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Achieving financial freedom means having enough investment income so that you don’t have to work for a living. When your investment income exceeds your living expenses (including taxes), you no longer need a job to pay your bills. Of course, you don’t have to quit your job once you achieve financial freedom, but you have instead the choice of whether or not you continue to work.

You will also want a margin of safety. If your living expenses are $5,000 a month and you make $5,000 of investment income a month, for example, you have little financial wiggle room if your living expenses spike or your investment income takes a hit. It’s better in such instances to have perhaps $10,000 or more of monthly investment income before submitting your resignation letter.

To achieve your Financial Freedom Day, you need to reduce your living expenses and increase your investment income until your investment income exceeds your living expenses by your desired margin of safety.

Reducing Your Living Expenses

The best way to reduce your living expenses and keep them low is to live well below your means. There are many good suggestions in the Personal Finance Education section of this blog. The idea is to maintain your quality of life while living it in a more frugal manner.

Borrowing money for consumption is considered “bad debt” because it costs you money. Bad debt takes money out of your checking account every month when you make the payments. To get rid of bad debt more quickly, consider a Prosper debt consolidation loan. By refinancing your debt at a lower interest rate, you will save interest expense. These savings can be used to help buy the income-producing assets you need to increase your investment income.

Increasing Your Investment Income

You investment income must come from a portfolio of income-producing assets. If you need $5,000 of investment income per month (or $60,000 a year), for example, you should work towards building a portfolio worth $1.5 million in order to be able to draw income at a 4% safe withdrawal rate.

If your investment management costs are 1% of your portfolio’s value and inflation is 3% a year, your portfolio needs to earn at least 8% (4% + 1% +3%) a year on average in order to be able to generate the same purchasing power of income on an inflation-adjusted basis.

Diversifying with non-correlated asset classes is important. Although the stock market averages 10% a year over the very long term, its returns also swing wildly on a year-to-year basis. Prosper loans, on the other hand, are correlated with the job market rather than the stock market. Hence, making loans to your fellow Americans is a way to help diversify your portfolio of income-producing assets. But since unsecured loans to people are also risky, it’s important to keep your Prosper portfolio to a small percentage (e.g., less than 5%) of your overall investment portfolio.

The only constant is change. Investment returns change. The inflation rate changes. The economy changes. You need to monitor the financial environment and make adjustments to your investment choices and living conditions as the world changes. This is an area where you need to take full responsibility for the results you get. No one else is going to do it for you.

Borrowing money to buy income-producing assets is considered “good debt” because doing so puts money into your checking account on a regular basis (so long as your investment return is greater than the interest rate on your debt). When you find the right opportunities, consider taking out a business loan on Prosper to be able to take advantage of them. With your good credit and your excellent track record of on-time Prosper loan payments, lenders will want to loan you money and you will find Prosper to be an ongoing source of inexpensive money to fund your wealth-building programs.

Making It Happen

The first decision you need to make is to decide you want to achieve financial freedom. Then commit to making it happen, whether it takes you years or decades to achieve your dream. With your decision and commitment, you will start looking for ways to increase your income, live below your means, and invest the difference. Set up a capital account and add to it the money you save by consolidating your debts with a Prosper loan (along with the many other ways you will discover to save money).

When you are tempted to buy a non-essential luxury item you just have to have, decide what you want more — the luxury item or financial freedom. Buying the luxury item will push your Financial Freedom Day further out in time; avoiding the purchase of the luxury item and putting the money into your capital account instead will pull your Financial Freedom Day in closer to the present. There is no right or wrong answer here. Rather, it’s what you decide to do with your money and your financial future.

The conceptual framework provided in this blog post will get you started on the road to financial freedom. All you have to do is reduce your living expenses and increase your investment income in a steady fashion until your investment income exceeds your living expenses by your desired margin of safety. Prosper is here to help when you need it. Enjoy your journey and may it be a profitable one.

Roger Steciak achieved early semi-retirement in 2006 and became a Prosper lender to diversify further his portfolio of income-producing assets. His book Happy About People-to-People Lending With Prosper.com, How to Lend Money to Friends You’ve Never Met was published in 2007.

