Our last post talked about the different levels of the Financial Ladder. That information isn’t really helpful unless it is possible to move between the levels. Luckily for most people it IS possible, and this post gives a basic overview how.
Saving Money IS Possible
The most important step to saving money is to acknowledge saving money IS possible*, and whether or not I do so is my own choice. This isn’t always true - if my income was below the poverty level ($11,880 for a single person, $16,020 for a couple, and add about $4,140 for each person after that), I probably couldn’t save much money. Although even being at the poverty line doesn’t necessarily deter me - my brother had low enough expenses that he saved a couple thousand dollars the year he had below poverty-level wages working for a nonprofit. But I, like most people, have income higher than the poverty level, and therefore am able to save money.
Although starting at the poverty line sounds extreme, it is the right place to start because it puts all my other financial decisions into the correct context: an active choice I am making. Poverty-level spending is by definition enough to survive, and everything I choose to spend beyond that is an illustration of what is important to me. The question then becomes not whether I can save money, but whether saving money, moving up the financial ladder, and reaching my long-term goals are more or less important than what I am spending my money on now. At present, we choose to spend extra each month to rent a nice 1-bedroom apartment because it is near work (5-minute walk!) and has a pool, big windows, and a very pleasant courtyard. We could spend a few hundred dollars less if we lived much farther away from work or shared a place with strangers, but we decided that the expense was worthwhile to live in a place I like to call “The Resort”. We choose to buy some pretty nice ice cream and cookie-brownies from Aldi (great combo), but we certainly don’t need desserts and could choose to save that money. The companionship of our dog (and the costs of his food and vet visits) and the chance to visit friends and family regularly (and the airplane tickets) are also more important to us than being $3,500 or so closer per year to our long-term goals. However, we don’t value having a TV or a new car or bicycle (or new-ish either: our car is from 2001 and our bikes were forged before we were) so we won’t spend money on those.
Our spending is a choice, and how much we are saving at any given time is a choice. It might not always be easy or convenient, but it is not out of our control.
* I said most, not all people can save money - particular health problems, unemployment, or certain pre-existing circumstances can make saving impossible even in America - but don’t blindly assume you are one of the unlucky few for whom that is the case. Optimism is usually the reasonable, thoughtful, and logical approach.
Not Spending ≠ Not Happy
It is also important to note that spending less does NOT equal being less happy. I think this is often a false message that we are fed through advertising, marketing, and our communities. But, for most of us, our happiness is usually tied to the people in our lives, the places we are living, our passions, and the work we’re doing. So not spending is not likely to affect our happiness as much as we might think.
When I think about what we don’t spend money on, I don’t feel like we are greatly limiting ourselves by spending less than we could, but instead we are just choosing not to spend money on things that aren’t that important to us. We like eating out, but prefer to go to restaurants infrequently enough so that it feels special and fun rather than just a way to get food quickly. We would probably like living in a bigger or fancier house or apartment, but I don’t think it would really make us happier - after a while we would get used to it and we would be the same people with the same attitudes, feelings, worries, and moods we have now. When we lived in our previous home I’d sometimes like to get to work 15 minutes faster by driving instead of taking public transportation, but I knew the costs (and increased risk of traffic accidents) didn’t make it worth it most of the time. If we had more time to take vacations, we would be happy to spend more money on those, but most vacations we do take can be done pretty cheaply while still being a great time.
Another way to think about how spending does not necessarily make you happy is to remember your college experience. I had a great time in college and grad school. During both I lived off less than $15,000 or so a year and could afford to do just about everything I wanted to do except take long international vacations. Although I realize college was a different stage of life, but it doesn’t have to be that different when it comes to finances - I can still take several steps towards that lifestyle without giving anything truly meaningful up (for example, secondhand furniture doesn’t feel that different from new furniture, and is often just as sturdy and lovely). Lifestyle inflation (when your spending grows to meet your earning) isn’t a required part of life after college and it doesn’t always make us as happy as we think. When Kate and I got married I did a lot of research about really nice cooking pots, and we registered for my favorite set. I was excited about moving from my hodge-podge of college cooking gear to new fancy kitchen tools. For awhile I liked those pots, but after a few years I realized they weren’t quite what I wanted….. And now, five years later, we are busy streamlining and de-cluttering our kitchen and are really happy with our pots (one hand-me-down pot, two Christmas presents, and only two pots from that original set of six).
