When it comes to financial freedom, one of the most important rules of thumb is to save money. Saving can help you plan for the future. But how do you know if you are saving enough? Here are 7 savings rules of thumb that can help you plan for your financial future:
1. Cash May Not Be King
While you want to use cash products in your portfolio for elements of liquidity and safety, it is important to realize that your returns on cash are likely to be lower than returns from other types of products. Some of your saving efforts, especially when it comes to retirement, should probably include stocks (funds can be a less risky choice than individual equities) and bonds, along with other investments if you have the risk tolerance for it.
2. Compound Interest Can Be Your Friend
We usually think of interest as the enemy. However, interest itself is not evil. Indeed, that same compound interest that is the scourge of those with high credit card balances can be quite helpful to the savvy saver. What matters is what end of the compound interest you are on. Compound interest is your friend if you are receiving a yield. When you set money aside in an interest bearing account, compound interest is working for you. The money you earn in interest is added to your balance, and soon you are earning interest on your interest yields. Make an effort to understand how this works, and then put your money to work for you.
3. The Earlier You Start, The Better
You’ve probably seen those figures that show you could bank hundreds of thousands of dollars more over your lifetime if you start saving for retirement at the age of 25, instead of the age of 35. The longer compound interest works for you, the more money you will have in the end. If you aren’t already saving, start today. Don’t wait. Every day you wait is one more day that you lose out on the effects of compound interest.
4. Rule of 72
This is one of the most basic rules related to how money goes. It provides a rough estimate of how long it will take your money to double. You divide 72 by your interest rate. If your rate is 3%, it will take 24 years (72/3) for your money to double. So, if you put in $10,000 and just let it sit there, in 24 years you will have around $20,000, and 24 years after that, you will have $40,000. If you end up with higher yields, your money will double faster, and your investments will grow faster, too, if you continue to add to your savings.
5. Set Aside 10% of Your Income
Conventional wisdom says that you should set aside 10% of your income for savings. Assuming a conservative return of 6% (assuming you include stock funds in your portfolio) if you set aside 10% of your income from age 18 to age 67, you should be able to live on your money indefinitely. You can use a compound interest calculator to help you work out how much you could save up if you put away 10% of your monthly income.
6. