How to Calculate Your Savings Rate – And Why You Need To

Do you know what your savings rate is? Do you know why it would be important to know this?

To put this a different way, do you have any idea when you might be able to retire? Because without understanding your savings rate, and how you can adjust it, it’s impossible to know.

Your savings rate could be so low that you won’t be ready to retire until 20 years after you think you will.

It’s also possible that you can make some adjustments to your savings rate and retire 20 years earlier than you thought you could. 

Maybe you could retire just a few short years from now.

It’s quite easy to just focus on the money-in/money-out balance. Anything beyond this involves too much math surrounded by too many options. At the basics, we have a checking account, a savings account to keep a few thousand dollars in, and hopefully an automated retirement savings plan through our employer. Our job is to earn money and then try to avoid overdraft fees and credit card debt along the way.

While this is one way to muddle through life, it certainly isn’t the only way.

Figuring out just how much you are saving is not as hard as you many think. It does involve a little bit of math. However, retiring 20 years early is worth a little math, right?

Taking control of your finances is important. And it’s not nearly as confusing as you may think. You don’t have to be an expert on investing. You don’t have to know the stock market to benefit from it. Believe it or not, you don’t have to do any confusing calculations, which means you don’t even need to hire an accountant to do this for you. The math isn’t that bad. And I’m about to step you through it.

Stay with me, I promise to keep it simple, and I promise that you will want to run some numbers yourself after reading this.

Savings Rate

To start off, let’s define savings rate.

Savings Rate:  The amount you are saving every month as a percentage of your take home income.

In order to calculate your savings rate, you need to know:

• Your income (take home)
• Your expenses

Here’s what it looks like:

Then you can multiply by 100 to see this number as a percentage of your earnings.

Useful tips when calculating Savings Rate:

• Add employer matching contributions to your income
• Don’t try to factor in gains/losses from investments
• When factoring in your mortgage:
  • Tax, insurance and interest are all expenses
  • Principal payment isn’t factored in (it counts towards your net worth)
  • Or, just count the whole thing to make it easier
• These are projections, it’s okay to estimate and round numbers. Don’t get too hung up on the minor details.

Let’s use an example.

Remember Joe and Rebecca? Personal Finance: Winning the Team Trophy But Losing at Life

Here’s a link to their Income and Expense Tracking for Joe and Rebecca.

Joe and Rebecca have a combined income of $290,000. They have $14,500 automatically deducted from their paychecks to go into their retirement account. Their expenses however are more than they actually bring home every month.

Joe and Rebecca’s savings rate is 4%. This is fairly typical for American families. You can see the average personal savings rate fluctuations since 1959 here.

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Retirement Calculation

So what does this tell us? At a savings rate of 4%, how long will it take them to retire?

First, in order to calculate this, we need to make some assumptions and use the 4% rule (not to be confused with the 4% savings rate we just calculated, just my luck that the numbers ended up the same). The 4% rule is a good rule of thumb to estimate how much money you need to have invested in order to safely withdraw your living expenses every month. In other words, if you have saved a large nest egg, and that nest egg is invested in a low risk investment account and provides an average rate of return of 4%, you can safely withdraw this 4% every year indefinitely without decreasing your nest egg total. You can live entirely off of the interest that you earn on your savings.

Using the 4% rule, how much do Joe and Rebecca need to save for their retirement nest egg? If we divide their total yearly expenses by 4%, we will be able to calculate the total savings needed.

Wow that’s a big nest egg!

Here is where savings rate comes in. At a 4% savings rate, they are able to save $11,600 per year, or $967 per month. Knowing their actual savings, how long will it take Joe and Rebecca to reach retirement?

Next, we will need to make a couple assumptions. Let’s assume that Joe and Rebecca put their savings into a fairly conservative investment account, such as Vanguard VTSAX index fund, and assume a conservative rate of return of 7% per year (lower than the 10-year average of 14.75%). Money will be added to this account every month and it won’t be touched until retirement. Dividend and interest earnings will be reinvested automatically and this takes advantage of compound interest, allowing this nest egg to grow faster than the savings contributions alone. 

Lastly, we will also simplify things by assuming that interest is compounded annually, which means that we are going to ignore some of the monthly fluctuations typical of the stock market and calculate interest and dividend payments compounded annually instead of daily.

In order to calculate Joe and Rebecca’s retirement timeframe, we need to use a compounding interest calculator. Here’s the link to one that I used.

I’m also going to assume that they’ve been adding to their retirement account for years and already have $100,000 invested. Here’s a snapshot of what I entered.

Looking at the calculation results graph, it will take a little over 46 years to reach a total value equal to their nest egg of $6,962,400.

Joe and Rebecca are in their late 30’s. Which means, they will be close to 80 years old before they have a nest egg big enough to support their current lifestyle.

Now let’s say that Joe and Rebecca run through this calculation and are horrified by the thought of retiring so late in life. They realize that they need to make some changes in their spending.

They focus on paying off their debt, create a budget, put their kids in public school and trade in their luxury cars for smaller, more cost efficient choices. Then they fire their gardener and house cleaners. Next, they decrease how often they eat out and budget their groceries by planning meals ahead of time. Joe and Rebecca also made a few changes to their basement and started renting it out every month for $2,500 (remember they live in a crazy expensive area!).

Now they have an extra $9,280 every month after all expenses. You can see the changes I made in their income/expense spreadsheet in the 4th tab. Let’s recalculate their savings rate.

Joe and Rebecca are now saving 38.4% of their $290,000 annual income.

Because they don’t require as much money every month, their nest egg won’t need to be as large. Let’s also recalculate their nest egg.

Now I can enter in $9,280 monthly contribution into the compound interest calculator. They will now reach their new and improved nest egg amount in just over 18 years. That’s 28 years earlier!  

Would you make some reasonable changes to your lifestyle if it meant and extra 28 years of retirement?

Read more on how much you should have saved at every age and how to use your savings rate to calculate your retirement goals. This Is What Your Retirement Savings Needs To Be At Every Age

Recap

Joe and Rebecca are a perfect example of a typical middle-class American family, particularly in regions of the US where income and cost of living are much higher than average. But even when the numbers all smaller, it all comes down to the savings rate. Importantly, the income/expense numbers can be small or large, the savings rate is the percentage that can tell you the real story. 

According to Trading Economics, a company that provides current and historical economic data for the US and many other countries, the current savings rate in the US is just 3.2%. Here is a link to their website. It has steadily declined in the last two years. In the face of changing economic times where social security and pension plans are uncertain, it’s imperative to our financial health to improve our savings.

As we saw from running the numbers on Joe and Rebecca’s finances, it’s easy and socially acceptable to live month to month with a low savings rate and not even know it. It’s also easy to run the numbers and realize some changes are in order. These changes aren’t necessarily very difficult to make.

Savings rate can be improved in two ways. You can either earn more income or you can decrease expenses. Joe and Rebecca were able to make some reasonable changes in their spending habits to greatly improve their savings rate. They could also have brainstormed some methods of increasing their income if they weren’t able or willing to adjust their spending as much. Some options, which will be explored in future posts, include passive income streams, investment options including real estate investing, and side hustles or businesses. But that’s for another post.