We are sure everyone intuitively recognizes the need to keep a portion of their income for various purposes, but we would understand if you struggle to decide how much to save and what it should be used for.
The purpose of this post is to discuss a few principles around saving: Part 1 will address why saving is important, what is and is not, and in Part 2, we’ll talk about how you could approach increasing your savings.
Most of us work on average 22 days a month (or more) to earn our income, but how much of the remaining 9 days do you really dedicate to your financial affairs? We bet the answer is very little or none. Imagine, so much time to create income but so little time spent to try to keep it or learn about money matters. Surely you agree this can’t make sense. Keeping your money is just as important as earning it, but keeping it also takes effort.
Target savings level
It’s worth reminding you that we recommend your savings target should be 33% of your after-tax income. We discussed this in the post Creating your Budget (33/33/33), which is quickly summarized in the box to the right. If it does not sound familiar, you’ll probably have to read the linked post, so you can understand properly.
If at first glance saving 33% of your take-home pay seems difficult to achieve, don’t worry, we discuss this in part two of this article. For now, just remember 33% is a target and your budget is your tool to help reach the target.
In the meantime, let’s continue.
Why is saving important?
While saving appears to be a short-term action, it should be viewed as part of a larger plan. Each month adds up to a year of savings, and each year then adds up over time. You use these accumulated savings to meet your medium-term goals or invest it to grow for your long-term goals. Medium-term goals could include saving for a deposit on a home or a car, your wedding, higher education, or for some other dream. Long-term goals could include children’s education or your retirement.
While you may think an irrational purchase now or even indiscipline with your spending only has a short-term impact, it paints a different picture if you think it was money you could have saved this month, which could have then been accumulated and invested to meet your goals. For context, every $1 saved today and continuously invested at 4% will become $2 (i.e. double) in around 17 and a half years.
The bottom line is your current spending decisions have a tremendous impact on your ability to meet your future goals and ultimately, your Financial Freedom.
What is not part of your savings?
We are sure most persons understand why saving is important, although they may not necessarily think about the longer-term impact of a bad spending decision today. But do you understand what your savings actually are?
Firstly, let’s start off by discussing what they are NOT. Have you ever heard someone say they are saving for a vacation, for Christmas presents, to buy a phone, their Carnival costume, or children’s school supplies, etc.? Well, we probably need to find a new way to describe these actions because these funds you accumulate are not part of your savings. Put another way, yes, you are saving for the item by setting aside money over a few months to gather the amount needed. But these funds are for a current expense (usually a want), so they are not part of funds you can designate as part of your savings pool.
This distinction is important because it is easy to mislead yourself by thinking you are saving a lot and then be disenchanted when you don’t see a growing bank account.
In the context of your budget, these items need to be included as part of your monthly expenses. If you use the Cari$ Sample Budget, you would include these items as either fixed or discretionary expenses (discretionary most likely, for the number of months you need to gather the funds). Just make sure you set it aside i.e. do not spend it on anything else. (See “Maintain order” below.)
What then are real savings?
Real savings are supposed to be for your medium to long-term benefit, and are what is left over after all your fixed and discretionary expenses. So, if you include the examples we gave above (vacation, phone, Carnival costume, etc.) as expenses in your budget, your true savings are what is left after deducting these from your income.
Your Emergency Fund is also not real savings, as you know these funds will be spent when the next unidentified unfavourable event happens.
As mentioned earlier, our 33/33/33 approach recommends your target real savings level to be 33% of your after-tax income. When you can save this amount consistently each year, you would be accumulating enough funds to meet the following objectives:
- Repay debt. Check out the “Be Debt Free” rule in the post Cari$ Rules for Financial Freedom.
- Medium-term goals (e.g. house deposit)
- Long-term goals (e.g. retirement)
Although your personal circumstances will determine how much you allocate to each component, we believe the best way to grow your personal wealth is to repay your debt as soon as possible, which will leave more free cash to allocate to objectives 2 and 3.
Ok, let’s summarize. Do not think of your savings as one pot; this is misleading. Instead, you should separately identify a few buckets:
- Funds being gathered for a short-term expense (e.g. vacation).
- Emergency Fund. Please don’t mix this up with your long-term funds. This is for your short-term peace of mind. Put it out of sight. Check out the post Build an Emergency Fund.
- Real savings. While this could be used for three purposes (repay debt, etc.), we don’t insist that you keep the parts separate, although it is good practice. These are collectively directed to building your wealth, so there is a common objective. Note, saving for your children’s education does not necessarily build your own wealth, but if you are short of funds for retirement, you can always let them take a student loan instead. They can borrow for education, but you can’t borrow to fund your retirement!
You might have all your surplus funds lumped together in one place, but as we explained, this could easily mislead you, so you should clearly separate true savings from other funds to help keep things in order.
We recommend using a main bank account for day-to-day payments, which you can also use to hold the funds you are setting aside for an upcoming purchase (a chequing account is usually best). Put your Emergency Fund somewhere safe and slightly inaccessible. Keep your genuine savings in a different account (the most common being a Unit Trust account, high-interest bank account, credit union deposit, etc.) where it can accumulate until you have gathered enough funds to pay down debt or to invest.
If you had any doubt about what are true savings and why you should focus on growing yours, we hope this article helped. In Part 2, we’ll look at the steps you can take to move from currently saving a low percentage of your take-home pay to our recommended 33%. [Update] Check out the post How to Approach Saving 33% to learn more.
We look forward to your thoughts or questions in the comments below!