Step 3: Focus On Your Savings Rate
Two major steps are out of the way at this point. To review, they are:
Step 1. Calculating Your Net Worth or Lifetime Earnings and Savings
Step 2. is broken down into 3 phases.
After eliminating toxic debt and building an emergency fund, you will finally be in a position of relative financial strength. For step 2, focus hard on paying everything off. Some of you may want to keep your mortgage, but please realize that the interest on the loan (even if it is only 3%) can dramatically reduce the amount of money you are putting toward investing over the course of 30 years (average mortgage duration). Remember, over the course of a 30 year mortgage, the average homeowner pays 2.5 times the original purchase price due to interest.
Third Step: Your Savings Rate
The first two steps of this journey were highlighted in Part 1 and Part 2. If necessary, go back and review those. The sole purpose of putting those two steps together is to get to the point of attaining a positive net worth.
After crossing the threshold into a positive net worth, now you can begin to focus on your savings rate. Savings rate is defined here as the percentage of your take-home pay put towards savings.
Here is a typical way to begin figuring out your savings rate. It is broken down into 2 phases.
A. Find out what your after-tax take-home pay is by assessing:
B. How much you are adding to the following accounts on a weekly, biweekly, or monthly basis?
To calculate your savings rate, what percentage of your after-tax, take-home pay (section A. helps you determine this) goes towards accounts listed in section B. above.
Savings rate = (monthly savings amount/monthly take-home pay) x 100
Once You Know How Much Your Saving, Find Out How To Increase It!
Now that you have determined how much you are contributing to saving, look at this figure at least twice per year to see if you can increase it.
Never stop doing this step. Ever. You want to see throughout the "seasons of life" if you can be more and more aggressive with your savings efforts. Only you will be able to determine for how long and how much money needs to be accrued before you relax this plan.
Many have used The Shockingly Simple Math Behind Early Retirement article as a means for figuring out their "FI number". Perhaps this will be your next step as well.
To increase your savings rate, you can focus on income and expenses. Ideally, focus on both for the biggest impact.
The goal: Increase income and decrease expenses simultaneously
Ways to increase income:
Ways to decrease expenses:
The wider the gap between income and expenses, the greater potential your savings and thereby investments will have.
If you only have $100 saved, who the hell cares if you invest in something that generates a 25x return... you'd still only have $2,500 dollars---hardly enough to make you rich. This is a 2,500% return on your initial investment of $100. Guess what, "the market" typically returns 8-10% over time, not 2,500%.
Remember, your most powerful weapon at your disposal is compound interest. The way you make compound interest even more powerful is by saving, early and often!
Step 1 - Calculate Your Net Worth or Figure Out Your Lifetime Earnings vs. Savings
Step 2 - Attain a Positive Net Worth (most often by eliminating debt) and create some breathing room with a fund of at least 3 months worth of expenses
Step 3 - Determine your savings rate and find ways to increase it