The Rules Of Financial Freedom

What is financial freedom? To most people it is having enough money so that they don't need to worry? To some it's all about being able to buy that dream house, yacht or car. To others it's simply to provide a good standard of living for their family.

Whatever your idea of financial freedom is, there are a number of simple rules that will help you to create and grow wealth, enabling you to have a financially richer and more prosperous lifestyle.

Rule 1 - Understand Compound Interest

When banks, building societies and credit card companies lend you money, they will charge interest on the loan - which is how they make their money.

For example, you might take out a loan for £1,000, which you will repay at the end of a twelve month period. The lender will charge you 10% interest on this loan, which will mean that your total repayment will be £1,100.

However, if you took out the same loan, but decided to pay it off at the end of a five year period your total repayment would be £1,611.

This is the effect of compound interest, where you are not only paying interest on the original amount of money that you took out, but also on the unpaid interest that you have gathered each year.

The following figures show how compound interest will change £1,000 into £1,611:

This is a very simplified example and in the real world, bank loans tend to be repaid monthly, which will limit the impact of compound interest.

However, the example does closely illustrate what can happen to people with large credit card debts, who only pay off the minimum monthly repayment figure, which does little to dent the impact of compound interest.

Is Compound Interest All Bad?

Well actually no! There are in fact hundreds of thousands of people who use compound interest to their advantage. In the same way that lending companies charge you interest when you borrow money; banks and building societies will pay you interest when you open a savings account with them.

Say you opened a savings account with your local bank and paid in £1,000, with an interest rate of 5% (banks tend to be less generous with the interest rate when we are saving), your savings will have grown to £1,276, within five years.

As you can see, it is important to be aware of the effect that compound interest can have on your finances and how it can become a useful ally in helping you towards your goal of financial freedom.

Rule 2 - Ditch The Debt

With so many different ways to buy now and pay later, its no wonder that debt affects millions of people and is one of the biggest obstacles in the journey towards financial freedom. As we have seen in Rule 1, becoming debt free will mean that you are no longer paying interest on your borrowings - interest that is making other people rich - but can begin investing your money to increase your wealth.

For most people, getting rid of debts and staying debt free for the rest of their lives will require a huge change in attitude. We live in a world of choice and are constantly bombarded with the latest gadgets, fashions and trends - plus easy ways to pay for them. However, being debt-free does not mean that you have to become an old miser, it simply requires a little more thought and planning over your purchases.

Rule 3 - Understand The Difference Between Good Debt And Bad Debt

Although the golden rule is to be completely debt free, some debts are necessary and can enable us to increase our wealth. The most obvious example of a good debt is a mortgage. Few people can afford to buy a house outright and the only way for the majority of us to purchase a property is to borrow money and pay it back over a period of time. However unlike cars, televisions, holidays and other consumer goods (whose value quickly drops), the value of property has tended to remain in tact and has even increased quite considerably over recent years. Therefore, provided you can comfortably make the monthly repayments, a mortgage is one of the few occasions where borrowing makes sense.

Other situations where borrowing money can help you to make more money include starting a business or investing in further education to improve your career prospects.

Rule 4 - Manage Your Money With A Budget

Budgeting is not just about cutting unnecessary costs, but managing your money and ensuring that you can do the nice things in life without having to borrow.

Why Should You Manage Your Money?

A budget will enable you to get a clear view of your financial situation, so that you can ask questions like:

• What is your monthly income?
• What are your monthly outgoings?
• How much money do you owe?
• How much money do you have saved?

Having a clear understanding of your financial situation will provide a starting point from which you can make decisions on how to improve your finances, such as paying off your debt or increasing your savings.

Your budget will also help you to plan for the big expenses that we all incur each year, such as car insurance, holidays and Christmas.

Rule 5 - Build Up An Emergency Fund

Life has a habit of throwing problems in our path - ranging from the small and annoying, such as a broken washing machine or burst pipe through to something more serious like an accident or redundancy. So to help deal with these problems, why not start building up an emergency fund which you can quickly access when things are not going right.

Setting up your emergency fund is simply a case of opening an instant access savings account with your bank or building society and then paying money into it each month. Ideally an emergency fund should be able to cover your expenses for at least three months and will save you from having to borrow money or sell investments in order to meet your costs.

Rule 6 - Harness Your Most Precious Resources To Increase Your Wealth

Throughout our working lives we sell our time and knowledge to employers in exchange for a salary. To increase our earnings, it is possible to do overtime or find a second job, which effectively means selling more of time. However, time is a precious resource and the number of hours that a person can work each week is limited, which places a cap on the amount of money we can earn by increasing our hours.

Build Your Knowledge

Fortunately knowledge does not share the same limitations of time, so by gaining knowledge and skills, we are able to offer our employers more value and significantly increase our earnings potential. This is why it is important to take advantage of every learning opportunity that you are offered and to continuously seek new opportunities to build your knowledge.

Creating Passive Incomes

The other way of overcoming the time-earnings barrier is to create sources of income which do not require our constant involvement. Often referred to as 'passive income', the key advantage is that we are able to earn money from more than one source and by increasing the number of earning sources it is possible to grow our income, without having to trade more of our time.

Typical sources of passive income include:

• Buy-to-let property rental
• Share dividends
• Interlectual property rights to books, music, industrial patents, etc

Many multi-millionaires have made their money using this principle - setting up companies and then employing management teams to run them on their behalf, whilst they use their newly freed-up time to set up the next business.

