Is your goal to reach financial independence? Do you want to retire early? If you have an ambitious financial goal, there are many things that you must do correctly. For example, you need to always be working on improving your ability to earn more money. You must live below your means. You must invest wisely in stocks and bonds. It is also important to take advantage of tax-deferred accounts like a 401K or IRA. Yes, all those steps are important, but in my experience, having a high savings rate is the most important step to becoming financially successful.
I see savings as the foundation for being financially successful. Without savings, there is no money to invest. It is the foundation for one’s financial house to be built upon. For a house to last, it needs a solid foundation. If you skimp on the sand or mortar, the foundation will not be suitable to support the structure that you are dreaming about constructing. If you are not saving enough money, you will not have enough to support a high quality of life when you retire and draw from your savings to pay your expenses.
This will probably not come as a big surprise, but American’s are not saving enough. The current national savings rate is just over 5%. As recent as the 1980’s, the saving rate in the United States was over 10%. If your goal is reaching financial independence and ultimately early retirement, a savings rate of 5% is not enough. Even with compound interest, it would simply take too long to grow into a substantial enough nest egg to cover your living expenses.
How Much is Enough
In the classic personal finance book The Richest Man in Babylon, a savings rate of 10% is suggested. I feel 10% is the bare minimum that the average American should be saving. I do not think that is nearly enough if your goal is early retirement. It might be suitable if your goal is to reach financial independence by age 65, but not if you want to retire at age 50.
If you are just entering the workforce, start by saving 15% of your salary. Work on increasing that rate every year. Try to increase it by at least 1% annually. Increase it with every annual raise or bonus.
Spending is the opposite of savings. Spending is the enemy of wealth creation. Spending leads to lifestyle creep. The more stuff you buy, the more stuff you will want. There is always something new or better than what you own.
Marketers earn a living by trying to convince you to buy what they are selling. When you see that your friends or neighbors have the newest products, you will want to upgrade your stuff too. This is a vicious cycle without an end.
The secret to winning this game is to not play. Every dollar that you spend puts you one dollar further away from financial independence. On the other hand, every dollar you save goes towards buying your freedom.
Debt is created when you spend more than you earn. Some debt is not as bad as other debt. Student loans provide you with the funds to get an education to obtain the skills to earn a higher salary. Taking out a mortgage enables most Americans to be homeowners. You still must use extreme caution before you incur any type of debt.
Bad debt comes in the form of credit cards, auto loans, and payday loans. All debt, however, prevents you from saving as much as you could be saving. When you take on excessive debt, you become a slave to your creditor. It is possible, but difficult to escape from the bondage of debt once you start to slide down that slippery slope.
Why Save So Much
Once you take on the mindset of a saver, you will never be a spender. Personal Capital is a free online platform that is great for tracking savings. That feeling of accomplishment of watching your savings grow is far greater than any new product that you can buy.
After you become a saver, you might notice a mental twist occur. Once you reach a point in life when you could afford luxury cars and upgrade to a larger house, you will realize that you do not want to waste your money on any of that stuff. Buying new stuff will become unimportant. You will see it as being wasteful.
At that point, spending is viewed as an opportunity cost. You will want your money to keep growing. Financial independence will become the most import thing that your money can buy. There is no product or service that is more appealing than having mastery over your own life.
As a saver, you will always be trying to optimize your spending and to live on less. It is fun to try to stretch a dollar as far as it can be stretched. This mindset will greatly help you on your journey toward financial independence because you will need less money to live on.
For example, if you can live on $40,000 per year, you only need to have $1,000,000 saved based on a 4% withdrawal rate. What about if you want to live on $100,000 per year? You would have to have $2,500,000 in savings at a 4% withdrawal rate. The more money you require, the further away you are from freedom.
Compound interest works no matter what your saving rate is. It is just math. It just works better if you have a high savings rate. For example, Joe saves $800 per month and Bill saves $2,000 per month. Their savings both grew by 8%.
How much will Joe have in savings after ten years? He will have over $147,000 saved. That is a nice sized nest egg. It is a solid foundation to build upon. However, he is still a long way from financial independence.
How much will Bill have saved? Bill will have over $368,000 in savings. Bill is well on his way to reaching financial independence. He is starting to see the light at the end of the tunnel.
As you can see, compound interest worked out well for both Joe and Bill. Joe has a nice financial foundation. Bill, on the other hand, has almost 10 years of living expenses stashed away assuming he can live on $40,000 per year.
Start saving early. Save as much as you can. Always try to save more. Don’t be fooled into thinking that you are missing out on anything because you are saving too much. Once you become a saver, you will have established the required foundation that is needed to fuel the wealth building process.
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