But Can I Actually Save Enough to Move Up the Financial Ladder?
Why yes, I can; if I decide to keep expenses modest, then my potentially radical savings rate could quickly bump me to the next level in the financial ladder. In 2015, Kate and I saved (well actually paid off debt, but that is functionally equivalent) her whole salary and lived off of mine. This allowed us to completely knock off all our student debt and move firmly into the Rung of Stability. I’m not trying to trumpet our success, but rather show that it is possible. We decided that getting out of debt was a worthwhile investment in our future, so we chose to take inexpensive vacations only to visit friends and family, not go out to eat more than a couple times a month, nor buy many clothes/shoes/tech devices/etc. We don’t make shockingly high salaries - in fact, last year we averaged less than the median income in 2014 for full-time US workers with at least a college education ($62,036), despite living in a very high cost-of-living area (DC). Even the median income for full-time workers without a high school diploma in 2014 was $23,912 (assuming 3 weeks not working each year), several thousand higher than our per-person expenses in DC. (The $23,912 per person doesn’t include taxes, but income taxes are minimal for someone with that level of income).
It’s not just us either. If our example seems unique or too dissimilar to your own situation, you should check out the annual expenses of these folks:
-a family of 5 in North Carolina ($32,000),
-a guy living outside San Francisco ($7,000),
-a family with 1 kid in Colorado ($24,000), and
-a couple living in Boston ($43,000), another high cost of living city.
(Do note that some of these folks have already paid off their houses, so some numbers don’t include a mortgage.) These people have a variety of lifestyles and spending patterns, but all have a couple things in common: they don’t spend much on transportation, utilities, shopping, and eating out. These are often four areas in which folks aren’t getting their money’s worth, but we’ll talk more in detail about how to save money later.
After Not Spending, What Next?
So I have decided to cut down on expenses and save a good bit of money, but what am I supposed to do with all of that money now?
Step 1: I think paying down high-interest debt should be the first priority; especially any debt with an interest rate higher than 6%. If you have a debt with an interest rate of 2 or 3% then it may make more sense to put extra money (anything above the minimal payment) into an investment fund (because the historical rate of return in the stock market is at least 7% and you’d be making money). But when your debt interest rate is 6% or higher the interest on the loan is growing at the same rate as your investments so you aren’t making any money (and you may be losing it if your debt interest rate is higher than 6%). So get rid of that high-interest debt!
Step 2: The next step is to enhance savings, by building up an emergency fund, obtaining insurances (if needed), and making sure you’re on track for retirement. These three areas each deserve their own detailed consideration, so I’ll discuss these aspects more in a future post.
Step 3: After all that is taken care of (and you are firmly in the Rung of Stability category), the next step is to invest. There are a variety of reasonable options for investments, but I advocate investing mostly in low-fee index funds (made of stocks) that cover the whole economy. In short, there are index funds out there that do a pretty good job of buying pieces of the whole U.S. and world economies. As a result, investing in these index funds are only as risky as the whole economy is - if the stock markets generally fall, these index funds will fall, but the money will only disappear if the whole world economy disappears (in which case I would have a bigger problem than what happened to my investments…). Index funds can be bought through normal taxable investment accounts, through IRA or Roth IRA accounts, and often through 401k accounts as well. I’ll explain more about how investments work in a later post, but if you want more information on this investing philosophy I highly recommend the Bogleheads website.
What Happens if I Save Money and Invest It?
You can move up the financial ladder surprisingly fast! The more money you save and invest, the faster your money accumulates.
This table shows approximately how many years you will need to work in order to advance to the Rung of Independence. It assumes you are starting with no savings or debt and will spend the same amount of money in retirement as you currently do. For example, if you save 10% of your annual salary, you will need to work 47 years until you will be financially independent and can retire. However, if you save 40% of your salary, you will need to work 22 years.