A word of warning! Creating sources of passive income normally requires a lot of investment in time and money at the start, before the income stream begins to pay. The Internet is full of dubious offers that claim to show you how to quickly make hundreds of pounds per week with just a couple of hours work - if it sounds to good to be true, then it probably is.

The other thing to be aware of is that few passive incomes are 100% passive and it is likely that you will need to spend some time maintaining them. For example buy-to-let properties will always require someone to manage the repairs and find new tenants.

However, this should not take away from the fact that the principle of passive income can be a very effective way to build up your wealth.

Rule 7 - Maximise Your Return On Investment

Putting money aside for the future is a great way to take advantage of the effect of compound interest and provide yourself with a retirement income, but it is important to understand that where you decide to invest your money will make a big difference to the level of income you can expect to earn.

Take twin brothers John and Richard Smith for example. At the age of 20, both decided that they will each invest £3,000 per year over 30 years in order to provide an income that would enable them to retire by the age of 50.

On average, John was able to grow his investment by 3% each year, whilst Richard managed to achieve 10% growth. The following table shows how the brother's finances performed:

As you can see, both brothers invested the same amount of money, but because Richard was able to get a consistently higher return, his investment rocketed, whilst John's never really left the ground. This means that whilst Richard is off traveling around the world, poor John has to carry on working until his 65th birthday, when he can pick up his pension.

How Do You Achieve Higher Returns?

The secret to achieving higher returns is where you decide to invest your money. Stocks and shares for example will generally provide a better rate of return than savings accounts or government bonds. There are other factors, such as tax rates and management fees that will also influence your rate of return, so it is worthwhile doing your homework to find the best place to invest your money.

Rule 8 - Improve Your Employment Prospects

You don't need to be an entrepreneur to make it big and for most of us moving to a new job or getting a promotion is one of the best ways to increase our income. Here are some tips on getting the most out of your career.

Make Use Of All Personal Development Opportunities

Build up your CV with experience and qualifications by taking advantage of any training opportunity your employer offers. This includes formal training, such as courses and seminars or experience gained from taking on extra responsibilities.

Sometimes it is also worth considering the long-term benefits against those of the short-term. Some roles may not pay junior staff particularly well, however the experience and training that they receive can allow them to earn considerably more money when they reach senior levels.

Raise Your Profile

Don't let a low profile stop you from getting the promotion you deserve. Become your own publicity machine and find positive ways to get yourself on the radar of senior managers. Consider joining a company committe, writing for the staff newsletter or representing your organisation at a charity event.

Find Better Ways To Do Your Job

Add extra value to your role and prove yourself as a competent employee by finding ways to do your job better. Maybe you can streamline a process, find new clients, become an expert on a particular topic or improve your personal organisation.

Set Personal Development Targets

Set yourself long-term goals and then develop a plan on how to achieve them. Perhaps your goals will be financial (to earn £100,000 per year), they may involve reaching a particular position (to become the managing director) or they could be a combination of both.

Your plan should consist of the steps that you will need to take to realise your goals and you should try to complete at least one step each year, whether it be a promotion, new job or learning a new skill.

Know When To Move On

Be careful not to get stuck in a rut and recognise when you are ready to move on. At some point, most people will outgrow the companies they work for and changing jobs will often bring fresh challenges and better salaries.

Rule 9 - Understand The Power Of Small Returns

Wealth building should be less about hitting home-runs and more about making small, consistent gains over the longer-term, helping you to become richer - little by little at first, but then astonishingly quickly.

Yes, it is possible to find shares that could make you a millionaire overnight, but with the reward comes the risk and unless you are prepared to make big losses during your wealth building journey, it is better to take your time and aim to make regular small wins, rather than trying to hit the jackpot.

Rule 10 - Start Investing As Soon As Possible

Perhaps one of the most important pieces of investment advice, is to start as soon as possible. To understand why, take a look at the following example:

Twenty year old Sue decides to start investing her hard earned cash in stocks and shares. Over a ten year period, she is able to invest a total of £50,000 (£5,000 per annum). By the age of thirty, Sue is married to Max and has left work to have children, so she decides to stop investing.

Whilst Sue spent her twenties working hard and saving money to invest, Max preferred to frit his money away on boozey nights and fast cars. However, after getting married to Sue and becoming a father, Max decides that it is time to take responsibility for his money and begins investing £5,000 a year for the next twenty years (a total of £100,000).

Assuming that both Sue and Max did not cash in their investments and that both were able to achieve an average return of 10% per annum, it is natural to assume that after 30 years, the value of Max's investments will be considerably higher than Sue's. However the results could not be more different.

Despite Sue investing less money than Max, the fact that she had started investing ten years before him, meant that her investments had more time to compound into a significantly higher figure.

Unfortunately many people make the mistake of putting off investing, because they do not think they can afford it. However, the great thing about investing is that you do not need to buy all your shares in one go. In the example above, Sue was investing £5,000 in shares each year, however she would have been able to buy her shares on a monthly basis, working out at around £420 per month (the same sort of money that people might pay when they buy a flash car on hire purchase!).

Admittedly, £420 a month is still a lot of money to many people, but that doesn't stop you from investing what you can comfortably afford. Many people start investing with as little as £50 a month, either buying individual shares or putting their money into managed funds. The smartest people arrange for the money to automatically leave their accounts as soon as they get paid, so that they don't even notice it has gone and as their income grows, they can simply raise the amount of money that is invested each month.