In one of my early posts, I discussed what financial independence meant to me. Within that article, I briefly raised the concept of savings rate and how it is an important metric to measure on your path to financial freedom.
But just how important a metric is it? Arguably it is the most important.
So today we will go into a bit more detail as to how important creating a good savings rate is for your financial future.
What is savings rate?
In the most basic sense, it is the difference between what you earn and what you spend. This is then expressed as a savings percentage, measured against your income.
How is savings rate calculated?
I think an example would provide the most straight forward explanation.
Sarah has calculated her annual expenses and she spends $40,000 per year.
Sarah’s after tax income is $50,000 per year.
Therefore, her savings rate is calculated as:
After tax income minus Annual expenses
($50,000) - ($40,000)
= $10,000 (annual savings)
Savings rate = ($10,000/$50,000) X 100 = 20%.
Some people prefer to use their pre tax income because it makes the savings rate number higher. But my opinion is what is the point of using your pre tax income when that just goes to the government taxes? It is not cash in the hand. After tax income is a much more accurate number.
Some also like to add their employee Kiwisaver contributions back in to their annual savings number. In our example, that would be added to the $10,000 number. There is no problem with that, as it is your savings after all. Don’t include the employer contributions though, because that will just cancel out. In other words, your employer contributions increase both your savings and income at the same rate, cancelling each other out.
Find a system that works best for you. The key is to keep it consistent. If you want to use pre tax income to feel better about your savings then that is fine, but don’t chop and change between using pre and post tax income in your calculations, otherwise you won’t get a true and accurate reflection of your progress.
Why do I need to know my savings rate?
Your savings rate will give you a great idea of how close (or far!) you are to financial freedom.
It is not enough to know how much you are saving every year. That means nothing if it isn’t measured against your income.
For example, if I told you that Mary was saving $10,000 per year you might be thinking “good job”. But if her after tax income is $150,000 then it isn’t that great. 6.7% in fact. Starting from zero, how long would it take to achieve financial independence with Mary’s numbers? Let’s check out the spreadsheet.
Some superannuation income in retirement may lower this timeframe slightly, but it goes to show how important savings rate is.
$10,000 savings a year for Sarah on a $50,000 income however, would be able to reach financial independence in 46 years. Almost half the timeframe. Same annual savings, different savings rate. Despite an income of $100,000 less, Sarah is much better off than the higher earning Mary, thanks to lower annual spending relative to her income.
This is the reason most people never become wealthy. Each time their income increases, so does their spending.
With a better savings rate, someone on a lower income can be much better off than someone on a much higher income. So don’t be discouraged, and keep focus on your savings rate. Just a 1 or 2% increase in your savings rate each year can reap great rewards.
Mind the gap
Savings rate all boils down to the gap you create between your income and your expenses.
This gives you two different levers to pull to increase your savings rate. You can either increase income or decrease expenses. Or ideally, both.
Have a play around with the spreadsheet above and see the effect that different alterations to your expenses and/or income can make. It’s quite amazing how such small tweaks can make such a big long term difference.
And the lower your income, the bigger the difference you can make. This makes saving extra important for those on lower incomes.
Some people find increasing income easier. Whether that is through a second job, starting a business, or great performance at your current job. There are many paths to increasing income and what suits someone else, may not suit you. Stay true to yourself and find what works best for you. For example, a man with a young family may not want to find a second job if it means more time away from the family. A better option may be to focus on their main job. Think of ways to increase your primary income. Could be through breakthrough work, networking with important people, asking for a raise, or any number of ways.
Whereas others find it easier to decrease expenses. Again, there are so many different ways of going about it. You could try to save a few percent focusing on small expenses such as cutting down on coffee and eating out. Or you may be in a position that I was, where I could focus on the big expenses of housing and transportation to really ramp up the savings rate.
It isn’t enough to just have a difference between income and expenses. You need to find productive assets to invest in so that you can give your savings a chance to grow. Otherwise, you will just lose your savings over time thanks to inflation.
First, focus on some easy wins to increasing income or decreasing expenses.
Remember, creating savings is never meant to be about deprivation. It is about minimising the expenses that bring you the least satisfaction. Things that are getting in the way of your future goals.
If you really can’t stand the option of reducing your expenses, then you are left with just one option. To increase your income.
Likewise, if you are no chance of increasing your income, then you are only left with the option to reduce expenses.
Once you get comfortable with your new savings rate, then look to increase it by a couple of percent per year with any increases in income you get. Most of us get pay raises that closely match inflation, sometimes more.
The key is not to increase your spending as your income increases. That is the trap that so many people fall into. The way to quickly get ahead is to bank some of those increases into different investments. Sure, everything gets more expensive over time, but we don’t have to buy everything.
Some years will be better than others, but don’t let that discourage you. I am a strong believer that the process and intent are more important than the end result. We can control our processes, but we can’t always control the end result.
The sooner you can create a healthy (one of non-deprivation) savings rate, the sooner you can reach financial independence. Check up on your savings rate once a year and don’t let it slip away on you.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here.