As you gain control of your personal finances, it is easy to get lost in all the numbers. You can obsess over the details of your budget, how much your spend on gas each week, the expense ratios of your mutual funds, or even the interest rate on your checking account.
However, when it comes right down to it, there are only two numbers that you need to be consistently tracking on your journey to financial independence:
- Net Worth
The reason for this is that financial independence is purely based upon saving a certain multiple of your yearly spending. In general, you can expect to be able to safely withdraw 3% of your net worth each year and not run out of money in your lifetime. Therefore, you will need a net worth that is 33x your expected yearly spending to reach financial independence.
By tracking your yearly spending and your net worth, you will essentially be tracking your progress towards financial independence. Here’s how to track your net worth and yearly spending.
Track Your Net Worth
This is the most important aspect of your finances. We talked about Net Worth in How to Earn Your Freedom, but in case you missed it:
Net Worth = Assets – Debts.
For our purposes here, your assets include your cash (checking and savings accounts), liquid investments (stocks, bonds, REITs, etc.), and any investment properties. It generally does not include your car and your other possessions since these do not generate income and do not appreciate in value. An argument could be made as to whether to include the equity in your primary home, but since your home is not particularly liquid, I would leave it out of the calculation. If you do have a paid off home, however, it will significantly reduce your projected expenses once you no longer need to work.
Your debts include any credit card balances, student loans, car loans, and the mortgages on your home and any rental properties.
You can calculate your net worth manually, but that is generally not an efficient use of time. Rather, I recommend using Personal Capital to track your net worth. Basically, you enter in all your accounts and Personal Capital will update your net worth every time you log on. You can also graph it over time. If it’s going up, you’re on the right track.
Track Your Spending
Spending includes all expenses you have in a given month or year. It includes housing, transportation costs, food, insurance, cell phone bills, and entertainment. Basically everything except your savings.
Again, you could track your spending manually, but this would be onerous. I recommend you track your spending using Mint (or similar budgeting software).
If you make most of your purchases with a credit card or check, you can import these accounts into Mint, and your spending will be tracked automatically. I recommend Mint over Personal Capital for tracking spending because you are able to customize your spending categories to help with budgeting. Personal Capital does not allow you to create custom categories. However, Personal capital is better at showing your investment income (such as dividends from stocks and interest from bonds), so I generally like it better for tracking your investments and net worth.
Track Your Progress Towards Financial Independence
If you know your net worth and spending, you have everything you need to track your progress towards financial independence.
However, there’s a way to make it even simpler. Once you have an idea of your yearly spending, you can estimate your net worth goal (yearly spending x 33) and then as long as you don’t let your spending get out of control, you only need to track your net worth with an eye on your net worth goal.
Another way to look at this is to create a graph with your yearly spending, net worth, and projected yearly investment income (using the 3% rule). The example below assumes that you are investing $8,000 monthly for 15 years at a 5% return. The numbers are derived from the Smart Asset Investment Calculator.
You can see that as your net worth increases, the amount that you would expect to earn from your investments each year (3% of net worth) also increases until it matches (or eventually surpasses) your yearly spending.
You can only improve what you can track. By tracking your spending, you can try to keep it as low as possible. By tracking your net worth, you can make sure it’s increasing at a fast enough rate to reach financial independence in a reasonable amount of time. If you haven’t already, set up accounts in Personal Capital and Mint so you can track these variables and earn your freedom.