Do you remember when I asked, “What would you do with $20,000 right now?”
Did you have a plan then?
Do you have a plan now?
Let’s turn this simple question into a hypothetical scenario.
It’s time to learn one final (for now) important personal finance tracking metric, known as “savings rate.”
Congratulations on your raise!
Let’s say you’ve been at your job for a few years. Your current salary is $100,000.
It’s salary review time, and you set up a meeting with your boss. You want to make sure she remembers all your major contributions from the past year.
Prior to the meeting, you send her a letter setting forth your top accomplishments. It’s a hard letter to write. It doesn’t feel like a normal thing to have to brag about yourself.
You remember seeing a quote somewhere, “If you don’t advocate for yourself, nobody else will.” You push on and send your boss the letter.
On the day of your meeting, you’re nervous walking into your boss’ office. Why did I ask for this? She’s going to be so annoyed.
Before you even sit down, she puts your mind at ease. Your boss has a welcoming smile on her face.
She immediately thanks you for your thoughtful letter. She appreciates the reminder of all your accomplishments throughout the year.
Your boss tells you that you’ve always been a valuable member of the team. She thanks you again for reminding here of some of the specific projects you worked on that year.
It’s not a long conversation. Before you go, she asks what else the company can do to enhance your work experience. You walk out of her office feeling like a valuable member of the team.
You’re happy that you initiated the meeting, even though you didn’t enjoy the process.
A couple of weeks later, you receive an email that your salary is increasing by $20,000.
You couldn’t be happier. You earned it.
Wait, a raise?
Work continues as normal the rest of the week. By the time your next paycheck hits your bank account, you sort of forgot that you’re now making more money.
After taxes and retirement contributions, your biweekly (every 2 weeks) paycheck is now for roughly $538 more. That comes out to $1,166 more money per month, which of course, is a very good thing.
But, you need to figure out what you’re going to do with that money.
Ideally, you’ll have a plan in place before you receive the money. Whether it’s a raise, a bonus, or you switch jobs and earn a higher salary, the thought process remains the same.
Thinking about what to do with this new money is what I’m getting at when I ask, “What would you do right now with $20,000?”
No, it’s not coming in one lump sump payment.
Fine, you have to pay taxes on the $20,000 so it’s more like $14,000 in new money.
The point of the question doesn’t change. What are you going to do with this money?
3 options for what to do when you earn more money.
You now have more income coming in each month. Let’s talk through some of the options on what you can choose to do with that excess money.
- Option 1: You do nothing. You leave the money in your checking account. Maybe you treat yourself to some extra lunches out or some concert tickets. Before you know it, these excess dollars have disappeared.
- Option 2: You tell yourself, “Man, I’m flush!” You start looking for a nicer apartment. You upgrade your plane ticket on your upcoming trip. You stop taking the train to work and instead opt for Ubers. Congratulations, you’ve become the real life, really lost boy.
- Option 3: You choose to put that money to work to fuel your Later Money goals. Even before you earned the $20,000, you decided that you wanted to be good with your money so you have the power to choose how to lead your life.
Spoiler alert!
I recommend you think long and hard about Option 3.
Make more money, spend about the same.
The odds are that you will make more money as your career progresses. Statistics show that the average salary for Americans tends to increase as we get older, up until about our mid-50s.
Your career trajectory may be different, and you certainly may continue to make more money well-beyond your 50s.
The takeaway is that you are most likely going to make more money. It’s up to you to make sure you put that money to good use.
The best way to supercharge progress towards your ultimate life goals:
Make more money, spend about the same.
It’s easier said than done. But, this is the key to getting ahead in life with your personal finances.
How can you measure whether you are saving more as you earn more?
By tracking your savings rate.
What is my savings rate?
Your savings rate is simply the amount of money you save each month divided by the amount of money you make.
Savings rate = Money Saved / Money Earned
Just like staying on budget with two simple numbers, you can monitor your savings progress with this simple formula.
I find it helpful to measure your savings rate based on your monthly income and savings. This way it matches up with your Budget After Thinking.
I also find it most useful to express your savings rate as a percentage. To see your savings rate percentage, all you need to do is multiply your savings rate by 100.
Savings rate % = (Money Saved / Money Earned) x 100
Moving forward, when I refer to savings rate, I will be talking about your savings rate percentage. It’s more informative to see what percentage of your money you are saving, rather than an amount with no context.
What I mean is this: if someone asked me if saving $10,000 per year was a good target, I wouldn’t be able to comment with more context.
If that person was making $75,000 per year, I would say that seems pretty good. That’s a savings rate of more than 13%.
If someone told me they were making $750,000 per year, and only saving $10,000, I would recommend that person revisit their Budget After Thinking. That’s a savings rate percentage of only 1.3%.
