The most important concept in all of personal finance is your Savings Rate. Your Savings Rate has a greater direct impact on your ability to accumulate wealth than ANY other concept regardless of your income level. The very basic calculation is:
$ Saved / $ Earned.
If you save $7,000 while earning a yearly salary of $70,000, your Savings Rate is 10%.
$7,000/$70,000 = 0.1 or 10%
Let’s compare three households to put the dollars we save in the context of our income.
All three households save the same number of dollars each year, $7,000. This results in a Savings Rate of 10% for household A. However, in households B and C, this results in a much lower Savings Rate. When your Savings Rate is low, it takes longer to accumulate money and, therefore, longer to reach your financial goals.
Why Is Savings Rate Important?
Imagine you wanted to build up a six-month emergency fund. If you only saved 1% of your income, it would take you 49.5 years to do so. (Really!…the math is included at the end of the article.)
But what would happen if you saved 25% of your income? You could build up a six-month emergency fund in 1.5 years. That is quite an improvement, even though you still get to enjoy 75% of your income.
What if you want to save and invest towards a much bigger goal than just an emergency fund? How about building up a big enough portfolio that you can live off of for the rest of your life? Savings Rate is so important because it directly impacts your ability to achieve Financial Independence!
How Long Will It Take To Reach Financial Independence?
The chart below will show you how long it will take you to reach Financial Independence (FI) based on your Savings Rate. Traditional personal finance advice is misleading because the recommended Savings Rate is typically 10-15%. When you look at the chart, that will result in 40-48 years to reach Financial Independence. The reason that doesn’t work is that almost none of us began saving 10-15% consistently since we graduated high school. And, on top of that, these estimations are based on the assumption that you have a Net Worth of zero dollars. But if you can increase your Savings Rate, you have the ability to reach your goals sooner. Check out the difference in the amount of time between a Savings Rate of 10% and 20%. A change like that would allow you to reach FI 13 years earlier!
Assuming every dollar of your Savings Rate is going towards assets (stocks) with an effective rate of return of 5.5%. (8% return minus 2.5% estimated future inflation = 5.5%) and a net worth of zero.
The estimated time until Financial Independence in the chart above refers to a goal portfolio size of 25 years of expenses based on the 4% rule. The 4% rule is a widely accepted “safe” withdrawal rate based on historical stock market data. It is a guideline that many people use to project the amount of money needed to support their lives during retirement. The assumption is that if you withdraw only 4% of your retirement portfolio to live off of every year that you have a greater than 90% chance of not running out of money. To achieve Financial Independence, your portfolio must grow large enough that a 4% withdrawal is enough to cover your expenses.
This is an introduction to the concept of Savings Rate, and increasing it can have a profound impact on your financial future. Each of us has different Savings Rate goals based on our income, age, lifestyle, and projected retirement. In the next article, I will show you a detailed way of how to calculate your savings rate. Then you can begin adjustments, if needed, to reach YOUR goals.