You are on part 4/9 in the Level 1 – The Basics Series covering the 7 concepts of early retirement.. Next up: Spending
Now that you better understand why it is so important to push your income as high as possible as soon as possible, the next thing to discuss is saving, and more specifically, savings rate.
This section is fairly short, but critical to understand how your savings rate can drive progress, or completely derail your financial future.
Let’s start with a Bob example using some general numbers:
Bob makes $100k a year and has a take home pay of $75k. His spending / take home pay (THP) ratio sits at only 10%. For most folks, this isn’t too bad. In fact, it is nearly double what the average American saves, and in the ballpark of what most financial planners suggest, which is typically between 10% -15% (Data).
Just doing some quick math, knowing that Bob has a take home pay of $75k and a savings rate of only 10%, we can calculate that Bob spends roughly $68,000 a year.
If we assume Bob wants to save approximately 25x his annual spending before he can retire, we calculate that he needs $1.7mm in savings before he can pull the plug on that 9-5. How long will it take him to get there? 36.5 years…or age 58, assuming he starts working right out of school at 21.
To recap, Bob is someone most financial planners consider to be on track and doing well, assuming he got a job making six figures right out of college (good luck) he will retire at 58. Could be worse I suppose but, retiring at almost 60 doesn’t seem ideal to me. I would rather take a different path, enjoy my youth, spend time with my significant other and young family, and make memories I can look back on in fondness and satisfaction vs. spending 40+ hours a week in an office.
Now let’s take a look at a few different saving scenarios. Let’s assume Bob could bump his savings rate to:
a) 15% – No brainer, only 5% higher than current!
b) 25% – Really not that difficult considering he has a strong income.
c) 50% – A stretch for some, but not for those dedicated to achieving financial independence.
Before we look at the results, keep in mind that upping your savings rate has two HUGE impacts on your potential to reach financial independence at an even faster pace:
1. Your money compounds faster. Money makes more money. The more you save and invest, the faster your money will grow, allowing you to reach financial independence as soon as possible.
2. The higher your savings rate, the lower your current spending rate. If you don’t plan to spend drastically more in retirement than during your working career, upping your savings rate now will allow you to retire sooner since your burn rate, or how much you need to spend to sustain your current lifestyle, is lower than before.
These two concepts work together to do some pretty magical things.
a) 15% savings rate. Still in the ballpark of what most financial planners suggest, and only 5% higher than before, this one should be a piece of cake. With only a few minor changes, Bob can retire after 31 years of working (vs. 36.5 in the base case), or, keeping our assumptions the same, age 52.
This is truly fantastic. With just a few tweaks to savings, Bob now has most of his 50’s to do as he pleases. Travel the world, spend time with his kids before they leave for college, spend time with his aging parents, or even…start a blog…
b) 25% saving rate. Easily achievable for most people, but probably requires a few lifestyle changes along the way. A more reasonable car, eating out less, maybe just Netflix instead of Hulu, Netflix, and cable? Between the extra dollars available and the decreased spending rate, Bob is able to reach financial independence after 24.5 years of working. By American standards, he is pretty much in the top 1%. At age 45, he is free. He has most of his adult life in front of him and is free to live his life as he sees fit. Pretty awesome.
c) 50% saving rate. For the average person, this might be a stretch. For those reading this article and have a true passion for reaching financial independence as soon as possible, this is achievable.
What does it take to save 50% of what you make?
· You have to live well below your means.
· Live close to work, use public or free transportation (walking and biking) and own a used reasonable car.
· Buy a house that meets your needs, and nothing else. Houses can eat up extra income like you never imagine.
· Think about everything you buy: food, entertainment, clothing, travel, etc. Is it worth it?
This might sound intimidating but can be a lot of fun and achieved through a combination of frugal living and conscientious decisions. If you are dedicated to reaching financial independence and gaining your freedom, you can and will achieve a 50% savings rate…but it likely won’t happen overnight. For that matter, I wouldn’t try to make it happen overnight. This is a process, and you must work your way towards it like any other long-term goal. Make a plan, stay the course, modify as needed. That simple.
Ok, what does a 50% saving rate do for Bob and his financial goals? After just 14 years, and at the ripe old age of 35, Bob is ready to retire.
Know how I mentioned in the 25% scenario that Bob would be able to stay home and watch his kids grow up? Well, Bob is retiring at such a young age that he might not have even met Mrs. Right yet! His whole life is in front of him, and HE is the one calling the shots. No more office or commute, no more rigid schedule. Freedom.
It is worth noting, however, that at only 35 years of age, Bob might actually want to keep working if he enjoys his job. The beauty of reaching his goal so young is that he gets to make the choice himself, instead of being forced to stay at a MegaCorp for another 30+ years.
Hopefully everyone sees just how important saving, and more specially savings rate, can be towards attaining your financial goals.
Before I wrap up this section, I want to provide one more example of savings rate, to give you something else to think on. Let’s take a look at the impact of a common expense to see exactly what sort of impact it has on your goals.
Let’s say you visited Starbucks on your way to work each day and spent roughly $6 on a tasty beverage/snack to start your day off right. It’s only six bucks and without it you literally might not make it through the day. Everyone knows that feeling. Assuming you get 10 standard holidays, two weeks of paid vacation, and didn’t need this beverage on the weekends, you would visit Starbucks 241 times in a year, and spend approximately $1,446. Wow, that adds up!
Now let’s use Bob as our base case, assuming Bob has a 10% savings rate from our first example, and then he picked up this morning habit. His savings rate would drop to 7.5%. This single habit costs him nearly 2.5% in savings a year! What does that do in terms of his retirement timing? Our base case had him pulling the plug at 58…now he will work until he is 61.
Unfortunately, most folks don’t think of their savings rate and spending in this fashion. That daily beverage, over a lifetime of consumption cost him nearly three years of his life in an office. Over your lifetime, the little things do add up…
Now, don’t deprive yourself of the things you love, but don’t make a spend like this a daily habit. A few times a month won’t move the needle that much, but stopping 241 times a year at six bucks a day, you just bought yourself three extra years of work!
· Savings rate can accelerate or completely cripple your journey towards financial independence
· The little things really add up – more on this in the next Level 1 article – Spending
· You should strive to achieve at least a 50% savings rate
· You can achieve financial independence in a very short period of time if you can hit the 50% savings rate
Your Next Steps
· Calculate your savings rate:
o Savings Rate (as a percentage) = (1 – (How much you spend / Take Home Pay))*100
· Is your savings rate at least positive? A negative number means you are spending more than you make!
· Set a goal. Where you do you want your savings rate to be 6 months from now?
· Think about any habits you might have that hold you back from upping your savings rate. Is it worth working multiple extra years in an office?