Escaping to Freedom is all about cutting through the mist of contradicting financial advice that peppers the internet. This is a place where people can find the often shockingly simple answers to the most common questions about money and work.
Today is no different, and I will present you with a mind-blowing fact. Get ready.
Your savings rate alone will determine when you’ll be able to reach financial independence.
Financial independence meaning the point when your savings generate sufficient income for you to cover all your expenses.
To put this into perspective, let me ask you a multiple choice question. Who will be able to save enough money and retire first?
- Doug, with his barista salary of $18,000
- Michelle and her big CFO salary of $350,000
- Enrique, who earns $4,000,000 through the 3 companies that he owns.
This was a trick question – sorry! The answer is that we don’t have enough information to answer.
For all we know, Dough might only be spending $12,000 out of his 18k salary, which would mean his savings rate was 34%. On the other hand, Enrique could be burning through his wealth with a long string of expensive habits and purchases – just to keep up with the appearance of a multi-millionaire!
Even with a much smaller salary, Doug would save enough to have his expenses covered way before Enrique did.
Income alone only tells us part of the story. If we want to know how long it’ll take for someone to reach financial independence, we need to know their savings rates.
What is The Savings Rate?
Someone’s savings rate is defined as the money they save as a percentage of their net salary.
If your take-home pay is $50,000 and you manage to save $20,000, you have a savings rate of 40% and are way ahead of the vast majority of Americans, who save less than 10%.
As I’m sure you can deduce from this, your savings rate consists of two variables:
- How much you earn
- How much you can save – which is a result of how much you spend.
Control these two variables and you can literally plan how long it would take you to reach financial independence.
When Will You Be Able to Retire?
You might now be thinking: “how does this apply to me?”.
Take a look at this tool and put in your numbers. What results did you get?
This works by making a few simple assumptions, which you can actually change as you please.
- You will be using 4% of your investment gains – this could be dividend income at a yield of 4% or using the safe withdrawal technique.
- All of these figures have taken into account taxes and typical inflation, so yearly returns would be 5%.
Putting it simply, this means that you need to accumulate 25 times your yearly expenses.
Let’s take Michelle, from the example above. She has a salary of $350,000 and saves $200,000 each year by tracking and managing her expenses.
This means that she’s got a savings rate of 58%. In 13 years she should have saved up enough money to generate her $150,000 yearly expenses.
Check out this table to get a wider picture:
|Savings Rate (%)||Years until FI|
If you save nothing, it’s obvious that you’ll never be able to reach financial independence, hence the number of years being infinite. On the other hand, if you save 100% of your income means that you have zero expenses, so you’re already financially independent!
If you’re wondering how anyone can have zero expenses, I guess someone could realistically live in the wilderness. If they were entirely self-sufficient and foraged all their food, they would have no need for currency!
How to Increase Your Saving Rate
I hope I’ve made it clear that your savings rate is, by far, the most important factor in reaching financial independence and being able to retire early.
Your salary or savings don’t matter.
All that matters is how much of your income you can save because the remainder will be what you spend – AKA what your savings need to generate every year.
Ok, that’s great Ricard, but how can I increase my savings rate and retire earlier?
I’m glad you asked! 😉
You need to do at least one of the two things below:
1. Increase your income
It’s gonna be hard to save most of your take home pay if you’re earning minimum wage. Even if you aren’t, you can always work hard to earn a promotion at work or change companies for a raise.
Alternatively – and something that I believe everyone should be doing – you could start a side hustle. Here are the best side hustles that you can start this weekend.
You could easily increase your savings rate by 10% with a side hustle which would only take a handful of extra hours a week.
Let’s say your savings rate is at 30% right now. After a successful side hustle publishing ebooks on Kindle, you could easily get to 40%. This would mean you could retire 6 years earlier.
Once you realise that a few extra hundred bucks a month can shave off years from your working life, you’ll start to see side hustles with different eyes.
2. Reduce your expenses
This is even more powerful than increasing your income because it has a double effect on your savings rate:
- It allows you to save more
- It means that how much money you need to live decreases, which lowers your income target for retirement!
To save money, you must first track your expenses. If you live in America and aren’t using Personal Capital yet, I really don’t know what you’re waiting for. It’s free and totally awesome.
Once you track expenses it’s time to scrutinise each and every single one. No exceptions!
I like to use what I call the Happiness Factor of things.
It’s a very helpful tool to realise which expenses are worthless and which ones really make you happy.
Finally, try everything you can to reduce those expenses! Here’s how I saved $20,000 in a year, which helped me quit my career and start this website!
Get Your Savings Rate Up!
If you only take one thing away from this article it should be that your savings rate is the single most important factor in deciding when you’ll be able to retire and achieve financial independence.
You can have the highest paid job in the world, but it won’t put you ahead financially unless you’re saving a percentage of it. You could also have someone on a very tiny salary being able to retire early in less than a decade.