 – Start saving into your pension fund.
Once you set aside enough money for an emergency the third step is to start saving into your pension fund.
Many employers match up to 3% of your gross salary, this means if you sacrifice 3% of your gross salary they will match another 3% and contribute a total of 6% into your pension fund.
Some employers will also contribute an additional percentage of your gross salary into your pension fund without you having to sacrifice any of your salary. If your employer matches your pension contribution take advantage of the full amount.
Try to save into your pension fund from as early as possible, in this way your assets will grow more over time utilizing in full the benefits of compound interest. Start with 3% to 6% and gradually build over the next years that percentage to 20% or above.
Contribute a significant part of your savings into your pension fund as this is the most tax efficient way to get your money to grow tax free.
Your pension fund will grow each year without having to pay any taxes on the gains made by the fund.
Financial Goal No.4 – Save for a deposit to buy an affordable flat/house to live in.
After you have started contributing into your pension fund at least 6% of your monthly gross income, the next step is to start saving for a deposit.
The key to this step is that your first property should be affordable and not put you in a financially stressful position or at risk of losing that first property. If this could be the case continue renting, saving and looking for a more affordable property.
Ensure you are buying an affordable property by calculating that a) the cost of buying is lower than the cost of renting and b) the monthly mortgage payment is less than 30% of your monthly net income.
Put down a deposit which is at least 10% of the agreed price.
Calculating the cost of buying can be complex as it has many elements and depends on how long you plan to keep the property.
We cover the cost of buying calculation in more detail in another article on our website.
Financial Goal No.5 – Invest in real estate and stock market investments.
Now you contribute at least 6% into your pension fund and you have bought your first property.
Depending on your personal circumstances, risk appetite and financial independence horizon you can use any additional monthly savings in a the following 4 ways.
a) Increase your pension contribution.
b) Invest in the stock market.
c) Save for a deposit in order to buy an investment property, or;
d) Repay faster the mortgage on your first property.
Every person has different circumstances and priorities. Although there is some flexibility depending on your personal circumstances, FILIP saves at least 20% of their gross salary into their pension fund, invests at least 20% of their net income in real estate and stock market investments and uses any additional savings to repay faster their first property and give back to the society.
Pension funds secure sufficient funds later in life while investments in real estate and the stock market provide additional income immediately. At sufficiently high levels investments lead to financial independence, i.e. having investment income which can cover all your monthly expenses.
Financial Goal No.6 – Give generously.
At every step of applying the FILIP formula you can consider giving a small amount of money or offering your time to a worthy cause based on your values.
Especially once you set up all previous steps and you save at least 20% of your gross income into your pension fund and at least 20% of your net income towards real estate and stock market investments be thankful for what you achieved. Give back to the society and to people who are in need.
You can give money directly or you can contribute your time towards the cause which is closer to your heart.
Many studies have shown that giving makes you far happier than receiving and that giving money to others or to charity puts a much bigger smile on your face than spending on yourself.
True wealth is not acquired through possession of consumer products but by leading a fulfilling life.
There is nothing more fulfilling than knowing you have made a positive difference in the lives of other people.
Begin with the end financial goals and life goals in mind
Before you start your financial journey and start applying the FILIP formula have a clear vision of your desired direction and destination.
This is not only about the amount of money you would require to earn from your investments and when you would like to reach financial independence but also the quality of life you want to achieve.
Determine the things that you value most in life and work towards them first.
Specifically, for your financial goals there are two methods to calculate the amount of assets required to reach financial independence, these two methods give the same result.
Method 1
1. For the first method calculate an expected annual amount you would require in order to support your lifestyle and multiply this amount by 25.
This is the amount of income generating assets you need to have in place in order to be financially independent.
Investment income will be taxed so any required amount should be pre-tax. You can use the current tax rates in your calculations assuming that the prevailing rates at the time you become financially independent will not differ materially.
For example, if you would require a pre-tax income of 2,500 USD or GBP each month, or 30,000 USD or GBP annually, you would need to put in place assets worth 750,000 USD or GBP.
Method 2
2. A second method to calculate the required assets to achieve financial independence is to calculate the amount of assets which would return investment income equal or more to the expected annual expenses required to support your lifestyle.
Assuming an average return of 7% on your investments which is also what real estate and stock market investments have averaged over the last 100 years in the developed world and an average inflation rate of 3%, the average post inflation return (i.e. real return) on your assets you can use for your calculations is 4%.
The main asset categories will be your a) Pension fund (accessible only after a certain age), b) Real Estate investment properties (illiquid) and c) Stock market investments (liquid).
Diversify your assets between these 3 categories depending on your circumstances, risk appetite and financial independence horizon.
For example, if you want to become financially independent at or after 65 then allocate the majority of your savings towards your pension fund.
If you want to become financially independent earlier allocate the majority of your savings in real estate and stock market investments.
As a general rule of thumb, the earlier you want to reach financial independence the more savings you should allocate to real estate and stock market investments.
Along the journey to achieve your financial goals and reaching financial independence don’t forget all your other life goals. Always consider all your life goals when making your decisions.
Check out our article with some examples of FILIP formula applied for specific level of income and different assumptions.
Until the next article or video, let’s all make informed financial decisions!