How To Calculate Savings Rate - Carreira Finance Coaching

How To Calculate Savings Rate – Scenario Analysis

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Knowing how to calculate your savings rate is one of the first steps in your journey to financial freedom. More and more millennials want to achieve financial freedom because they don’t see themselves working their entire life until retiring.

The formula to calculate your savings rate is straight forward. Savings / Income = Savings Rate Percentage. In other words, it is equal to your savings divided by your income.

However, defining savings and income is more complicated than what most people anticipate. There are a few nuances that can lead you to create a false savings rate calculator.

But in the end, choosing what to include or exclude from the calculation is your personal decision.

In this article, I go over different scenarios on how to calculate your savings rate and try to explain why it is essential for you to know your savings rate.


Everything To Know About Savings Rate - Carreira Finance Coaching

What Is A Savings Rate?

When we look over the last 10 years, the average household savings rate fluctuated between 6 to 8%. But what does this number mean?

Your savings rate is the percentage you get when dividing your savings by your income.

In 2019, the median income in the U.S. was around $50,000 a year. So for a 7% savings rate, Americans are savings $3,500 on average per year.


How To Define The Terms Behind Your Savings Rate Calculation?

Savings Definition

Your savings is the money you put aside in financial institutions. In other words, it is the money you didn’t spend on your expenses.

For future references, let’s divide your savings into two categories.

  • Post-Tax Savings for the money you save after-tax. For example, deposit accounts, taxable investment accounts, cash, and bonuses.
  • Pre-Tax Savings for the money you save before tax. For example, retirement accounts and health savings accounts.

Income Definition

Your income is the money you receive on a regular basis. Generally, it comes from your employer or your own business.

For future references, it’s best to split your earnings into three categories.

  • Net Income is your after-tax money. Simply put, it’s the paycheck that goes to your deposit accounts. You can either spend it or save it.
  • Gross Income for the money you get before tax. It’s the salary you negotiated before accepting the employment offer. It includes your pre-savings, taxes, and deductions.
  • Total Compensation for the money your employers give you on top of your salary. For example, 401k matching, bonuses, HSA matching, and stocks.

Why Calculating Your Savings Rate Is Important?

Your savings rate is one of the main components of your financial plan. It allows you to have a better feel of what your finances look like and pinpoint how to improve them.

Keep Control Over Your Finances

When you think about how our financial system works, we don’t control much. We keep our money in bank accounts that don’t earn any interest, and when we invest our money, we can’t control our return rates.

The only rate you can control is your savings rate. Experts recommend having a savings rate of at least 20%.

If you have a savings rate lower than 20%, you should review your financial strategy. Looking into your spendings, asking for a raise, or change jobs are things that you can do to raise your savings rate.

Road To Financial Independence

Financial freedom is a dream that everyone wants to achieve in their life. But how do you figure out what is enough money? And how many years do you have to work to achieve it?

Mr. Money Mustache wrote an article a few years back about the simple math behind financial independence.

He assumes that you will get a return rate of 5% and won’t withdraw more than 4% from your savings every single year. Also, it doesn’t account for salary or expense increases. But it’s a great tool to see if what you want aligns with what you do.

If you were to start your savings from scratch, with a 20% savings rate, you could be financially free after 40 years of working. With a 40% savings rate, it becomes 21 years.

Take Advantage Of Compounding Interest

When you know how much money you are saving regularly, you want your money to work for you. And that’s when compounding interest is so valuable.

Compounding interest is the interest earned over your initial capital and your accumulated interests.

For example, Mr. Carreira has a high yield savings account that earns 1% APY. He starts with a principal of $10,000. In the first year, he’ll earn $100. The second year, he’ll earn $101 (2% on $10,100).

Now, let’s say that Mr. Carreira has a savings rate of 12% on a gross income of $50,000. He’ll save $6,000 per year or $500 per month. If he adds his savings to his account, at the end of 30 years, he’ll have $264,985.39.

If Mr. Carreira increases his savings rate to 24% and adds his savings to his account, at the end of 30 years, he’ll have $511,758.69.


How To Calculate Your Savings Rate?

This is where things become complicated. Your savings rate will vary depending on the scenario you choose for your calculation.

Let’s take an example before going over the three scenarios.

Last year, Mr. Carreira earned an annual income of $50,000. His 401k contributions were equal to $5,000 or 10% annual salary. His employer matched his 401k contributions and gave him a $6,000 bonus. Mr Carreira net income was $36,500 (post-tax). His annual expenses were $28,500.

Now, let’s take a look at the three scenarios and how they change Mr. Carreira’s savings rate.

Scenario 1 – Savings Rate vs. Net Income

To calculate savings rate of the scenario 1, we need to divide Mr Carreira annual savings by his annual net income.

(Post-Tax Savings + Pre-Tax Savings) / Net Income = Savings Rate Percentage

($8,000 + $6,000 + $5,000 + $5,000) / $36,500 = 65.7%

The scenario 1 savings rate is equal to 65.7%.

Scenario 2 – Savings Rate vs. Gross Income

To calculate savings rate of the scenario 2, we need to divide Mr Carreira annual savings by his annual gross income.

(Post-Tax Savings + Pre-Tax Savings) / Gross Income = Savings Rate Percentage

($8,000 + $6,000 + $5,000 + $5,000) / $50,000 = 48%

The scenario 1 savings rate is equal to 48%.

Scenario 3 – Savings Rate vs. Total Compensation

To calculate savings rate of the scenario 3, we need to divide Mr Carreira annual savings by his annual total compensation. Keep in mind that the total compensation is equal to gross income, bonuses, and matching.

(Post-Tax Savings + Pre-Tax Savings) / Total Compensation = Savings Rate Percentage

($8,000 + $6,000 + $5,000 + $5,000) / ($50,000 + $6,000 + $5,000) = 39.3%

The scenario 1 savings rate is equal to 39.3%.

Scenario Analysis

As you can see, there is a huge difference in savings rates depending on the scenario you choose.

Personally, I’m using scenario 3 in my savings rate calculator. Even if it’s not as easy to calculate as scenario 1, the number is closer to reality.

I still encourage you to start with scenario 1 or 2 as your first step. It will be easier to calculate, and it’s always great to get a feel of what your savings rate is.

Also, keep in mind that I used a simple example for illustration purposes. In your situation, calculating your savings rate with scenario 3 will probably be more complicated than in my example.

If you need help to calculate your savings rate, feel free to contact me.


How To Increase Your Savings Rate?

You don’t have many options if you want to increase your savings rate. Either you increase your savings or your income. So, what are the best ways to do that?

How To Increase Your Savings?

The only way to increase your savings is to decrease your spending. And the best financial tool to help you with that is a budget.

By creating a budget, you will have a better picture of your monthly expenses. Look through each expense and ask yourself if you need it. The goal is to keep only the expenses that are making a positive effect on your life.

Read our previous article to learn more about the 19 easy ways to save money.

How To Increase Your Income?

Increasing your income can allow you to automatically increase your savings rate without having to cut on too many expenses. However, they aren’t many ways to do it.

Either you ask for a raise, change jobs, or start a side hustle.

Remember that the goal of increasing your income is to increase your savings rate and not your lifestyle.


How To Calculate Savings Rate - Carreira Finance Coaching
How to increase your savings rate - Carreira Finance Coaching

Conclusion

In conclusion, there are many ways you can calculate your savings rate. But the more information you include in your calculation, the more accurate your savings rate will be.

If you’re interested in achieving financial freedom, let’s start the conversation.


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