Calculating, following and optimizing your savings rate is important if you are pursuing financial independence and early retirement.
For me, the savings rate is the most important metric, and I track it religiously every month to see how I am progressing on my FIRE journey.
In the past few months, I have been getting one question more than others: “How do you calculate your savings rate – what is included/excluded?”
This is a question that often yields different answers and people in the personal finance sphere have very strong opinions about it. Of course, I also have a certain way I like to do it.
If you want the short answer on how to calculate your savings rate, I’ll give it to you here:
(Income – Expenses) / Income
That is the basic formula, and this is the right way to do it, but then the questions are:
What income?
Which expenses?
If you are curious, I’ll give you my take on four ways to calculate savings rates.
What should be included in your savings rate calculation
Before we start off, I’ll show you an illustration of my personal finances from December 2017. It contains all elements necessary to calculate the four different savings rates:
The elements needed to calculate your savings rate(s) are:
- Total income: Your gross salary including tips, bonus etc. and pension before taxes
- Pension: Includes HSA, 401k pre-tax contributions and employer matches/contributions and similar
- Taxes: Taxes paid on your gross salary (pension is usually not taxable at the time of deposit) – remember, I live in Denmark, and taxes here are pretty high
- Net income: The amount that hits your bank account when you receive your salary (your take-home income)
- Recurring expenses: All expenses that you have to pay every month such as mortgage, other debt payments, food, subscriptions etc.
- Other living expenses: For me, this includes restaurant and bar visits, clothes etc. (but as long as you have all your expenses in this or the recurring expense category, you’ll be fine)
- Cash savings: The amount you have left at your account for your disposal by the end of the month after incurring all expenses
- Home loan principal payments: The principal payments in your mortgage – this does NOT include your interest payments
- Home equity and cash savings: Cash savings and home loan principal payments combined
Now that you know what elements are needed to calculate your savings rate, let’s have a look at the different ways it can be done.
The four different ways to calculate good savings rates
As I told you, there’s plenty of ways to calculate savings rates. I’ll show you four ways that I consider acceptable (the names of them are self-invented FYI).
Savings rate 1: The all-inclusive savings rate
The first savings rate takes most elements into account and will usually yield the highest savings rate. It is calculated like this:
(Pension + Home equity and cash savings) / (Total income – Taxes)
Using my income and expenses from the example above, I would have had a savings rate of:
(6 + 14) / (67 – 29) = 53 %
People using this savings rate would argue that you should include all of your income as part of the savings rate. They would say that all income will be used to support you in the future and therefore you should track it all.
Savings rate 2: The less liquid savings rate
The less liquid savings rate does not take home equity into account, but otherwise it is similar to the first savings rate:
(Pension + Cash savings) / (Total income – Taxes)
Using this savings rate method, I would have had a savings rate of:
(6 + 10) / (67 – 29) = 42 %
People using this savings rate would argue that you should include pension since you will depend on this amount later in life and it will be part of the net worth that will support you through your life.
They would argue that you should not include home equity because you often buy a house to stay there in the long run, and since people rarely downsize when changing houses, the home equity would always be “locked” in the house and never be possible to use to cover your expenses.
Savings rate 3: The more liquid savings rate
The more liquid savings rate does not include pension, but it does include home equity:
(Home equity and cash savings) / (Net income)
Note that we now use “net income” as the denominator and not “total income” minus “taxes”. This is because we do not include pension in the numerator anymore, therefore we do not need to include it in the denominator.
Using the more liquid savings rate, I would have had a savings rate of:
(14) / (32) = 44 %
People using this savings rate would argue that home equity must be included since it is considered savings in your house. It is a relatively liquid investment in an asset – just like stocks or bonds. Home equity is not as liquid as cash or stock investments, but if you really need the money, you could sell your home and rent a place or buy a smaller, less expensive house to realize the savings (and potential gains/losses).
They would argue that pension should not be included because it is very illiquid and you cannot get access to it before you are 60+ years old. It might come in handy at that point in time, but it is not something you can expect will cover your expenses in the next many years to come.
Savings rate 4: The stripped savings rate
The stripped savings rate does not include pension or home equity. It only includes your cash savings:
(Cash savings) / (Net income)
This is the savings rate that gives the lowest rate:
(10) / (32) = 31 %
People using this savings rate argue that the only things you should use in your savings rate calculations are highly liquid assets. They argue that you should not include pension because you will not see that money for a long time. They also argue that home equity is illiquid and will never turn into actual money on your bank account. Therefore, they only focus on the actual cash savings in a given month. This means the cash that is still on your bank account at the end of the month – against the net income you had on your account at the beginning of the month.
The best savings rate – in my humble opinion
As you can see, the different savings rates varied with more than 20 percentage points (from 31% to 53%), so it does make sense to choose a specific savings rate calculation and stick to it.
I spent a lot of time considering which savings rate I should choose. For me, the choice was between savings rate 3 (including home equity) or savings rate 4 (only cash savings). I do not consider pension a valid part of my savings rate or net worth, but for some people it might make sense. I am going to retire when I am 33 years old, so it will be a long time before I see that money. I consider pension to be a nice payout once I get old, but I will not let my FI journey depend on it.
In the end, I decided to use savings rate 3: the more liquid savings rate.
I have decided to include home equity because I expect to sell my house in the future and either rent a place or downsize. Therefore, I expect to get access to the savings in the foreseeable future. Also, I believe that home equity is liquid enough to consider it part of my net worth. I view my house as just another asset that I can sell at market value any time. Just like any other asset, it has risks, holding costs and transaction fees, but the money is still relatively accessible.
A technicality: I use “home equity” to describe the difference between my remaining mortgage principal payments and the purchasing price I paid for the house. Some people use the market value instead of the purchasing price, but for me that is too much work, and the uncertainty is too big. Also, the potential appreciation/depreciation on the price of my house do not reflect my ability to save, so it would make my savings rate less useful.
In the end, there’s many ways to calculate your savings rate. It is not important whether you use one method or another. The most important is that you are consistent in tracking the same savings rate. This way, you’ll be able to get good insights on your savings performance. For me, it is an excellent tool to keep myself focused on the goal of achieving financial independence.
No matter what savings rate you use, I recommend that you use the following principles.
General principles to calculate your savings rate correctly
There’s a few principles you should follow to make sure you don’t calculate an incorrect and misleading savings rate:
- The numerator should always be in the denominator: If you include a number in the numerator of your savings rate, it should always be included in the denominator to get a correct savings rate.
- Don’t use gross income: There’s no need to include anything in your savings rate that will not hit your bank account. If you have to use gross income for some reason make sure to subtract e.g. taxes.
- Don’t include savings that are highly illiquid: This is a principle I follow because I base my financial independence calculations on the savings rate. If you can’t get access to the money relatively easily, you can’t expect the money to help you out if you need it.
- Don’t include capital income: I don’t think you should include any income/savings that are dependent on market returns. First of all, it does not reflect your ability to save and makes the savings rate less useful. Also, it might make your savings rate exceed 100% if you use your net income as denominator. Instead, I highly recommend tracking your investment returns separately.
- Track your expenses and savings: Without having a good method to track and compare your expenses and savings on a monthly basis, your savings rate will not be insightful. Make sure to have a good overview of your expenses and savings, so you can calculate a correct savings rate each month.
I love tracking my savings rate, and I hope you find it as useful as I do. I am dying to hear how you calculate your savings rate and what you think about mine, so please let me know in the comments!