Let’s get straight into some math, your savings rate is defined by this equation:
So for a couple with take home incomes of $60,000 and $20,000 after tax and a cost of living of $40,000 their savings rate will be:
When it comes to the how long it’ll take you to achieve financial freedom, it’s all about your savings rate. Because compound interest, as awesome as it is, takes a while to have a significant effect, in the short term your savings rate is actually far more important that your rate of investment returns. Check out this table that shows the percentage of investment returns vs total investment fund value for 20 years. The portfolio is modelled on a household with a take home income of $80,000 p.a. with a cost of living of $40,000 and an expected portfolio return of 7%.
You’ll notice that during the 5th year their portfolio increased by $52,432 but over 3 quarters of this is accounted for by the $40,000 contribution that they made from their own savings. In fact it’ll take a little under 12 years before the market driven gains become greater than the $40,000 household contribution.
Another interesting fact is the relationship between your savings rate and your time taken to retire is that the amount earned does not matter – the most important factor is the savings rate. Don’t believe me? Check out this example of 2 households with the same savings rate (50%) but one household having a take home income of $450,000 and the other with $50,000. What we can see is that the household with higher income, and higher expenses needs a portfolio 9 times the size of the household on lower income, which given the same portfolio returns and savings rate results in 18 years to satisfy the 4% rule.
For me this is hugely motivating, what this means is that as long as you can control your expenses relative to your income you will be able achieve financial freedom. The other cool thing about it is that you have more control over your cost of living than income and investment returns.
Here at the FFE household we save between 50% and 60% of our take home income, outside of superannuation. Now many people may wonder how this is possible, or simply dismiss it as something that they can’t do. But I’ll reiterate this now that it is totally achievable and I’m going to share some of my tips on how to do it in the coming posts. First tip: it’s mostly about psychology.
Once again it doesn’t matter if you’re on 50 thousand or 500 thousand; you have to take charge of your own journey. Your savings rate that’s going to determine how fast you can reach your freedom and it’s also the factor that you have the most control over.
Engineer you freedom