Achieving Financial Independence is Not About the Amount of Saving But the Saving Rate

importance of saving rateEarly retirement stories can be very inspiring for most of us. Nevertheless when looking behind the numbers, many people can get discouraged. They might think “I will never have millions on my account” or “Ha, it’s easy with a six figure salary”.

What those people don’t understand is that you don’t need to have millions or a six figure salary to achieve financial independence. It’s not about the amount you earn and save, it’s about your lifestyle and your saving rate! Let me show what I mean:

First of all let’s start with a quiz!

Take two guys; Joe and Jack. Joe is a high level finance guy at a multinational. He earns 150k net per year. He lives in a posh house, drives a fancy car and can afford to go on an exotic holiday each year. His annual expenses add up to 120k.

Jack doesn’t have a fancy job, he takes home 40k per year. He doesn’t live a fancy lifestyle, but still consider himself happy. His annual expenses are adding up to 24k.

Who do you think can achieve financial independence earlier?

The answer can be surprising. Even though Joe is earning nearly 4 times more and saving almost twice as much as Jack, considering their lifestyles, Jack in a much better situation. This all relates to the saving rate. Joe’s 30k saving represents a 20% annual saving rate, while the same number for Jack is 40%.

The Importance of Saving Rate

I will show you why the saving rate is the most important thing on your way towards financial independence.

Let’s say you earn 100k. (I chose this number because it’s nice and round, it can be 1k, 1 million or 32,456, the math and the end result is the same.) So you earn 100k (yeah!). If your saving rate is 20%, this means your annual expenses are adding up to 80k. If your saving rate is 30%, your expenses are 70k etc. So far it’s pretty clear right?

You will achieve financial independence when the returns (or withdrawal) from your savings can cover your annual expenses. How can you know how much money you need to meet this requirement? Well, there is a financial rule of thumb, which is the 4% rule. The 4% rule says that if you withdraw maximum 4% from your nest egg per year, your investments should be sufficient to last until the rest of your life. Some people say that it’s safer to apply a 3% rule (of course it is, and guess what, a 2% rule is even safer 🙂 ), but we will use the 4% rule here.

So if you earn 100k and your annual expenses are 80k (equals 20% saving rate), you would need a nest egg of 2 million (80,000 / 4%). In case your expenses are 70k, you would need 1,750,000.

How much time do you need to have this much money? Well, we can estimate this by taking the annual savings as an extra each year, plus multiplying the previous year’s balance by 1.07 (which is the historical average of stock market returns). Of course this is not granted, but will give us a fairly reasonable guidance. I put the numbers to the below table:

saving rate table

Click to enlarge

What do we see here? If with 20% saving rate we need 2 million, then it takes nearly 30 years to build up this portfolio. With 30% saving rate you can reduce it to around 23 years. Increasing the saving rate by 10% has resulted in 7 years less required for reaching financial independence. (If you increase the saving rate to 60%, the number of required years will be reduced to less than 11.)

How many years do I need to retire early?

The following chart might clarify further how many years you will need to reach financial independence based on various saving rate:

years required to FIRE

I cannot emphasize enough that we are talking about saving rate here and not required amount of money. You do not need a high salary in order to start investing in your future financial freedom.

In addition, over the time your saving rate will get increased, even if you don’t spend less. This is because of the fact that your investments will also generate income that you can reinvest. This will result in a compounding effect, that will help to further accelerate your journey towards financial independence.

I hope the above helped to convince you that even though high income is an advantage, achieving financial independence is all about the saving rate. What does still stop you from investing in your future?

 

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Disclaimer: This post or any other information on the site is not intended to be and does not constitute financial advice or any other advice. I am solely sharing my idea, plan and progress on financial independence and early retirement.

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2 Comments

  1. MUSTARD SEED MONEY March 8, 2017
    • Roadrunner March 8, 2017

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