In a world where saving money seems like an easy task, everyone would do it. However, the reality is quite different. When your income is low, just balancing your expenses can be challenging. Rent and food are necessities you must pay for, not to mention all the other countless things waiting for you to purchase.
With an increase in income, you may allow yourself to be a bit more generous. You might rent a bigger apartment or buy a newer car. You’ll dine out more frequently and treat yourself to a better phone. Despite earning more money, a month still seems longer than your paycheck.
The expenditures of high-income individuals often astound others. The installment payments for a high-end car may exceed the rent of many. Maintaining a large house alone could consume a significant portion of an average person’s income, and those with high incomes often own more than one property. Vacations require international travel, a stay in a five-star hotel after at least a business class flight.
Earning more doesn’t just mean having more opportunities to save money, it also means having more opportunities to spend money. Items that used to seem luxurious in the past are now considered basic necessities that you cannot do without. There always seem to be more places to spend money on.
Your house can always be bigger, or you can buy another one. Holidays can be longer, more adventurous, more luxurious. The labels on your clothes can also be more dazzling.
People who don’t save money often think that if they earn a bit more, they’ll start saving. They are mistaken. If they earn a little more, they’ll only spend more. Whether you save money doesn’t directly depend on how much you earn but on your willingness to save and whether you are willing to make the necessary sacrifices to save.
Because saving money itself requires sacrifices. It means being willing to give up immediate pleasures that money can buy for greater peace of mind in the present and the potential joys it can bring in the future.
Saving money is a decision you make today to plan for the future and prepare for tomorrow. It’s a smart choice, and you don’t have to be wealthy to make it.
As long as you have a roof over your head, food on the table, clothes on you and your family, you can save money. If you earn more, of course, you can save more, but even if you earn less, you can still save.
So, saving money involves making sacrifices. But how much of a sacrifice should you make? How much should you limit your lifestyle now to build security, prepare for a significant expense, or accumulate wealth for the future?
The right answer that suits everyone doesn’t exist. It’s easier to cut expenses when your budget includes first-class plane tickets, but when your only option for transportation is public buses or walking, it becomes much more challenging. However, there is a formula you can refer to.
In general, financial experts recommend following the 50/30/20 rule.
Fifty percent of your income should go towards essential expenses like rent and food. Thirty percent is disposable income for spending freely. You should save 20%.
Therefore, for a person with a post-tax annual income of $50,000, their annual spending on rent and food should not exceed $25,000. They can spend a maximum of $15,000 on shopping and entertainment, with the remaining $10,000 allocated for savings.
How difficult it is to adhere to this formula depends on how much you earn. According to data from the US Department of Agriculture, the average American spent 9.5% of their disposable personal income on food in 2019, but this percentage varies significantly among different income quintiles. Those in the lowest income quintile spent up to 36% of their income, about $4,400 annually, on food. Whereas those in the highest income quintile spent almost four times that amount, $13,987, accounting for only 8% of their disposable income.
Definitions of “essential expenses” and “discretionary expenses” may vary among individuals. For many, a car is a necessity, but not for everyone. There are many forms of saving money. If your employer contributes to your 401(k) plan on your behalf, even if you don’t feel it, you are already contributing to that 20% savings rate. If your employer offers a matching contribution plan, every extra dollar you put into your retirement account earns you more money from your employer.
Hence, one way to think about how much money you need to save is to calculate it as a percentage of your post-tax income. The goal is 20%, including your retirement contributions. So, if your post-tax income is $50,000, you should save a total of $10,000 annually. Part of it will go into your retirement account before taxes, and the remainder will go into your savings account.
The problem with saving money based on income ratios is that your income can fluctuate. For instance, salespeople often work under a commission system. They might easily save a portion of their base salary but enjoy the rest as extra rewards, which often constitute a significant portion of their income.
However, bonuses themselves are not stable. Even the best salesperson may experience slow seasons, while an average salesperson might land a large deal but never replicate it. Such unstable income can lead to an unstable saving plan.
Another approach is to set a clear financial goal. It becomes easier to do when you know where that money will be used. For example, if you aim to save $50,000 for a down payment on a house, you can calculate that saving $500 per month will take 100 months, a little over eight years. By tightening your belt and doubling the savings rate, you could have your own house in a little over four years.
Having a clear vision of your goal should help you stay disciplined.
However, maintaining saving discipline in the long term is always challenging, which is why financial experts often talk about short-term, mid-term, and long-term saving goals.
Short-term saving goals serve to demonstrate the effectiveness of saving money. They help build confidence, accumulate motivation for long-term savings, and prove that saving money is not difficult.
