As you’ll learn, I’m a numbers person. This means that some posts will be wordy (like the previous ones) and some full of numbers, like this one.

As I’m about to post our January 2021 results, which include a few terms, I thought it would be beneficial to explain an important one that we measure each month – the savings rate.

What is savings rate?

In simple terms, it is the part of your income that you do not spend.
It is usually shown as a percentage.

So the equation, in essence, is quite simple:
(income-expenses)/income

If you deduct your expenses from your income (as seen in the equation above, what you’re left with is your savings. Divide that by your income and you have your savings rate.

I don’t think you would write a separate post about this if it were that simple, would you?

Of course not! The way to calculate your savings rate is quite a sensitive topic in the FIRE (Financial Independence, Retire Early) community and every person calculates it differently.

Let’s dive deeper.

Why is it important?

The 3 keys to FI (Financial Independence) are:
– Earning more
– Spending less
– Maximising investment returns.

The savings rate covers 2 of those 3 keys: earning and spending.
As you earn more (without changing your expenses*), your savings rate will increase. The same happens with expenses but in the opposite direction- As you spend less (without changing your income), your savings rate will increase.

In addition, as opposed to the 3rd key, maximising investment returns, you have a lot more control over your earning and spending. So your savings rate is almost like a score on how well you’re doing in your journey to FI- the higher (as long as it’s sustainable**), the better.

How to calculate your savings rate

As you see in the equation, there are only 2 numbers we need: income and expenses.

In addition, you may have noticed that I don’t calculate savings directly. Instead, I calculate it as income minus expenses.

How do we calculate our savings rate?

Income

Some people use gross income (this is your salary before tax), mainly in the U.S. where it’s more common for you to pay your own taxes and it’s not always automatically deducted by your employer from your payslip.

Some people use net income (the amount that goes into your bank account, usually salary after taxes).

Income item number 1- Net income

I started with net income and then started adding items to it so it will be more accurate.

Income item number 2- Employer pension contribution

This is “free” money your employer gives you towards your pension. I treat this as an income item, which is also a savings item (this is not an expense).

Income item number 3- Employee pension contribution

This one will be a bit longer but it summarises a long thought process I went through when deciding if I should include this as an income item.

This is the part of your salary that you contribute towards your pension. Initially, I did not include this as an income because you’re the one paying it. However, after a deep review, I realised that excluding this item will be wrong and I’ll explain why:

Let’s take 2 imaginary people, they both have £1,200 of monthly expenses, they both earn £30,000 gross per year, and they both have a 5% employer pension contribution, this will be £125 a month calculated this way: £30,000*5%/12=£125.00 £125). However, Person 1 contributes 5% and Person 2 contributes 20%, that’s where they differ.

 Person 1Person 2Calculation
Annual gross income£30,000£30,000N/A, given
Employee annual pension contributions£1,500£6,000Gross income (£30,000) * contribution percentage
Taxable annual income£28,500£24,000Gross income – Employee annual pension contributions
Net annual income£23,020£19,960Used a calculator, see this one I created.
Monthly net income£1,918.33£1,663.33Net annual income / 12
Monthly net income calculation

Please notice that the Employer pension contribution isn’t included in the table above, because it does not affect the net income.

If we ignore Employee pension contributions we get these savings rates:


 
Person 1Person 2Calculation
Monthly net income£1,918.33£1,663.33From the table above
Employer pension contributions£125£125Gross income (£30,000) * contribution percentage / 12
Total income £2,043.33£1,788.33Sum of the 2 lines above
Expenses£1,200£1,200N/A, given
Savings£843.33£588.33Total income – Expenses
Savings rate41.27%32.90%Saving / Total income
Savings rate excluding Employee pension contributions

The issue: Did Person 1 really save more? The answer is obviously “no”.

They both have the same salary and they both spent the same, they should have, at least, the same savings rate (or Person 2 should be better off due to tax savings). The method above completely ignores the fact that Person 1 contributes 5%*£30,000/12=£125 each month while Person 2 contributes 20%*£30,000/12=£500 each month, which would clearly change the picture.

