Why you should care about your savings rate
Often when you think about higher-earning individuals you think that they are likely to retire earlier. Today I will show why this estimation is wrong. To understand this is extremely important for your motivation. Especially if you aren’t one of these high earning individuals, but want to become financially free. Therefore I will explain to you the concept of a savings rate. You will understand why your savings rate should be extremely important to you when you want to retire early. To make this clear I am going to give you an example with exact numbers that will show you the magic of percentage.
Saving rate explained
Your saving rate is the percentage of your earned money that you are going to invest in. You can calculate your savings rate by dividing your savings for a time period through your earning in the same period. The number which comes out should be between 0 and 1. If you multiply it by 100 it is the exact percentage of your income that you save.
To know your savings rate is extremely useful if you want to know when you can retire. You can calculate the exact amount of years you still need to work if you know your savings rate. This works because if you want to live from your investments you will have to take money out of them.
Live from your investment
How much you take out in percentage is your withdrawal rate. Because of studies, we know that you can have a withdrawal rate of about 4% consistently. That means you can take out 4% every year and your investment won’t shrink. If you know your exact spendings for a year you just have to divide them by 4 and multiply them by 100.
Then you have the amount you need for your retirement.
And because you know also how much you save per year, you can calculate how many years you need by dividing your goal trough the amount you can save per year. But because you earn interest on the money you already saved the calculation becomes a lot more complex. If you still want to calculate it, you can use one of the endless retirement calculators out there.
But you might have noticed that you need a few important numbers to calculate your savings rate. You may know your earnings, but you probably won’t know how much money you spend exactly. If you Budget your money and you know how much you spend, this won’t apply to you. But if you don’t do that, I would suggest that you read this article I wrote about Budgeting:
The magic of percentage
The main point of this article is to prove that you are wrong if you think that someone with higher earnings is financially free earlier. This is because of your savings rate is counted in percentage and not the total amount.
What I want to show you is:
Person A earns $30,000 per year and has a savings rate of 50%.
Person B earns $300,000 per year and has a savings rate of 50% too.
The Situation is that Person B earns 10 times as much as Person A. But they will be financially free at the same time because they have the same savings rate. The money they booth need to cover their annual costs of living is 50% of their income.
Person A has $15,000 in expenses per year.
Person B has $150,000 in expenses per year.
If we know remember the rule to divide the annually needed costs by 4 and multiply it with 100 we will get the amount they need as savings to live from the interest their money generates. In our example this means:
Person A needs $15,000/4100=$375,000 as savings to be considered financially free. Person B needs $150,000/4100=$3,750,000 as savings to be considered financially free.
Here you can already see that Person B needs also 10 times the amount that Person B needs to reach financial freedom.
And if you know to calculate how long they need to reach this amount you can see the following thing:
Here you can see that the booth needs 25 years to save the amount they need for their financial freedom.
This happens because you calculate everything with percentages. Therefore the person who ears more needs more money to be financially free and everything runs out that they both need the same time. This should show you that you can reach financial freedom at the same time as the person who earns more.
And you don’t have the excuse anymore that you have to wait until you earn more.
But it also should be mentioned that Person B has a more expensive lifestyle than Person A. So Person B can have more Luxus. Another point is that if Person B starts to spend less the savings quote can be easily increased. This will result in a decrease in the time needed to reach financial freedom.
When are you able to retire
The example before has shown us one important thing, if you know your savings rate you know the time you need until you can retire. This is why your savings rate is important. Typically you want to retire as early as possible, and you can reach this by improving your savings rate. If you have a savings rate of 50% you can retire earlier than in 25 years because we didn’t calculate that you ear interest in the time you still need to save up.
In fact with a savings rate of 50%, you need only 16.6 years and not 25. So you can see that this interest makes an extremely huge difference. If you want to know how big this difference really is, I would suggest reading this article about the magic of compound interest:
Decrease the time you need to become financially free can be done in two ways. You can either increase your earnings or you can decrease your spendings. Because those are the two things that influence your savings rate.
In order to be able to do that it is extremely important that you know where you are spending most of your money. To get a really clear overview of that I would suggest budgeting your money. I have written a really good article about that here:
Thanks for Reading!
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