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Your Savings Rate Matters

One of the biggest misconceptions is that you need a high income to achieve financial independence.

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Your Savings Rate Is Important

Your savings rate is much more important than absolute dollars earned. Your savings rate is determined by dividing the amount you saved over the amount you earned.

For example, if you earn $250,000/year as a doctor or lawyer, but spend $240,000, you can become financially independent after a long but productive 55 years on the job. Hope you enjoy your occupation, because you would be working well into your 70s or 80s.

On the other hand, if you make $60,000, but live on half of it, you can retire in 15 years.

While it may look “easier” to save a higher percentage with a higher income, you may also have to keep up with the expensive tastes of peers (expensive houses, cars, clothes, vacations etc). Hedonic adaptation, keeping up with the Joneses mentality, can lead to a gradual inflation of your lifestyle.

Managing your savings rate effectively is an exercise in playing effective offense and effective defense.

Growing Dividend Income

Effective offense is the ability to grow income over time, which can increase the savings rate over time. This could mean getting promotions, starting a side hustle or a second job. Growing dividend income is an effective side hustle, where you generate extra income.

If you earn $50,000/year, and save $10,000, your savings rate is 20%. If you manage to grow earnings by 10% while keeping expenses constant, your savings increases by 50%. That’s a $5,000 salary increase. Your savings rate rises to 27%.

Growing income is not easy of course. In my experience, I ended up working much harder for each raise beyond a typical inflation adjustment. Switching jobs can help too, but you also need to take into consideration if there are other costs to do that job in terms of work attire, longer commute, working longer hours etc. This difficult work environment does provide motivation to pursue financial independence however.

Effective defense is the ability to contain expenses, stick to a budget and look for ways to eliminate waste from the system.

Reaching Financial Independence

Again, as we saw above, if you earn $50,000/year, and save $10,000, your savings rate is 20%. If you manage to decrease expenses by 12.50%, or $5,000, your savings rate increases by 50%. Your savings rate rises to 30%. As a result, it would take you less time to reach financial independence for each dollars of cost you take out.

The nice thing about being frugal, is that it gives you a double benefit.

For example, if you spend $30,000/year, you would need a $1,000,000 portfolio of dividend stocks yielding 3% to reach the dividend crossover point. If you earned $50,000/year, it would take you 19 years to get to the dividend crossover point. This example assumes investing $20,000/year in dividend growth stocks yielding 3% and growing dividends at a rate of 6%/year. The math behind early retirement is shockingly simple.

Let’s look at an example where your salary increased by $3,000, to $53,000. Let’s assume that your spending remained at $30,000/year. You still need to accumulate $1 million in dividend growth stocks yielding 3% in order to retire. But now you can save $23,000/year. It would take you 18 years to reach the dividend crossover point at this rate.

If you cut expenses by 10%, to $27,000/year, you would only need $900,000 invested in dividend growth stocks to reach retirement. You would be able to save $23,000/year., and reach the dividend crossover point in 17 years. In a way your needs are smaller, which means you need a smaller nest egg. But your savings rate also increases from 40% to 46%, which speeds up time to retirement significantly.

Today we discussed the importance of the savings rate in achieving financial independence.

Each dollar that you reduce your expenses by has a higher impact on your savings rate than each dollar that you increase income by.

The issue of course is that you can only cut out so many expenses. That’s why you need a good offense (grow income) and a good defense (keep or lower expenses).

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Article by Dividend Growth Investor

 

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