Why Saving Is as Important as Earning and Investing
Personal finance is not always as easy as experts make it out to be. In fact, the process of building a financially sound future can be daunting. You have to start by establishing your current financial picture and then outlining your financial goals. Then comes the most difficult part: identifying the best way to reach these goals.
As we consider various options, the natural tendency is to assume that a high income or robust investment returns are the most meaningful factors to financial security. However, saving is a crucial and often undervalued — or worse, ignored — contributor to a strong financial future. Saving enables you to grow your nest egg with stability, assuming very little risk while taking advantage of the power of compounding. Your cash is put to work, earning passive income on its own.
Plus, it can be a lot easier, especially in the short-term, to commit to more aggressive money-saving habits than to simply increase your income. Depending on factors like your age and career path, you may not have much control over securing a higher salary, or have access to new income streams.
Now, maybe you’re already setting aside some of your income, but it’s different amounts each month. That’s a good start, but you will benefit from a more systematic approach.
How Much of Your Income Should You Save? What’s the Right Way to Decide?
One of the most popular and widely accepted practices for setting a savings target for yourself is the "50/30/20" rule.
What is the 50/30/20 rule? This method suggests that you divide the whole of your after-tax income into three parts: 50% is allocated for “needs,” 30% for “wants” and “financial goals” get the remaining 20%.
Your needs are items necessary for your survival, such as rent or mortgage payments, groceries, health care, utilities and other similar items. Your wants are things you would like but do not require to survive. Items that fall under the wants category include expenditures like vacations, entertainment (think movies and concerts), gym subscriptions and dining out. The easiest way to distinguish between your needs and wants is to question yourself every time you purchase something: are you buying this item because you cannot live without it, or simply because you like it?
Finally, the 20% allocated for your financial goals includes paying down debt as well as contributions to savings. That bucket might include college funds, savings and retirement accounts.
Why does this method work for people? It allows you to cover your essential costs, enjoy some leisure, and still pocket some savings.
Using the 50/30/20 rule is relatively simple. To apply the rule, first calculate your after-tax monthly income or that of your household collectively. This is your “take home” income. Ensure that you account for any deductions initiated in your workplaces, such as 401(k) contributions, workplace retirement funds, or discretionary bonuses. After determining your monthly income, calculate your spending allocations for each bracket and use these figures to set your monthly budgets.
For example, we can calculate how much a person living in the U.S. can save on average each month using the "50/30/20" rule. According to the U.S. Department of Labor, an American citizen's average monthly after-tax income is estimated to be $3,600. When we apply this framework, we get the following breakdown:
This means that if an American who earns the average income follows the "50/30/20" rule, their savings based on this calculation come to approximately $700 monthly, or $8,500 annually, assuming no debt payments. This value also does not account for how that growing stockpile of cash is managed. If it’s held in high-yield deposit accounts, earning interest on the balance, the value will grow incrementally on its own.
While this amounts to a sizable emergency stash, people have different financial needs and a 20% saving rate may not be feasible for everyone. For example, trimming your budget for needs to account for only 50% of your take home income may be challenging if you live in an expensive city or have high medical or child care costs.
You may be wondering: "If not 20%, then how much?" In that case, you can consider alternative personal budgeting practices, such as the "70/20/10" rule. Here, 70% of your income is allocated toward your needs and living expenses, 20% toward debt commitments, and the final 10% toward savings. However, it’s important to note that determining how much to save based on these rules is only one step on the path toward achieving your financial goals.
Which Budgeting Rule is Right for Me?
While a baseline savings rate of 20% is considered good practice, it’s also crucial to recognize the shortcomings of budgeting rules like "50/30/20". Besides the uncertainty inherent in categorizing items under these brackets, a major drawback of the rule lies in its limited potential for personalization.
It’s essential to tailor the rules to your needs before applying them to your budgeting plans. If you are a high-earner and have substantially lofty financial goals, like buying property in an expensive city, you may want to save a higher portion of your income.
For instance, the average price for a house in Boston was over $740,000 in June 2022. To buy a home in Boston, you would have to save roughly $89,000 in order to put down the average down payment amount of 12% of the purchase price. On the other hand, if you are a retiree without an active income, you may want to save much less than 20% given your need to allocate more toward your daily expenses. Tailoring the budget allocation rules lets you incorporate your current financial standing as well as your short-term and long-term financial goals.
Am I Saving Too Much?
It’s just as unwise to save too much as it is to save too little. If unspent income allows you to build a large cash reserve, that hardly seems like a problem. However, if you don’t manage that cash thoughtfully, it may result in missed opportunities. For instance, if your liquid cash has already reached six to nine months worth of essential expenses (“Needs”) — and that money is working to earn interest in a high-yield savings account or money market account — then you should consider putting additional cash into investments and/or deposit products that pay the highest interest, such as long-duration CDs.
Another sign you may be saving too much is if you are prioritizing saving over settling your debts. Although experts suggest having some savings before paying down debt, this amount can be modest. To avoid a debilitating debt pile-up that impacts your long-term financial security, it may be important to prioritize getting out of debt over allocating funds toward savings, especially if your debts are substantial.
Where Can I Save Every Month?
Raisin is an innovative platform that helps savers make intelligent decisions. Raisin gives you access to multiple saving products like money market deposit accounts and high-yield savings accounts at federally insured banks and credit unions through a simple, one-time registration on our platform. Our customers enjoy among the most competitive interest rates offered in the nation, and a hassle-free saving experience without the need to open and manage multiple accounts at multiple institutions or monitor several financial statements. Check out the current product offers here.