How Savings Rate Affects Working Years Until the Rung of Independence
I think this table illustrates a few facts really well. Most importantly, your savings rate is the most important factor in advancing rungs on the financial ladder. A large income is only helpful in that it makes it easier to have a high savings rate. If Person A makes 50K and spends 25K a year, they have a 50% savings rate. If Person B makes 80K and spends 60K, they have a 25% savings rate. Even though Person A makes much less than Person B, they will advance to the Rung of Independence almost twice as fast as Person B! The math also shows that it is surprisingly simple to retire by age 40 if you start working in your early 20s. If you save half of your salary (or get married and save one spouse’s salary), you will be financially independent in 16.5 years. Lastly, at the low end of the savings rates, a few percentage changes in your savings rate makes a BIG difference. Simply moving from a 5% savings rate to a 10% savings rate allows you to retire eight years earlier. For most people, that is eight years of freedom for saving just a few thousand dollars a year!
Climbing the Financial Ladder - Hypothetical Examples
For fun, I’ve created a few sample tables of different possibilities for moving up the rungs of the financial ladder. Notice how it takes a few years for things to get going, but each additional (optional) year working past the Rung of Financial Independence really balloons the amount of wealth you have available to help good causes.
The assumptions for these tables include: historical averages of 10% rate of return, 3% inflation rate, 4% safe withdrawal rate, and that neither income nor expenses change over time (which obviously is false, but for most people income rises as fast or faster than expenses over time). Please note that ‘Real Value at Year-End’ means that this is the value in today’s dollars, after the effects of inflation have been eliminated. 'Annual Investment Income' represents the amount of income that can be safely drawn from the investments to fund one's lifestyle without fear of ever completely using up those investments.
The years in which the individuals reach the next rung of the Financial Ladder are highlighted with the following colors:
Yellow – Rung of Stability
Orange – Rung of Flexibility
Red – Rung of Freedom
Green – Rung of Independence
Purple – Rung of Surplus
Mr. Average Saver - SAVINGS: $10,000 ANNUAL INCOME: $60,000 ANNUAL EXPENSES: $54,000
Mr. Average Saver seems to be doing well at first glance by starting with $10,000 in the bank and following conventional advice of saving 10% of their income. However, you can see that actually doesn’t produce great results; it is 6 years before he even reaches the Rung of Stability and 12 years before the Rung of Flexibility. It is a full 45 years before he reaches Financial Independence and can retire, which means he is at least 65 if not much older.
Ms. Poor But Thrifty's - STARTING DEBT: $10,000 ANNUAL INCOME: $55,000 ANNUAL EXPENSES: $24,750
Ms. Poor But Thrifty doesn’t seem to be doing that well at first glance; she starts with $10,000 in debt and has a lower income than the other two examples here. However, she succeeds where it counts by having annual expenses a touch under $25K (still considerably above the poverty line and about what Kate and I spent in grad school) and therefore a savings rate of 55%. By doing so, Ms. Poor But Thrifty skips straight past the Rung of Stability to the Rung of Flexibility within two years, and ends up racing to the Rung of Independence (and never needing to work again) in 15 years. If she works for 20 years, she will probably want to set up a charitable foundation to give away all the excess money she won’t know what to do with.
Mr. High Earner: SAVINGS: $20,000 ANNUAL INCOME: $110,000 ANNUAL EXPENSES: $66,000
Mr. High Earner has the best starting position of the three examples with $20,000 in the bank and a nice income of $110,000. However, his savings rate is only decent at 40%, with $66,000 worth of annual expenses. He reaches the Rung of Stability and Rung of Flexibility quite quickly, but needs 12 more years to get to the Rung of Freedom and 21 years to the Rung of Independence. The one spot where he does shine is the amount of money he could choose to give to charity if he aimed for that: a standard 40-year career would result in nearly $200,000 being available annually for charitable giving. That kind of money is enough to make a substantial impact on many peoples’ lives.
What are your goals for moving up the financial ladder? Could you save more than you are currently spending? What is your target savings rate?