As we’ll see in the next section, tracking your budget is crucial and serves as a good starting point for setting short-term financial goals. When you realize you’re spending $4 each workday at a local Starbucks on a Frappuccino, swapping it for the office kitchen’s coffee could save you $20 per week. By the end of the month, you could have an extra $80 in your pocket just by subbing free coffee for expensive coffee.
If you also skip three takeout meals per week, cook a simple pasta dish at home instead, or pass on ordering dessert at restaurants, you could easily find an additional $250 in your pocket every month. It’s almost like getting a raise without much effort.
When you see this extra money, you’ll soon understand the meaningful and positive impact saving can have. You’ll realize that by sticking to it, you could save even more and genuinely transform your lifestyle.
Most importantly, before long, you could establish an emergency fund worth several thousand dollars. Having enough funds saved to sustain your expenses for a few months grants you valuable security. If you suddenly lose your job or find yourself temporarily unable to work, you won’t have to worry excessively, let alone turn to friends or family for help.
You’ll have time to regain your footing on your terms.
The results of short-term saving goals are usually evident in a few weeks. By the end of the month, you’ll find that you have more money on hand than you expected. In a few months, you’ll feel the boost in confidence that comes from heightened security.
At this stage, you can start considering mid-term goals.
These goals vary from person to person and depend on your circumstances and initial financial situation. Your mid-term goal might be saving enough to pay off student loans, make a down payment on a house, or save for starting a business.
At this stage, you need to focus not just on not spending more than you earn but also on making your money work for you. These savings may sit unused for several years, and during that time, inflation will continually erode their value. You need to protect them.
In the latter part of this guide, we’ll introduce various tools for storing savings, but now is the time to start understanding them.
The biggest challenge in personal finance is that when you don’t have extra money, learning how to save seems irrelevant – that’s something richer people worry about. Yet, by the time you actually have savings, it might be too late: inflation has already weakened their value, and the opportunity cost of not investing has diminished returns.
It’s during the mid-term saving process that you can begin to address this contradiction. As your savings grow, start researching different savings accounts and investment tools. You should also understand the variable maturity periods of these savings instruments. The longer you’re willing to lock your money, the more interest you’ll typically earn. But if you’re in the process of saving for a mid-term goal, you might not reap all the benefits of long-term savings.
For example, you won’t enjoy the tax benefits of contributing to a 401(k) plan or an individual retirement account (IRA), nor will you garner the full returns of holding onto bonds until maturity.
Nevertheless, you can still lock funds for a limited time frame and enjoy some of the benefits.
Estimate how long it will take to reach your mid-term goal – whether it’s a down payment on a house or a fixed amount needed to start a business. When you’re saving money each month, remember to limit the term of investment of these funds to not exceed the target date. You’ll find that your savings grow faster, and you can achieve your goal sooner.
When financial advisors talk about long-term saving goals, they often refer to retirement. They envision that day when you close the last file, set down your keyboard, and trade the days staring at a screen for time with family, travel, and enjoying life.
When you’re just starting your career, it’s challenging to think seriously about retirement.
Retirement is decades away, and who knows what will happen in that time. Do you really need to lock your money for 30 years or even longer? Maybe you won’t need it by then. Perhaps in the years to come, you’ll start a successful business, land a high-paying job, or hit the jackpot. If you suddenly become wealthy during that time, you’ll have tied up today’s money for a future where you don’t need it.
We all hope for an opportunity to strike it rich between our first job and our last day at work. Google might acquire your company with a truckload of stock options; patent licensing fees might flow steadily; salaries and bonuses reach seven figures… and keep growing.
However, this isn’t something anyone can rely on. Planning personal finances based on the assumption that “something good will happen” is not just a bad decision but also costly.
The greatest benefit of long-term saving goals is the power of compound interest. The money your money earns continues to earn more money. The longer you lock your money, the more compound interest you accumulate, and the more your money works for you.
If you start saving $500 per month at the age of 25 and retire at 65 with an annual interest rate of 3%, you’d have $464,687. Your principal investment of $240,000 would earn an additional $224,687, averaging $5,617 annually.
But if you start ten years later at 35 instead of 25, by the time you reach 65, you’d only have $292,596. Your $180,000 investment would have yielded only $112,596, averaging just $3,753 per year.
Starting to save for long-term goals early allows your money to work more effectively for you. Not only will your eventual “retirement nest egg” be larger, but you’ll also need to save less to reach that goal!
Even if you have a plan to become wealthy before retirement, you should still save for long-term goals and begin as early as possible.
In this series of articles, we also discuss why saving money is essential, how to track your expenses, where to keep your savings appropriately, and retirement funds.