Your Savings Rate Is the Number One Predictor of Future Wealth (2024)

Tell me your savings rate, and I’ll tell you where you’ll be financially in five years.

Your savings rate is the most important number to monitor when pursuing financial independence because it’s not yourtotalwealth that matters; it’s your wealthrelativeto your living expenses.

In this article, I drill down into the importance of increasing your savings rate and how you can do it.

How to calculate your savings rate

We need to start by establishing a shared understanding of what your savings rate means. To do that, you’ll need to know the difference between gross and take-home pay.

• Gross pay= The total amount you make before any taxes or deductions are considered.
• Take-home pay= The total amount you make after taxes or deductions. This is the amount that hits your checking account on payday.

If your monthly take-home pay was $10,000 and you save $5,000, you would have a 50% savings rate.

What should you consider “savings?”

Some people overthink their savings rate by only including money that is invested or other arbitrary rules. I have a much simpler definition of what constitutes savings;

That includes the principal portion of any loan payment. Every dollar of principal paid increases your net worth by a dollar.

However, I do not include savings that are intended for future consumption.For example,I have a savings account I use as a vacation fund. It’s been accumulating a decent balance recently because I have not had the opportunity to travel. I don’t consider it as savings because the purpose of this money is to be spent in the near term.

Now that we have a shared understanding of how to calculate your savings rate, let’s get into the good stuff and talk about how to boost yours.

How to increase your savings rate

Remember, there are only two variables in the savings rate equation;

1. How much money you make.
2. How much money you save.

Therefore there are only two actions you can take to increase your savings rate;

1. Reduce your spendingwhile maintaining your current income.
2. Increase your incomewhile maintaining your current spending.

Let’s dig into each of these ideas a bit further.

Want to reduce your spending?Think houses, not lattes

One of the most tired takes on personal finance is that the key to saving more money is by cutting back on small purchases like lattes. Call me a radical thinker, but it seems to meif you want to reduce your spending, you should look at the largest — not the smallest — line items on your budget.

1. Housing.
2. Transportation.
3. Food.

Some very quick tips on reducing your big-3 expenses

If you want a deep dive on reducing your spending on the big-3 expenses, I’ve written 4,000 words on therehere. In the interest of time, here is a quick summary to act as a starting point.

• Buy or rent the smallest home you are comfortable living in. Which is probably less than you think it is.
• If you want to get really aggressive with housing costs, you can implement a house-hack like buying a duplex and renting the second unit out.
• If you can get by without a car, don’t own one; there is no bigger money pit in the world.
• If you’re a 2-car household, try your hardest to become a 1-car household if possible.
• Buy and own the crappiest (and safest) care you are comfortable driving.
• When buying groceries, the biggest thing is tohave a weekly meal plan. That plan can be based on what is on sale that week to minimize your cost per serving.

Cutting your living expenses is a great way to quickly increase your savings rate.If you can keep your savings rate low, it also means you need less total wealth to one day cover those living expenses and achieve financial independence.

Once you have cut your expenses to the lowest point you are comfortable with, the next step to obtaining an ultra high-savings rate is increasing your income.

A side hustle is an incredible way to increase your savings rate

One reason many people struggle to save money is that they have a tendency to spend based on their paycheck and only save if there is money left over after they bought everything they wanted.

There are ways people with one paycheck can increase their savings, like automating their savings and then spending what is left. However, it is much easier for most people from a psychological perspective to save money they earn from a side hustle or second job.

Since side hustle money is independent of your 9–5 paycheck, you may find it easier to look at that money as separate money and dedicate it to saving. That is exactly what I do with my side hustle money, which perfectly compliments my 9–5 paycheck;

• I have a job that provides a nice paycheck, excellent benefits, and a defined benefit pension.
• My paycheck and benefits cover my retirement income (through the pension,) any medical or dental expenses (through my benefits,) and all of my living expenses with a healthy amount left over to save and invest (through my paycheck.)
• This allows me to save and invest every single penny I earn from my side hustle.

An 80% savings rateputs me on track to reach financial independence in a few short years.

In my opinion, a digital business with limited customer service is the best bet for someone looking to start a side hustle.It allows you to be completely flexible when you work, which is crucial if you hold down a traditional 9–5 job.

Start with baby steps

For many people reading this, the idea of achieving this kind of savings rate may not feel realistic. Boosting your savings rate is not something that happens overnight; it’s a long-term process.

In 2010, I could barely pay my rent, let alone save and invest for the future. But over the years, as my income began gradually increasing and my debts melted away, I began to build more confidence.

How do you achieve an ultra-high savings rate?

One small step at a time.