Credit grades (e.g., the FICO score and Experian ScoreX) attempt to predict the likelihood of borrowers repaying their loans. While this score is useful, it is best to supplement it with the borrower’s credit and employment information when developing a lending strategy.

To understand how all of this fits together, it pays to understand the five C’s of credit: character, capacity, capital, collateral, and conditions.

Character

Character refers to a borrower’s willingness to make their loan payments. While bad things do happen to good people sometimes (which result in delinquencies and public records), people who haven’t learned yet to take their financial responsibilities seriously enough also tend to accumulate delinquencies and public records. Favor listings with a low number of delinquencies and public records (ideally zero, but it’s your call) to be on the conservative side. Also favor higher credit grades for people with delinquencies and public records to take advantage of what the credit scoring model knows that you don’t know.

Consider a high number of inqueries (more than one or two) as an indication the borrower may be shopping around for additional credit lines because they see a financial crisis on the horizon. According to MyFICO.com, people with six or more inquiries are eight times more likely to declare bankruptcy than people with no inquiries. The Average Credit Statistics page on MyFICO.com provides a good credit profile of the general population that can guide you on what to use in your lending strategy.

Capacity

Capacity refers to a borrower’s ability to make their loan payments. Although Prosper allows “unstated income” listings, you might want to favor listings where the borrower has indicated an income and the debt-to-income (DTI) ratio is reasonably low. A DTI ratio of 20% or less for non-mortgage debt (which is the approach used on Prosper) is considered normal, while higher DTI ratios are considered more risky. Another indication of capacity to pay is a relatively low bankcard utilization. Low utilization means the borrower has a spare credit reserve to absorb an unexpected financial shock (such as an emergency car repair).

Capital

Capital refers to the assets owned by a borrower that could be seized to satisfy a judgement in case of a default. Once a loan defaults and is sold to a distressed debt buyer, that buyer can sue and get a judgement against the borrower. Assets owned by the borrower can then be seized by the sheriff to satisfy the judgement. The only asset that we know the borrower might own is a home (which appears as “homeowner” in the borrower’s listing).

At the last debt sale, the defaulted loans to homeowners received 12 cents on the dollar, while defaulted loans to non-homeowners received between 5 and 10 cents on the dollar. To maximize the salvage value of any defaulted loans you might get, consider bidding on listings of homeowners. At the same time, the Prosper historical database indicates that while loans to homeonwers default less frequently, loans to non-homeonwers have a higher ROI. You get the make the tradeoff here on how you go about determining your lending strategy.

Collateral

Collateral refers to property used to secure a loan. Prosper only offers unsecured loans, so this criteria does not apply. Prosper does not hold the deed to any property nor the pink slip to any car. When you see a listing that says “You are protected because this loan is secured with _____”, that borrower is mistaken. Whenever you see such a listing, you may want to report it so that Prosper has the opportunity to educate that borrower on how Prosper loans work.

Conditions

Conditions refer to the general economy. During recessions, unemployment increases and people tighten their belts. Payments on unsecured loans often suffer as a result. While the last official recession in 2001 was relatively mild compared to the previous official recessions of the early 1990s and early 1980s, who knows how severe the next recession will be. Since Prosper loans funded in 2008 will have their three-year payment cycle end in 2010 (and so forth), you might want to start favoring borrowers who are under less financial stress and are in the higher credit grades if you believe we will have the next official recession in the early 2010s (if not sooner).

Backtesting Your Proposed Lending Strategy

Once you have an idea of what you want to use for a lending strategy, test it using Prosper’s Marketplace Performance page. You will be able to get an idea of how a lending strategy would have performed in the past and can make any necessary adjustments. While a lending stragegy that performs well on past data may not perform the same on actual listings in the future, it’s still a good way to start.

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Roger Steciak has been lending on Prosper.com and Kiva.org since the summer of 2006. He is also the author of the book Happy About People-to-People Lending With Prosper.com: How to Lend Money to Friends You’ve Never Met.