What is your savings rate? How do you calculate it. These are questions the FI community is asked all the time. Your savings rate is simple, here’s the math.
Yearly Savings ÷ Yearly Income = Savings Rate
Here’s an example. Lets say I make $100,000 per year (that’s alot of money but bear with here) and I have $75,000 in expenses, therefor I saved $25,000 for the year,
$25,000 ÷ $100,000 = 0.25, which is 25%
Using this same income for an example, lets calculate how many years it will take to reach theoretical financial independence assuming we’re following the 4% rule and 5% annualized return.
Assuming the 4% rule,
$75,000 ÷ 0.04 = $1,875,000
Why did we use $75,000 and not $100,000? Well, when you reach financial independence, theoretically you don’t need to save money anymore since your income covers your expenses. This is a low tier of financial independence without much buffer, however, this number will get you technically to financial independence.
Now lets calculate how many years it will take to get to financial independence. For this exercise, we’ll assume an additional $25,000 in contributions each year as well as an annualized 5% growth. I show it graphically below.
It’s a little tough to see, but at a 25% savings rate, you’ll achieve financial independence in about 32 years. This graph shows the portfolio value in Blue and your contributions in Red. The gap between the contributions and the portfolio value really start to separate around year 18-20, highlighting the necessity to save as much as possible and invest it early in your career.
To highlight the GAP, I’d like to show you another graph with a savings rate of 50%
THIS is the magic in the Pudding
By increasing your savings rate, you’re also reducing the amount of money it takes to reach financial independence. Lets take a look at the math.
$50,000 ÷ $100,000 = 0.5, which is 50%
Assuming the 4% rule,
$50,000 ÷ 0.04 = $1,250,000
You just cut financial independence number by $625,000. This is crazy right!?
Let take a look at that graph now.
Now just 17 years to financial independence! This is the power of the savings rate. It works two fold on your path to financial independence. 1) Reduces your FI $ number, 2) Dramatically reduces the amount of time it takes to reach that number.
SO what is the GAP then?
The GAP is the difference between your Income, and your savings. The wider the GAP, the faster you’ll reach financial independence.
I’m imagining some day there will be enough financial education that people will walk around asking strangers on the street “How wide is your GAP?” …. Maybe that’s just a pipe dream.
Influences on the GAP
The two drivers of the GAP are income and expenses. One can either increase their income or reduce their expenses. This is a hot debate in the financial independence community on which is better to go after. Personally I like the approach to increasing your income rather than reducing expenses. Reducing unnecessary expenses like random retail therapy or opting for the cheapest grocery in town even though its a little further from home. These sort of activities are fun for me. I have a tough time paying more for everyday things than I need to. I don’t however reduce m y expenses to the point where its hindering my life. I don’t get rid of internet in my house. I don’t bike to work (its over 20 miles). I don’t skip on the gym. I don’t put off home improvement projects, etc etc etc. We don’t reduce our life to the point where were pinching pennies. I know there’s some proud people in this community that live substantially below their means to achieve FI on a $20,000 per year income. That’s not for us. For me I’d rather focus on increasing income. I am aware that one cannot just go to their supervisor and demand a 50% raise. However, most have substantial potential for upside no matter if you’re a checkout clerk at Target (my first job) or a high level executive. There is always room for upside and negotiation. The stronger your financial position, the more leverage you have. A few years of grinding hard and standing up for yourself at yearly reviews can really pay off in the long run, especially in the early years. It is unfortunate that in many cases, you can actually achieve a much higher raise in income by switching companies. I wish more companies would reward all star employees with financial rewards, even if its in the form of a bonus rather than in salary bump. The last company I worked for said I was the most driven and productive engineer they’ve ever hired (whether that’s true or they were just blowing smoke) I was rewarded with a raise of 1%. I mean come on that’s like a slap in the face. I said thank you for your generosity and applied for several jobs, within a few months I had landed a job that was a substantial 20% raise and a fast growing company with a kick ass culture. All it took was a little motivation and telling myself that I’m worth more than this.
I got a little side tracked there but I just wanted to illustrate that there is unlimited opportunity to earn more income and a finite opportunity to cut expenses without reducing your life.
If you’ve got a specialized skill in any way, that can be leveraged in your 5pm to 9pm after you’ve worked you 9am to 5pm. (No one said this would be easy!) For those that are motivated to change their financial future. A little extra work goes a long way in to spread the GAP.
My personal favorite way to make extra money is to scour craigslist in the “FREE” section. Most of the time its filled with garbage, but every once in a while there’s a piece of gold in there like an unopened ink cartridge from HP. Yes i said ink cartridge. People throw printers out all the time, and often they have extra ink around that they have no use for and they’ll put it up for free on craigslist or a neighborhood site call Nextdoor, or Facebook marketplace. I’ll message them immediately with my phone number and tell them I can stop by right away. I’ll go get the ink and then post it on eBay using the phone app. These ink cartridges sell sometimes literally minutes after posting. I’ll print a shipping label and throw it in a bubble envelope and just like that I’ve profited $20-30. Now that may not seem like much, but If I do this 3-5 times a month that’s an extra 60-150 dollars a month. Not bad for something I commit only a couple hours a month to! Every once in a while you’ll hit the jackpot and find something like a 2 year old lawn mower that wont start. Throw a new spark plug in it and new gas, give it a good wash and you’ll be able to make 2-300 dollars in one sale. These are rare but oh so fun when you find them!!
Personally I just find the hunt for extra income so much more fun than trying to clip coupons and pinch pennies. Simply drive used cars that get high gas mileage. Track your spending you don’t over spend on unnecessary things. And have fun finding ways to find extra income, and before you know it, you’ll be minding the GAP.