I think everyone agrees that saving is important, and most people wish they could save more than they are. Saving is one of the most crucial steps in personal finance aside from being out of debt. Saving money is the first step to becoming financially independent. In this article I will be giving some rules of thumb for saving, ways to get started, how to not go crazy, and closing with smart places to put your money.
Once you’re finally debt free you’ll suddenly have a lot more disposable income! Please try not to spend it. When I finally paid off all my loans it was very difficult to not spend the extra $500 I had per month. The hard part is taking your income and saving. If you need a little motivation, see my article The Many Benefits of Saving
At this point, you may be asking “How much should I be saving?” There is one major school of thought on this matter, but it’s all up to your personal preference.
- Save a percentage of your income.
- This is one is one of the most popular methods people use to plan their savings. The recommendation is to save at least 20% of their after-tax income. Saving 30% of your take home pay is preferred. This method makes it easy to plan for the future: saving 25% for 4 years equals 1 year in retirement at your current spending levels. It also scales as you continue getting more pay. One flaw with this is if you don’t increase your savings rate as your pay increases, your spending may increase. This isn’t necessarily a bad thing, but it can increase the length of time you have to work.
After you’ve determined how much of your income you want to save you can start to figure out where you want your money to go. When you first start saving, the first step is to build an emergency fund. This first step is recommended by financial advocates all over the world. Your emergency fund is an account (or accounts) you have that are very accessible and easy to withdraw from. The most common account type is a savings or checking account. The main purpose of an emergency fund is to keep you from going (back) into debt. Most people only have around 3 emergencies in their lives. An emergency can be losing your job, an accident, your house falling down, etc. I will go into more detail in a later article about emergencies and the accounts you can use for an emergency fund.
The two most popular ways of saving are save based on expenses and save a flat amount.
- Have one month of expenses saved.
- This is a method popularized by Dave Ramsey, but is used by many people. The recommendation here is to use how much you spend each month as a base. From there, you save a certain number of months worth of expenses. The recommended rules here are to have between 3.5 and 6.5 months of expenses. For me, I have calculated that I spend ~$2,000 a month at most. This means that I should have between $7,000 (3.5 x $2,000) and $13,000 (6.5 x $2,000) saved up in my savings account before I move on.
- Save a flat amount.
- This method has been popularized by (as far as I can tell) Andrew from Listen Money Matters. This method is targeted towards people who aren’t using their bank account for their emergency fund. He recommends using an alternative <automated investing service>, like Betterment. I will go into more detail about this in my article on financial planning. He recommends saving 1.5 months of expenses in your savings account, and then having $25,000 in your taxable investment account. This works great with accounts like Betterment because the money is growing at the same rate as a retirement account would. So even if you don’t end up using all of the money due to emergencies (and hopefully you won’t) you can retire on it.
I personally use the monthly model of saving for my emergency fund. This money is split between my bank account (1.5 months) and the remainder is building up in Betterment.
Once you have your emergency fund build up, what’s next? To keep this post manageable I’m only going discuss emergency funds. Already have your emergency fund built up and are looking for the next steps? Check out my financial planning article!
On to the next phase of savings:
How to not go crazy
When it comes to saving money there is a spectrum of personality types. On one end are people who want to save every single penny possible and miss out experiences, opportunities, and interactions. On the other end are people who don’t care about save little more than token amounts of money.
Either type of person can end up being driven crazy by trying to save. The OCD savers may end up feeling like they aren’t experiencing life to the fullest, are missing out on friendships, and any number of other things. On the other side of the fence, the actionless savers may feel like they want to save but can’t bare to miss out on the experiences. They may also not feel as financially secure as they like.
Regardless of what type of saver you are, I think this simple method will help keep you sane: Pick the top three things that you will not compromise on and rarely (or never) drastically cut back in those areas. Obviously, your budgets should still be within reason. Blowing half your income eating out at restaurants is insane, no matter how high up on your list it is. You will always have to make sacrifices, but these three areas should the the last. For example, I may need to cut my overall expenses by 20%, but only 2% will come from my budget for groceries.
For me, they are:
- Eating out at new restaurants
I usually end up being somewhat frugal with #2 and #3 anyway, but I try to keep my budget for eating out at restaurants as high as possible. Leave your top categories in the comments below!
Smart Places to Put Your Money
No, "underneath your mattress" is not one of them. I’ve gone over this in the article, but I wanted to separate it out for ease of reading. I think the three accounts you should use are: checking, savings, and automated investing.
Checking - The most liquid account you could possibly have. You can take money in with a debit card, and ideally have it linked to your credit cards to make paying a breeze. I want to have half a month worth of expenses in here at any time.
Savings - Some people question whether or not a savings account is necessary. I say that it has a place in my financial plan, but you may decide differently. Savings accounts offer slightly higher interest (i.e. 1% instead of .1%). The 1% is fairly insignificant and doesn’t outpace inflation, but it it secure. You never have to worry about your account decreasing in value. I plan to have 3 months of expenses in my savings account.
Automated Investing - This is a relatively new technology and hasn’t been incorporated into all savings plans as of yet. I think they can have a very important part in almost any portfolio. When using an account for this, it is essential to balance risk. Having all of your savings in an account that can lose value is not a smart idea. This is why I will be keeping 6 months of savings (or $12,000) in my Betterment account. This way, I have 3.5 months to find out what to do before having to tap into this account.
Well that’s it! While the methods may be different they seem to agree on one thing: You should be mindful of your saving and spending. Also remember that it’s a marathon, not a sprint. Slow and steady wins the race. Stay tuned for my How to start saving more money today article.
What here appeals to you? What are the three areas of your life that you value? I was certainly at both ends of the spectrum in my life, and would be interested in hearing from you!