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Me: Baby, how much should I save, and why?
Her: How much? A lot. Why? To make me happy.
We each have our own reasons for saving… what are yours?
How much should I save, and why?
Before we can answer this question, we need to ask another question: What is my time preference?
In plain English, this means: How long am I willing to wait in order to reap a greater reward?
Often, we are not very willing at all to wait: We want to enjoy life today, so we charge our credit cards, enter into debt, and spend years paying all of it off. Our governments seem to operate on the same philosophy: while millions of bureaucrats, politicians, and politically-connected executives enjoy nice payoffs and benefits, our roads are crumbling, our bridges are deteriorating, and the national debt is soaring through the roof.
Advancing technology means that we are going to live much longer and healthier lives than preceding generations
A famous economist once said “In the long run, we are all dead.” This is undoubtedly true. However, when he said it, people weren’t living lives quite as healthy and as long as we live them today. I fully believe that this is a trend that is going to continue into the future.
Can you imagine living 150 years or more? Surely the standard notion of saving up some money until you reach your 60s, and then spending it all over 15-20 years until you die, is outdated. What steps are you making in your life today to ensure that you will be equipped, mentally, financially, and physically, to cope with the changes coming up ahead?
How much do I need to start putting away today?
The world is going through a debt crisis, and a lot of capital has been needlessly and wastefully consumed in the process of central bank manipulation, bailouts and other political misadventures. I fully expect that this is going to hit us all personally in the form of lower growth rates and higher taxes in some form or another.
Eventually, we will get over this debt crisis and growth will take off again, but until we get there it will be a trying time with many swings up and down, and small steps forward.
With this in mind, I feel that this is the best time to be stashing a significant amount of money away. Squirrels prepare for winter by storing up nuts; we should be preparing for the financial winter by doing the same.
So, how much is enough? With stock market returns near 0% for the previous decade, do you believe that we will average 8% real growth rates from 2000 on anytime soon? It’s possible, but I think we’ll need to wait a while for it.
The “normal” guideline during good times is 10%, and that definitely isn’t a bad place to start. In current times, I feel that 30% to 50% of net income is a better goal to target.
What are the benefits of saving so much?
Here are three important ways I personally feel a high savings rate is beneficial:
- You learn to enjoy more, with less. Perhaps instead of a $50 movie, you take your girlfriend to a movie in the park, or you go for a picnic or have a romantic dinner at home. Maybe you’ll even find it more enjoyable, and because you go to the movies less often, when you do go those times will be more enjoyable as well. Instead of thinking about the crowds and the prices, you’ll be enjoying the popcorn and the company (perhaps!).
- You reduce your exposure to lifestyle inflation. This is related to the previous point. When you are saving 30% to 50% of your net income, you’re forced to make choices. Want a 55″ 3D TV and a vacation overseas? Well, you can pick one today, and another one in a few months from now. You can’t have both. Perhaps you decide that the vacation is what you really want, and you have such a great time that when you come back you’ve forgotten all about your lust for the big screen TV… at least for a while. 🙂
- It becomes easier to get out of the rat race. This is perhaps the most important point. When you are saving a lot of your net income, over a decent period of time, you gain a vast amount of financial dependence. Imagine having so much less debt over your head. Imagine having the freedom to take some time off your job, or at least not worry about how you’ll pay the bills because you have that covered for some time ahead. Doesn’t just the taste of that feel so good?
Why 50% of net income?
I could have said 33% of gross income or something like that, but tax rates vary so much from place to place and also with different income levels. For someone paying 10% tax, saving 50% of gross income is clearly a different burden than someone paying 50% tax and trying to save the 50% they have left, which is clearly impossible.
So, instead, consider the money that actually gets deposited into your accounts, and save 30% to 50% of that.
How do I calculate my net savings rate?
For the purposes of calculating one’s net savings rate, this is the formula I use:
Savings from direct income + Debt principal reduction – Depreciation
Savings from direct income: This includes savings coming from your primary job and from any side income which you may have. It includes bonuses, retirement savings matches, and other income directly related to your labour.
It doesn’t include interest income, capital appreciation, nor dividends.
Why not?
The goal of savings is to build up your capital. If you include the returns of your capital as part of your savings toward your capital, then you might not actually be saving as much as you think you are. If your house goes up $50k in one year, are you really going to say that you don’t need to save anything else cause your house took care of it? You could, but if the market later adjusts you’ll find you actually didn’t save any money at all, and you would not have built up any capital whatsoever.
