The Most Important “Rate” of Your Financial Life

What’s the first thing comes to mind when you think of word “rates” as it relates to your personal finances?

Mortgage rates, interest rates, tax rates or rate of return?

Those are the top four “rates” when we ask the question amongst our friends and colleagues. That shouldn’t be a surprise as all four of those “rates” may play an important role in your financial life. However, none of them are more important than your savings rate.

The Savings Rate

The savings rate is the percentage of gross income that you save. If you make $50,000 per year, and you save $5,000 in savings accounts or retirement accounts, your savings rate is 10% ($5,000 / $50,000).  But don’t count money that you save and shortly thereafter take back out and spend.  What did you put away in savings that you don’t intend to touch for a long time?  Your savings rate is the most critical number when it comes to your financial independence and retirement. An aggressive savings rate can allow you to skip all of the retirement calculators and boil your financial independence plan down to one simple number.

Your savings rate is the only “rate” that is completely within your control. Let’s face it, you have little control over tax rates, interest rates or the rate of return on your investments. Those are all influenced by a multitude of factors that you have little to no influence over. So pay more attention to your savings rate to have the largest impact on your financial independence.

The table below illustrates your savings rate and the corresponding number of years for you to be financially independent – when you have enough saved up that you don’t need to earn income to support yourself. As you can see, saving a high percentage of your income can mean financial independence in a very short time horizon. For example, saving 20% of your income every year (and spending 80%) means that you can be financially independent in about 32 years.

The Math Behind Your Savings Rate

Despite the critical importance of the savings rate, most investors place the majority of their attention on interest rates and rates of return. People are often surprised to find that their savings rate will have a much larger influence on the value of their investment accounts than rate of return. The math shows that an investor who saves a greater percentage of her income, will end up with significantly more money than an investor who saves less and earns a higher return. The earlier you get this message, the more money you will have in your portfolio and the more choices you will have when it comes to the way you lead your financial life.

Let’s look at an example.  Over the past 10 years, a moderately aggressive portfolio comprised of 80% U.S. stocks and 20% bonds grew at a compounded annual rate of return of just under 8%. To illustrate the importance the savings rate, let’s review the investment portfolios of two savers who are both 25 years old.  Sally Saver knows the importance of saving for later and saves 15% of her $100,000 salary in a moderately conservative portfolio earning 5% annually.  Sam Spender also earns $100,000 per year but is enjoying the finer things in life and saves only 5% of his income.  But Sam is an astute investor and invests in a moderately aggressive portfolio earning 8% annually.  Sam believes this rate of return should make up for his lower savings rate.  Let’s see how they fare in 20 years.

Twenty years later, Sally’s portfolio has a balance of $496,000.  Sam’s portfolio is worth $229,000.  Sam starts to realize that he’s not saving enough if he wants to retire in 20 years and decides to start saving 15% like Sally.  Sally is still earning 5% on her portfolio, and Sam is earning 8%.

After ten more years, Sally’s portfolio has grown to $997,000, and Sam’s has grown to $711,000.  By the time he retires at 65, Sam’s portfolio will still not have a higher value than Sally’s even with a higher rate of return.

The message is this: you have more control over your savings rate, and your savings rate has a much greater effect on the amount of money you will have to spend in retirement than your return. Rather than focusing on how to squeeze out a few more percentage points from your rate of return, you are much better off focusing on how to increase your savings rate.  Want some tips on how to save more without cutting back? Read our recent article 5 Ways to Save More Without Cutting Back.