In my previous post, I suggested an optimal order for investing your money. To summarize, the steps were:
- Create a monthly surplus
- Emergency fund (3 months)
- Set 401(k)/HSA contribution to minimum to receive full employer match
- Pay off debt above 5%
- Emergency fund (6-12 months)
- Max HSA
- Max Roth IRA
- Max 401(k)
- Consider other options (pay off low interest debt, taxable brokerage account, real estate investing, starting/buying a business)
Based on the amount you’re saving per month, you’ll only be able to make it so far down the list. Note that while steps 1-8 have finite limits, step 9 is infinite. Even if you had billions to invest per year, you could invest it all in step 9. If you follow the above steps and make it to step 9, you’re doing pretty dang well.
But what if you’re only saving enough to make it to step 3, 4, or 5, and you want to go further?
You have two options: cut your spending or increase your income (or both).
In this post, I’m going to focus on the first option: cutting your spending.
Determine Your Desired Savings Rate
First, think about what your desired savings rate is. The higher your savings rate, the faster you’ll reach financial independence. This graph shows how many years it will take to reach financial independence given your savings rate.
This graph has a few assumptions worth noting. First, this graph does not depend on your income. That’s because this figure assumes your expenses will stay the same (adjusted for inflation) forever. If you currently spend $20k and save $30k, it assumes you will retire on $20k per year.
It also assumes a 4% withdrawal rate, which is widely accepted as the percentage you can withdraw from your savings invested in the stock market indefinitely, without depleting the principal.
If those assumptions do not hold true for you, know that the years may be a little off (in reality it could be more or less years for you). But in general, this graph gives a good enough estimate. We can sharpen the pencil as you get closer.
For further reading on savings rate, here is a good article from the great blog, Mr. Money Mustache.
So, let’s say your goal is to reach financial independence in 15 years. You need to save 54% of your income (assuming you’re starting from 0 savings).
It’s also okay to “ramp up” your savings rate over a couple years if it’s not feasible to cut things cold turkey. Maybe your current savings rate is 10%, and your goal is 40%. Over time, you’ll identify new, substantial ways to save. Maybe you can significantly cut your housing costs next year by finding a cheaper place to rent, or maybe you sell your car and replace it with a cheaper one in a few months. So maybe you save 10% this year, 20% next year, and 40% the following year.
Pay Yourself First
You may have heard the common financial advice, “Pay Yourself First.” Although it’s common, it’s good advice! But very difficult to adhere to in practice.
But what does this phrase even mean? I didn’t understand it for a while. How can you pay yourself first when it’s so important to make sure you don’t have any credit card debt?
Paying yourself first means setting aside your desired savings rate, and then using the leftover money to pay your bills and living expenses. This DOES NOT mean that you don’t pay your bills or go into credit card debt. It means you design your lifestyle such that you only spend what you have leftover. Yes, that requires planning and budgeting (link to relevant budget posts). You can’t just save 75% of your income and “hope” you have enough to cover your bills—this will likely end in credit card debt and a bad credit score. After determining your ideal savings rate, you must adjust (and stick to) your budget.
Let’s say you have an income of $50,000 after taxes. If you decide you’d like to save 30% of your income, you must find a way to decrease your monthly spending to $3000.
Paying yourself first is not deprivation. It’s the opposite. You are putting a certain percentage aside to serve your future self. You are saving for your freedom. Paying yourself last will most likely result in a savings rate of 0%, because there’s always a way to spend available money.
To hit your desired savings rate, I recommend modifying your budget based on your values (link to posts). If you value going out to eat often with friends, then move to a cheaper apartment. If you love your house, then get rid of your car payment by getting a cheaper car. If you value getting to financial freedom as fast as possible, then slash your spending in every category. It is possible to both choose what spending is important to you today, and make a conscious commitment to your future financial freedom.
So now that you’ve chosen your ideal savings rate, and have a budget that supports it, how do you actually follow through with that plan?
The most effective way to sticking to a plan is to force the surroundings. 401(k) or HSA contributions that come directly out of your paycheck is a good example of this. You won’t miss the money if you never have it in your checking account in the first place. If you can set your desired savings rate based on these automatic deductions from your paycheck, that’s the most effective way.
Most likely, you will have some money from your paycheck that you want to dedicate towards savings. Maybe it’s money you want to use to build your emergency fund, or fund your Roth IRA, or use to paydown debt (or some combination).
In this case you should use automatic transfers and multiple savings accounts. Set up a high-interest savings account for your emergency fund, and set up automatic transfers from your checking account to this savings account to happen shortly after each paycheck. Set up automatic payments from your checking account to your loans, or to your Roth IRA account.
And then make sure you stick to your budget with your remaining income, so that you don’t have to dip into your emergency fund for expected expenses!
Watch Your Net Worth Grow
Now, for the fun part! You get to watch your net worth grow! Well, it’s fun to me…
Set up a Personal Capital and/or Mint account, and watch as your net worth grows. You’ll be able to watch your debts go down and your investments go up over time. It’s really satisfying to watch, knowing that every $1,000 invested or used toward debt payoff is $1,000 closer to your freedom.
This will keep you motivated to continue saving. As your net worth snowballs, it becomes fun to find new ways to further increase your savings rate and make your net worth compound faster.
And just think, it all started with a commitment to pay yourself first.