We must all pay bills.
And most of us pay for these expenses by getting a job and earning a wage.
Before understanding how to become financially free, we should first understand the financial dependence formula.
What is the financial dependence equation?
The Financial Dependence Equation is:
Regular Job Earnings = Spending
If your regular job earnings are $5,000 in a month, you spend $5,000. If you earn $30,000 a year, you spend $30,000 a year. This is the Financial Dependence equation.
Occasionally, you may be lucky enough to get a pay rise. But guess what, as your regular job earnings increase, so does the money you spend. If you now earn $5,200, you spend $5,200.
This cycle of earning and spending what you earn is a difficult to break. Most people never break it, or only do when they reach traditional retirement age.
To crack the formula to Financial Independence, you must break the Financial Dependence cycle.
Are you financially dependent?
To understand if you are financially dependent, simply look at your bank balance each month. Do you have zero left at the end of a month of hard work? Or worse, you have an overdraft and credit card bills?
Even if you have some saving and a positive bank balance, if the balance is static or declining, you are financially dependent.
There is a famous Dickens quote:
“‘Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.”
David Copperfield (1850)
Here, Mr Micawber is using the financial dependence equation. But his conclusion is that if you have have one penny of income above your expenses, you are happy.
This is wrong for two key reasons:
- Working to earn doesn’t necessarily bring happiness.
- Any tiny unexpected cost, even just two pence and you are in misery.
There is nothing to be ashamed of about being financially dependent. In fact, it is very common. In the developed world, the average household saves less than 10% of their income. That means half of households are either financially dependent or close enough to be in Mr Micawbers’s situation.
Five reasons why financial dependence is a problem.
- No safety net – when you spend all that you earn, even a small cash flow shortage can be devastating for your financial health.
- Challenging to leave or move jobs – you can’t take a lower paid job because then you would have a shortfall in between jobs. You can’t take a break from work because there’s no income to pay your expenses.
- Difficult to pay for quality – you have no flexibility in your spending. Every penny in immediately goes out. If you wanted to pay more for something that would last, you have cash spare to do it.
- Unable to payback credit – if you are spending everything you earn, and something does go wrong, you may be forced to use credit. But, there is no spare money in the future to repay that credit. As a result, you risk spiralling out of control.
- Unable to invest for the future – the greatest power of money is to earn income for you. When you are financially dependent, you will never benefits of financial freedom.
Am I stuck being financially dependent?
The great news is, you do not have to be financially dependent. But before we look at how to become the financial independence equation, we need to know our net assets.
Key takeaways of the financial dependence equation:
- If you spend everything you earn, you are financially dependent.
Now you are ready to calculate your net asset trajectory.