Follow these tips for calculating your savings rate.
Just like we talked about when creating your budget, don’t overcomplicate this process. Here are some suggestions to help you easily calculate your savings rate:
When you calculate your savings rate, be sure to use your take-home pay for “Money Earned.” This means the amount of money that hits your bank account after taxes and retirement contributions.
Like we discussed before, you’ve already made a terrific choice by investing it for retirement. Feel good about that. For calculating your savings rate, ignore it. We are only concerned with tracking how much we are saving each month from our take-home pay.
This next part gets a little bit tricky to explain, but it’s important.
If you get paid biweekly (every other week), that means you will receive 26 paychecks every year (52 weeks / 2 = 26). If you are paid twice per month, like on the 1st and 15th of every month, you only receive 24 paychecks.
OK, so what?
To determine your monthly take-home pay, so you can calculate your savings rate, you need to know the amount you earn for the whole year.
To figure out how much you earn in a full year, multiply the amount you receive in one paycheck by 26 (or 24). That’s your annual take home pay.
Then, to calculate how much you earn per month, divide your annual take home pay by 12. This is the amount you’re going to use for “Money Earned.”
For “Money Saved,” include all of the money you are putting towards your Later Money goals each month (except your retirement contributions through work).
I know it’s called savings rate, but for this purpose, include all your Later Money in the savings rate equation.
Of course, we know that “saving” is different from “investing.” Saving is also different than paying down debt or any other personal financial goal you’ve set.
It doesn’t matter. When calculating your savings rate, your goal is to see what percentage of your take-home pay is fueling our Later Money goals.
What can I learn from tracking my savings rate?
Tracking your savings rate will help you understand if you are making progress over time. It’s not about comparing yourself to someone else.
Whatever your current savings rate is, the goal is to seek personal improvement. Just like with tracking your net worth, the purpose is to see if you are making personal progress over time.
When it comes down to it, there are really only two ways to improve your savings rate.
- You can spend less, and save more, of the money you’re currently making.
- You can make more money and save most of that money, all while keeping your expenses the same.
Combining those two ideas is even better. Like we just said, make more money, spend about the same.
Use the excess money you make to fuel your Later Money goals.
If you can do that, your savings rate and your net worth will steadily climb. You’ll experience that your Later Money goals are closer to becoming reality than you think.
Let’s do the savings rate math together.
Now that we know what our savings rate is and why it’s such a useful metric, let’s revisit our $20,000 raise to do some math together.
Going back to our hypothetical, you were making $100,000 before your raise. Let’s assume that your take home pay was $70,000 per year after taxes and retirement plan contributions.
Let’s also assume you were putting $1,000 per month towards your Later Money goals.
Using our savings rate percentage formulas above, we see that:
- Money Earned = $5,833 per month ($70,000 / 12)
- Money Saved = $1,000 per month
- Savings Rate = $1,000 / $5,833 = .17
- Savings Rate Percentage = 17%
17% of your take home pay to fuel your Later Money goals is great!
Now, let’s see what happens if you add your entire raise to fuel your Later Money goals.
Earlier, we assumed that after taxes and retirement contributions, your take home pay increased by roughly $1,166 per month. With your raise, your annual take home pay has now climbed to $84,000, or $7,000 per month.
Look what happens to your savings rate percentage when you add the full $1,166 to Money Saved (instead of spending it)
- Money Earned = $7,000 per month ($84,000 / 12)
- Money Saved = $2,166 per month
- Savings Rate = .31
- Savings Rate Percentage = 31%
You more than doubled your monthly savings contributions and improved your savings rate to 31%!
Think about how much more quickly you can reach your goals by planning out this one decision.
I know what you’re thinking.
This guy’s no fun!
I earn a raise and he wants me to save it all.
This is just an example. I’m not suggesting you have to, or even should, save your entire raise. I want you to spend your money on things and experiences that are meaningful to you.
My point here is show you how dramatically one decision can accelerate your progress towards your goals.
If you don’t want to save the full $1,166, can you save $600 each month while enjoying the rest? That’s still an incredible improvement.
It’s your money and the choices are yours.
Before you spend the whole raise though, think and talk it out with your people.
Maybe you just need to ask yourself:
“Is spending more money right now on things I don’t really care about going to make me happier?”
“Do I even want to go out to more restaurants? Or fancier restaurants?”
“Do I despise my home/my car/my wardrobe so much that I must replace it immediately?”
Only you can answer these questions.
Maybe you’ll realize that your life is pretty good right now as it is.
You might just decide that you don’t need the extra money at this moment.
You’d rather use the money as fuel for what you really want in life.