Debt principal reduction: Reducing your debt also improves your overall savings position, as it reduces the liabilities that you have outstanding. This should be considered as a balance between direct savings and paying down debt: you don’t want to do too much of only one or the other.
Depreciation: It’s important to also consider the effects of depreciation on your savings. If you take $10,000 and buy a car that you believe you can sell for $8,000, then that’s an additional $2,000 that you need to save in order to account for the fact that you’ll need to replace your car someday.
If for some reason your car became a hot model and its value went up to $20,000, then we wouldn’t consider it a loss, but for the reasons I outlined above, we wouldn’t reduce our savings rate below our target, either.
When do I reevaluate?
After a considerable period of time, you may have built up enough capital, or perhaps reduced your expenses and debt to the point where you don’t need to save as much. Reducing expenses is part of the philosophy behind early retirement extreme.
My income is low — what can I do?
I was once a full-time student with an apartment, a car, and part-time work at nights and on the weekends, and I was just barely getting by. If someone had told me that I should have been saving 50% then, I would have told them that they were crazy.
However, they still would have had a point. I still could have reduced my expenses; then perhaps I wouldn’t have needed to work as much, and I could have focused on my studies and done even better. Investing in yourself so that you can do better in the future is also a very important form of savings. Just remember the opportunity costs of your time as well.
So, reader, what are your thoughts? Am I nuts for suggesting that we should be saving 30% to 50% of our net income? Am I simply a miser who doesn’t know how to enjoy life? Or… am I positioning myself to enjoy it more fully and deeply?
I would love to hear your thoughts and your own views on the subject.
No, you are nuts at all. Saving 33 – 50% of net income is a worthy goal. It’s a little out of reach for me right now, with three elementary school age children and a being up to our eyeballs in mortgage payments. We need to save more, and reading articles like this give me much needed motivation. I appreciate the depth of your analysis.
I don’ think I would be there with three elementary school kids either! Definitely adjust the guidelines to fit in best with your personal situation.
I am all in for saving around 30% of your income IF POSSIBLE. Right now, my savings are all going into the mortgage. Hopefully, this will be over in a few years!
That will be a huge burden off your monthly payments. 🙂
Anything in the extreme is difficult to maintain! I you are earning $500K it is easier to save a high percentage of your income. I think it is more important for consistent savings over time. Every time I received an pay increase I put half in savings. If savings is a priority, determine what is reasonable and take that amount out of your paycheck before you receive it.
If I was making $500K I could probably save 85% of net income cause I live a pretty moderate lifestyle atm… I like the idea of consistent savings and putting in raises toward savings as well!
We are saving over 50% of our net income now so we can achieve my early retirement goal. If you don’t make much money, it’ll be much more difficult to save 50%. In that case, save a little bit, generate higher income, and then increase the saving rate. Easy to say, hard to do.
Awesome, you guys are doing great so far. I agree it will be difficult if you don’t make much money. However, I think a couple could easily do it on $24K gross f they don’t have kids… I was making between $8K and $12K as a student so double that I should have been able to save quite a bit if I kept expenses at the same level (because even at $24K you’re not going to pay that much tax)
Fifty percent is a noble goal to be sure. If you are investing wisely, I don’t know that you would need that much over many years. I guess part of it depends upon your particular goals with the savings.
That’s true. I think you could scale this down over time, either by increasing consumption or by decreasing expenditures which would decrease your income requirement. However, I don’t know that I would increase consumption all that much — if the economy recovered well and I had been diligent with savings, then maybe I’d spoil myself at some point with a really nice car, or maybe a trip around the world or something like that. I don’t know though. Kids will also come at some point and that will likely increase consumption by quite a bit, too!
While I understand the value of this question, I struggle with working through the numbers. There is so much that can happen between now and then… and I’m sure the numbers will be skewed. I wonder how many people, for example, answer that question with divorce in mind? Perhaps I sound like a doom and gloom even bringing it up, but c’mon, it’s a reality for so many… even though they may not think so at this moment. Just one example… the others, I promise, are not so gloomy.
This is a good point, Doctor Stock. Personally I place low % on this sort of outcome, because hey, if it happens it happens, but I don’t expect it to, but even if it does, I’m not doomed.
