Now that you’ve got a bigger picture of your long-term financial goals, it is equally important to identify ways to achieve those goals. Hopefully by now you’ve set yourself some big financial goals to work towards to in the near future. These could range from earning some extra cash, becoming debt-free and paying off your mortgage, to reducing your work hours or retiring early.
Why exactly do so many people still have debt or no financial or pension plan for their future? Ask anybody in your environment and a vast majority will say that they just don’t have enough money to pay off their debt or to throw at their pension fund. They’ll tell you that they might plan to pay off their debt as soon as they get that promotion and accompanying pay raise. But by now you probably know that even when they get that increase in income, they still most likely won’t be using that money to pay off their debt, nor will they tuck it away and use it to invest in their pension. They’ll simply spend it on new things and without them even realizing it, their lifestyle will gradually inflate to a new level.
And are you maybe still telling yourself a version of this story as well?
Let’s think about how you can speed up your savings goals. Simply speaking and as we have already discussed in earlier steps, there are generally two ways to increase your savings:
- increasing your income
- decreasing your expenses
The disadvantages of looking at achieving your savings goals in this way however is that it is easy to focus on the finding excuses for not saving more: “I don’t make enough money”, “If only I earned another $1000 a month”, “It’s so much easier for my neighbor, he earns a lot more than me”, or: “I wish I didn’t have a mortgage for 30 years, it’s a big expense each month”, “It’s easy for you to say, I came out of university with a $50,000 debt”, “I have two young children, do you know how expensive they are?”…. And the list goes on and on and on.
Frankly speaking, even though your level of income and your expenses are without a doubt important determining factors in your path to financial independence and other financial goals, there is a third factor that is arguably even more important: your Savings Rate.
Your Savings Rate is the proportional amount of your income that you manage to save monthly, i.e. your savings expenses divided by your total income. Say you make $2,000 and manage to save $200 per month, your savings rate is 10%.
Interestingly enough, if you earn more you might not necessarily be saving more. If your neighbor makes twice as much money and takes home $4,000 per month but only hits a savings rate of 5%, his monthly savings are equally $200. You’d be surprised at how often people with higher incomes have shockingly low savings rates. Why? Because of that good old lifestyle inflation. They earn more so they buy a bigger house, a bigger car, another holiday and more expensive toys for their kids.
Guess who’d be better off if both you and your neighbor lost your jobs and you both had $20,000 in savings that you’d need to use to replace your income? It would be you of course, as you are used to spending far less than your neighbor. Without changing your expenses, the $20,000 would last you 11 months (at $1,800 a month) whereas your neighbor would see the end of those $20,000 after just over 5 months, as she spends $3,600 a month.
By focussing on and ultimately improving your savings rate two major things happen:
- you stash away more money, meaning you reach your savings goal faster;
- you need less to live off, meaning your savings goal will be lower
Think about this for a moment, do you see how increasing your savings rate speeds up your savings process in two ways? Let’s go back to the example where you earn $2,000 and manage to hit a 10% savings rate. It means that you spend $1,800 each month and save (or invest) $200. Now let’s imagine that for the next year you manage to get to a 20% savings rate consistently. Instead of spending $1,800 you now manage to live off only $1,600 per month and you’ve doubled your monthly savings from $200 to $400!
Assume that you are building a 6 month living expenses fund as you are going to set up your own company and you want a 6 months financial cushion in case you don’t bring in any money for the first half year.
- In the first example where you spend $1,800 you need $1,800 x 6 = $10,800 in your 6 month fund. With $200 set aside a month, this would take you 54 months or 4.5 years.
- In the second example you spend $1,600 meaning you need less money in your 6 months fund: $1,600 x 6= $9,600. Setting aside twice as much money as before, it takes you only 2 years (24 months) to get this money together, i.e. less than half the amount of time!
An increased savings rate leads to a reduced amount of time needed to achieve your goal firstly because you set aside more money and secondly because you simply need less to live on and therefore have a lower target to work towards to.
Step 80 – Your Savings Rate – in Detail:
- You can calculate your savings rate in different ways, so you need to carefully decide what your real savings are each month. If you are simply looking at the amount of money you didn’t spend this month, you might get a disfigured picture. What if those $20 you didn’t spend this month you simply spend on the first day of next month? Then that wasn’t a real saving but a delayed expense.
- Look carefully at your money and budget and decide which dollars to include in your calculation, such as:
- Pension contributions
- Mortgage and debt principal payments
- Savings account contributions
- Note though that even with the above it can be arbitrary whether or not to include your savings account contributions if (some of) that money is already earmarked for a very specific short-term goal such as a holiday or new laptop. Only you can decide whether or not that still means a saving to you.
- Total the amounts for any contributions you make to saving and growing your money for the last month, then divide that by your total monthly income to get your savings rate of the last month.
- See how your saving rate varies over the last few months by calculating your savings rates for the last 6 months for example.
- Set yourself a target for the next month and closely monitor how well you do with your savings.
- Set yourself an overall yearly target and add this to your yearly budget review to look at monthly and to adjust budgets on a monthly basis if you get off track.
- Calculate how different savings rates affect your savings goals differently. Look back at the previous step and calculate how a higher savings rates would reduce your total annual expenses and therefore reduce the capital needed in order to be able to take out 4% annually to live off your savings and investments.
- Work out how much longer / shorter it would take you to get to that capital depending on different savings rates. Remember that both inflation and compounding interest would play a part in this calculation too, although to simplify you can of course decide to ignore these for now.
Becoming aware of your savings rate will greatly help improve your financial situation even more and to speed up your savings goals over the next few years. Remember that the more you set aside, the less you need to live off, the less you need to set aside to reach financial independence!
Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.