Your Savings Rate is a simple concept that has a HUGE impact on wealth accumulation and your ability to achieve Financial Independence. I introduced you to the basic calculation in the Savings Rate Secret article: $ Saved / $ Earned = Savings Rate. However, the limitation with that calculation is its simplicity. Do you count debt paydown? How about pre-tax vs. post-tax income, or savings in a retirement account vs. a savings account? There are so many different ways of looking at all of these numbers, so that is why it is essential to have a consistent and detailed way of tracking your Savings Rate. Without doing so, it will result in wildly inconsistent results that do not have nearly the same impact.
Why Is Calculating Your Savings Rate Important?
There are two reasons why calculating your savings rate is so important:
- Provide a consistent way of measuring financial progress over time that automatically adjusts for changes to saving, spending, and income.
- Provide a calculated result that can be used to estimate the time until Financial Independence.
It all starts with your Wealth Contribution. Your Wealth Contribution (WC) is calculated by adding up the total number of dollars dedicated to increasing your Net Worth, then subtracting any newly acquired debts.
- Assets acquired: cash, investments, real estate equity, etc.
- Contributions to savings, checking, 403b/401k, IRAs, brokerage accounts.
- The Principal portion of your mortgage payment.
- Your employer match counts here as well.
- Debts Eliminated:
- Only include extra (optional) payments towards principal debt balance such as paying extra towards a personal or school loans every month.
Do not include:
- Regular required (minimum) monthly debt payments. You don’t get credit for that because that would suggest that getting into large amounts of debt results in a large Savings Rate, which is not accurate.
- Rent Payments
- The interest, insurance, and taxes on your mortgage payment.
Subtract any debts acquired during the timeframe you are calculating.
The equation for Wealth Contribution is: Assets Acquired + Debts Eliminated – Debts Acquired
Wealth Contribution Example
The following calculation is based on a household with a gross income of $150,000 per year. I find it easier to calculate by month rather than by year, so this example is based on take-home pay of ~ $7,232 a month (after taxes and 403b contributions).
- Assets Acquired
- 403b contribution: $1,625
- Employer 403b match: $500
- Savings account: $250
- Mortgage principal payment: $600
- Debts Eliminated
- $1,000 extra put towards school loans.
- New debts acquired
- $250 on credit card
Let’s plug in those numbers into the Wealth Contribution equation:
WC= (Assets Acquired) + (Debts Eliminated) – (Debts Acquired)
WC = ($1,625 + $500 + $250 + $600) + ($1,000) – ($250)
Calculate Savings Rate Based on Wealth Contribution
Now is the moment you have been patiently waiting for, the calculation for Savings Rate:
The part of this equation that may catch you off guard is that the Wealth Contribution shows up in the denominator. That is because if you don’t account for it there as well, it will significantly overestimate your Savings rate. We are going to take the WC of $3,725 from above and plug it into the calculation along with the after-tax take-home pay, which is $7,232.
If you reference the time until FI chart (included at the bottom), you will see that a 34% Savings Rate equates to achieving FI in about 23 years. Note that the time until FI calculation is based on an expected rate of return of 8%. Suppose you have significant assets with a lower return (like bonds or a savings account) or are paying down other debts (like school loans). In that case, these variations should be considered in your calculation as they would lengthen the estimated time.
Also, if you account for ‘extra debt payments,’ this calculation assumes that you will put this same amount of money towards asset creation after the debt is paid off. If the money you are currently contributing towards paying down debts does not go towards asset creation, it should not be included in your savings rate calculation.
And lastly, the time to FI is based on assuming your current Net Worth is zero dollars. If your Net Worth is positive, your time until Fi is reduced, but if your Net Worth is negative, your time until Fi is increased.
Once you have calculated your Savings Rate, the next steps include increasing your Savings Rate to achieve your goals sooner and breaking down your goals into parts to create a more focused plan.