If we recalculate both of their savings rates we will get a much better picture:


 
Person 1Person 2Calculation
Monthly net income£1,918.33£1,663.33From the table above
Employer pension contributions£125£125Gross income (£30,000) * contribution percentage / 12
Employee pension contributions£125£500Gross income (£30,000) * contribution percentage / 12
Total income £2,168.33£2,288.33Sum of the 3 lines above
Expenses£1,200£1,200N/A, given
Savings£968.33£1,088.33Total income – Expenses
Savings rate44.66%47.56%Savings / Total income
Savings rate including Employee pension contributions

2 comments on the table above:
1. Although they both have the same gross salary and monthly expenses, person 2 ended up with a higher percentage rate because by increasing their pension contributions, they reduced their taxable income and therefore paid less tax, so the difference between 44.66% and 47.56% (2.9%) is all due to tax savings.
2. The table above assumes no tax is paid on pension, I will explain in the future why I ignore tax in my pension calculations.

Income item number 4- Other income

This can be the interest you earn on your savings, gifts, any benefits you get from the government (like child benefit), dividends you receive from your company, the rental income you receive from your properties, etc. As you can see this is a very general category and we each have different items that would go in here.

Income calculation= Net income (salary) + Employer pension contributions + Employee pension contributions + Other income

Savings every month to get closer to FI

Expenses

This part is pretty simple, it’s all the money that goes out of your bank account, credit card, and cash. I exclude any principal payments, which is the non-interest part of debt repayments (like student loans and mortgage). The reason I exclude the principal part of debt repayments is that they directly increase your net worth (your total assets minus your total liabilities) by decreasing your liabilities.

So does my whole debt payment count as savings?

Not exactly, the interest part should be treated as an expense and the principal part (the one that reduces your debt) should be treated as savings.

If you know the principal part- exclude that from your total expenses

If you only know your interest part- you can calculate the principal part in this way: total payment minus the interest part.

An example of principal payment:
Let’s say I have a £100,000 loan with a monthly interest rate of 0.2% and a £1,000 monthly payment. At the beginning of the month I owed £100,000 but then it accrued interest of £200 (£100,000 * 0.2%) so I now owe £100,200. Then I paid £1,000 to decrease my debt to £99,200.
Did you notice my debt only decreased by £800?
That because out of the £1,000 payment, £200 was the interest part (I include this part as an expense) and £800 was the principal part (I exclude this part from my expenses).

Expense calculation= Total expenses – principal part of debt repayment

Summary:
After you calculated your total income and expenses, the calculation is simple.
Step 1: Deduct your expenses from total income to get your savings.
Step 2: Divide your savings by your total income

An illustrative example (test yourself):

Lazy FI person has a net income of £3,000 a month and a gross annual income of £50,000. Lazy FI person contributes 5% of his annual income to pension and his employer contributes 7.5%. He has no other income

Lazy FI person’s monthly expenses are:
Mortgage: £1,000 (£300 is interest).
Groceries: £300
Transport: £120
Bills: £150
Holidays: £100
Going out and eating out: £80
Other expenses: £400

What is Lazy FI person’s saving rate?

Income:
Net income: £3,000
Employee pension contributions: £50,000*5%/12= £208.33
Employee pension contributions: £50,000*7.5%/12= £312.50
Total income: £3,520.83

Expenses:
Total expenses from the list above: £2,150.
However, we said that the principal part of debt (including mortgage) payments shouldn’t be an expense so we should deduct it.
As the total mortgage payment is £1,000 and the interest part is £300, this means that the principal part is £700 so we will deduct this from our total expenses.

Total expenses: £2,150- £700= £1,450

Saving rate

Saving: £3,520.83- £1,450= £2,070.83
Income: £3,520.83
Saving rate: £2.070.83 / £3,520.83 = 58.82%

“Do you really go through this lengthy manual calculation each month?”

Hell no! I’m lazy and hence hate working hard when unnecessary. I have an Excel that does all these calculations for me in less than a second, I set it up once and that’s it.

Now we know how to calculate our saving rate

What is the ideal saving rate?

There is no ideal savings rate, it is different for each person. The higher your saving rate is, the faster you can reach FI. However, you shouldn’t decrease your expenses to a level that makes you feel deprived or gets you to a lifestyle that is not sustainable.

That’s it, good luck calculating (and increasing) your savings rate!

*This is known as lifestyle inflation, where people increase their lifestyle along with pay raises and promotions. Avoiding this, which means keeping your lifestyle the same even though you earn more, is a huge step towards reaching FI.

**Of course, reaching 100% is not possible and you shouldn’t just aim for the highest savings rate. In my opinion, you should aim for the highest SUSTAINABLE savings rate. This means a level of savings rate where you enjoy your life, don’t feel deprived, and you can see yourself keeping this lifestyle in the long term.