The savings also helps us plan more together and brings us closer together which helps avert such scenarios. 😉
I agree with you. Pay yourself first is a great habit. As income increases, the % saved can increase. We have done this for 20 years. We now save 30% of gross. I feel very blessed that we can do that and hope the money we have invested doesn’t drop horribly in this crazy market. So frustrating.
Doctor Stock, I think this habit of ours probably helps our marriage. Just this week 2 of my friends told me they were getting divorced. When my husband and I were discussing, he joked and said “I would never leave you because I would have to give you half of everything”. He was kidding, but not completely. I think financial stability is a super asset to a marriage. For us, having financial stability and planning early retirement together really keeps us close. But I do know that at any time things can change and our situation can be turned upside down. But if that happens we just adjust and move on.
30% of gross is very good! Depending on your tax this could be 50% of net income or more!
If we spent more we would probably enjoy life more in the moment, but I’m not so sure. We’re enjoying it pretty well already and the savings is going to lead to VASTLY more enjoyment down the road. It also helps that we make enough that 40% – 50% still affords us a decent lifestyle.,.. but we do definitely live more frugally than our peers. We use NetFlix instead of cable, for one… $7.99/month beats $60 or whatever cable costs these days.
Hello!
Last year we saved around 26% towards permanent savings (i.e. not the vacation or large expense accounts, but retirement, emergency savings, investing, etc.). This year, I made a goal of 50%! By June we had saved 44%. Now let’s see how the second half of the year goes….
44% by June is awesome! You’ll definitely break through your goal this year 🙂
I think it can be tough to achieve that goal in your 20’s. Most people are loaded up with student loan debt and maybe some consumer debt too and they are starting their professional lives, which includes buying cars, furniture, work clothes, etc. I still saved money but I don’t think I could have done the 50% number with the other expenses I had (unless you could principle repayment of debt…in which case I was definitely at 50% or more).
As people get older they “should” be able to save more. Americans have so much disposable income it’s nuts. Even people who are crying the blues about not having money have smart phones and fancy cell plans. I really think a lot of people who have income could be doing a lot more with spending less of it. If you’re unemployed or on disability that’s a different story.
Oh, I agree. For most of my 20s I was a poor student, and it’s only since I graduated that I’ve really had the opportunity to start putting some of it away. All I can say to my fellow recent graduates who suddenly find themselves with income: save it! This is the best time in your life to do so.
P.S. Yes I count principal repayment. You need to keep it balanced with savings and also with the opportunity costs and rate of return, but it definitely counts as a form of savings since you’re reducing consumption in order to improve your standard of living down the road.
Nice article. I think your savings portion is right on 🙂 Not crazy at all, but I’ve always been a saver 🙂 Thanks for sharing.
Thanks for confirming that I’m not crazy 😉
We started saving more than we could afford when we were quite young. We continued over time putting the abslote maximum into tax favored retirement plans and over the years we have seen our net worth grow substantially. Although we have made many sacrifices, the security and options are worth it! great article.
Thanks, Barb! I don’t doubt that you are on the good path. I don’t know when I will reduce savings, and it’s tough with all this life stuff coming up, but hey, if we keep this up then maybe we’ll be out of the rat race by 40 or earlier. That is definitely worth it.
A 30 to 50% savings rate would be phenomenal. I like to save so that I have more money to invest!
Heh, me too. I don’t actually keep too much of it in cash, except lately with all of the strange economic moves…
Interesting idea. I agree that the saving rate gets much easier to go up when your income goes higher. Based on your formula I’m saving about 56% of our net income (it might be closer to 60%, but I’m guessing on a few of my numbers and went on the low end).
Perhaps the other major factor is how expensive is housing compared to income in your area. Some locations are horrible for your savings rate, while others can really help it along.
Tim
56% to 60% is awesome. Housing costs can be a big burden, but I count principal repayment as part of savings. Of course, you need to balance this out. If you bought in at the peak of the housing bubble and had low equity… well, there went all of your “savings”!
Good stuff!
I personally think saving 50% of your net income would be a baseline figure and I am averaging just above that this year, which is my first year into a frugal living doctrine. I hope to be at ~60% next year. I won’t really be happy until I can get it around 70%, which I believe would be optimal in trying to become financially independent.
60% to 70% is incredible. I won’t get there without an income increase because of where my expenses are, but of course I chose this lifestyle for myself, too. The good thing is that we’re young and we can increase that income, while I don’t see us increasing expenses by all that much at least until a baby arrives!