This is the first of a series of articles that provide step by step instructions on progressing towards financial independence. We'll use a unique and accurate way to quantify our financial health status, and based on that come up with concrete steps to improve and enhance it.
We often think of our financial state as "poor", "middle class" or "rich". In this article we'll see how to use a different but more precise way to evaluate our financial health, and how to use it to progress towards financial independence.
First, let's define some terms. Let's call the income from our main work (job with an employer, self-employed, etc) as our primary income. Suppose we've saved a little bit of the primary income and have put some of that savings into some investments (e.g., CDs, bonds, funds, or real estate) that are now generating some revenue (e.g., CD or bond interest, stock dividends, rent). Let's call that our secondary income.
We'll use the terms "red zone", "blue zone" and "green zone" to indicate where we are in the financial independence spectrum. Let us define and quantify each of these zones to understand them better.
Being in the red zone simply means that our expenses are more than our income (primary and any secondary, combined). Our income does not meet our expenses. This could be for various reasons: perhaps we are starting out on our own in life and have multiple big expenses to deal with — renting a home, getting a car, and so on. Maybe we're starting a family and just bought a home, greatly adding to our debt. Or, it may be that we simply have large expenses (supporting our children or aging parents, or due to any reason). In any of these cases, if our income is not enough to meet our expenses (including any regular debt repayments), we're in the red zone.
This means that we have to keep working. If our income stops or decreases (by choice or due to events in our life), we could sink into deeper financial difficulties. To alleviate this, we sometimes get a helping hand in the form of loans, etc., which, though they help us in the short term, may actually lengthen our stay in the red zone.
Later in this series, we'll see how to work our way out of the red zone.
The next zone is the blue zone, which means that our expenses are less than our primary and any secondary incomes, combined).. Our combined income is able to meet our expenses. This is a good zone to be in. We could remain here indefinitely as long as our income is adequate. We feel comfortable that we're no longer in the red zone, but we still need to continue working to stay in the blue zone.
Our debts are also under control and are slowly decreasing. We're able to take care of all our expenses (including any periodic debt repayments) without incurring additional debt — as long as we are careful to not get cocky and take on a new debt which might send us into the red zone!
The third and final zone is the "green zone". It indicates that our expenses are lesser than our secondary income. Our secondary income alone is sufficient to meet all our expenses. That means our investments are making money even while we sleep at night. Thus, though we don't need to work to make a living, we can definitely choose to continue to work without feeling a sense of pressure. Our "real work" now is tracking the health of our investments to ensure that they continue to generate enough secondary income to support all our life's needs.
The green zone is where most of us would like to arrive at, and stay in. The other articles in this series discuss techniques to progress towards this.
Each of us typically moves between these different zones as we move through life, based on what life throws at us. For example, we could start out in the red zone and reach the green zone by the time we retire. Along the way, life events could cause us to go back and forth a bit — a sudden medical expense could force us to dip into our investment capital and put us temporarily in the blue or even the red zone — until we can recover from the situation.
Note that the we did not use any actual income or expense amounts. The actual amounts are irrelevant for this discussion. A person could have a really high income, but their expenses could be more than what the income can support. Such a person would be in the red zone. Conversely, a person with modest expenses could very well be able to meet that with their secondary income alone, and thus be in the green zone.
Knowing where we stand financially is is very educative. The different financial state zones help quantify the stages in our journey towards financial independence: