In Part 1 of this post (What are Savings?), we discussed a few principles around saving, including considering why it is important, what it is and is not, as well as how to arrange your savings in different buckets. In this post, we explain how to approach increasing your savings to our recommended target of 33% of your after-tax income. (Learn more in: Creating Your Budget (33/33/33).)
Don’t be discouraged
If you are currently saving around 5% of your after-tax income, it’s easy for advice like “you should save 33%” to be discouraging. It may seem nearly impossible to move from 5% to 33%. The first thing is do not give up. 33% is your TARGET level of savings and getting to 33% takes time because it often means you need to rebalance your lifestyle.
You do not need to get to 33% tomorrow, you just need to commit to the idea and start taking steps towards it by gradually increasing your savings velocity. This means, just continuously try to make small increases in the percentage of your after-tax income that you save, and over time these increases will snowball. Just don’t accept the status quo as all you can do.
Let’s see how you can approach it using a hypothetical scenario. You make $5,000 a month after tax. Your expenses plus loan payments are $4,750. You try to save $250 a month (5% of your after-tax income). We’ll also assume you have some debt and very little real savings.
Like most projects, there are steps you can take immediately, in the short term, and the medium term. It is difficult to be more precise about the time frame for short and medium term because it really depends on individual circumstances. So, short term for one person could be 6 months, but for another it could be a year or more.
Once you are in a situation of having just a small amount of savings, you are vulnerable to unexpected expensive events; therefore, the most important first step is to Build an Emergency Fund by aiming to save about three months of expenses as soon as possible. Over time you could try to increase it to six months, but this is not the primary objective. If three months seems difficult to achieve, start small by aiming for one month. Just start saving something; it is better than nothing.
The only realistic way to do this quickly, is to slash your discretionary expenses by temporarily eliminating most wants and focusing on your needs alone. This would take a couple months of real sacrifice (no liming, drinking, eating out, etc). Commit and just do it.
So instead of spending $4,750 a month, let’s say you realize that you can eliminate several wants and your basic needs cost $4,000 instead. This means you should try to save an Emergency Fund of three months expenses ($4,000 x 3) $12,000, but as we said, at least start with one month and increase from there.
Put the card away, far away, give it to someone you trust to hold for you, whatever you need to do. Just stop adding to the debt with new purchases. You have to adopt an all-cash lifestyle for a while, until you reach the medium-term steps.
If you have a lot of debt, another way you can try to accumulate cash is by going to your lender and asking them to extend your loan over a longer period of time. If you are in good standing, this should be possible. Just ensure you save whatever you reduced your loan by.
This is important. When you complete the actions above i.e. starting a small Emergency Fund and stop using your credit card, please take a moment to celebrate. These are huge steps forward. Just don’t celebrate by using your credit card to buy something!
Once you have an Emergency Fund in place (even if one month of expenses), you can start to sleep better because you know if something bad happens, at least you have some money set aside to meet the expense. This allows you to focus on the next action: tackle your debt.
Do the following:
- Gather the current balance on all your loans. If you have a mortgage, just ignore it for now and focus on all other loans. We’ll come back to mortgages.
- List all loans from smallest to largest.
- Find out which you can repay early.
- If you have credit card debt, you MUST focus on repaying this FIRST.
- After repaying credit card debt, then start paying down your other loans, starting with the smallest one. You’ll feel great when you start knocking them off one-by-one.
Depending on the size of your loans (excluding mortgages) you may take a while to pay them off. That’s fine. Just keep paying down all your surplus funds each month on them, one loan at a time. Don’t put a little money on each loan. Focus on only one loan and fully repay it. Then move on to the next loan. Remember, ALWAYS start with any credit card debt. (Learn more about credit card debt: Understanding Credit Card Debt.)
You do not need to worry about any other type of savings at this point, except trying to build your Emergency Fund, if it’s too low (remember try to get to three months of expenses, and later on, build to six if you want to be truly secure). Forget retirement, forget deposit for house, investing, etc. Just focus on repaying your debt.
Going back to our example, let’s assume after the Immediate steps above, you have a current Emergency Fund of $4,500. So your monthly surplus funds are ($5,000 income less $4,000 expenses) $1,000.
You are trying to target at least three months of expenses for your Emergency Fund ($4,000 x 3) $12,000. So every month, just keep adding a little to your Fund e.g. $250 and use all the rest ($1,000 less $250) $750 to pay down one of your loans.
This is important. When you pay-off your credit card, or your first loan if you don’t have credit card debt, make sure and celebrate. You could probably cut yourself a little slack by not sacrificing as much e.g. if you enjoyed liming on Fridays, then start back doing it once a month, as a reward.
Just don’t go overboard. Spend a little on yourself, but not a lot. And don’t use your credit card!
By reducing your expenses and reducing your debt, you would realize you now have more surplus money each month, and if you check, you’ll probably realize your surplus funds are now 10% to 15% of your after-tax income, compared to the 5% you started with. Little-by-little your savings velocity is increasing and building to something fantastic…
After following the Immediate and Short-term steps, you might have stabilized your monthly surplus funds at around 15% of your after-tax income. Remember, you are trying to get to 33%, so just focus on achieving 5% increases at a time.
The reality is though, at this point, continued expense reductions by sacrificing becomes tiresome. You need to start living a little! The only real way to make additional or sustained expense reductions is to make some lifestyle choices. Check out this section of the website Reduce Your Expenses for more information on what this means.
But apart from making these lifestyle choices, in order to move from 15% surplus funds to 33%, you really need to start focusing on your income and take these actions:
- Save all future income e.g. salary increases. This means if you get a salary increase, or any additional income in the future, do not spend it. Instead pretend you never received it and save it fully.
- If you receive any lump-sum income (e.g. bonuses etc), save the majority e.g. 90% and spend 10%.
- Invest in yourself by getting more qualified, which usually means a greater chance to earn more in the future.
Once you are close to 33% you could start to allocate your savings in 3 buckets we described in What are Savings?.
- Repay the rest of your debt. Usually what is left by this point would be your mortgage (or possibly car loan). Remember, as soon as this is extinguished you can fully allocate this amount to other long-term goals. Don’t be shy to allocate as much as you can to repay debt because this is usually the most important action you can take in building personal wealth, unless you can invest your surplus cash to earn more than the interest rate you pay on your mortgage. Learn more in Be Uncomfortable With Debt.
- Save for long-term goals (buying a home if you do not already have a mortgage, a wedding, your own or children’s education)
- Save for retirement, which should be invested and never touched.
Keeping more of your money is critical to achieving Financial Freedom, and we hope you now realize that getting to a 33% savings level is possible, but it requires effort and commitment. The approach taken would depend on personal circumstances, but generally we expect the building blocks described above to be unchanged, but each person may spend more or less time on a specific step/action.
The last point to note is, while we have been discussing everything in this post in monthly terms, if you check out the post How to Create a Personal Budget, you’ll notice we strongly recommend (can we say insist?) that you always consider your finances in twelve-month terms (January to December) e.g. what are your annual savings. Please read that post to understand why.
Good luck and we’d love to hear your thoughts and experiences in the comments below!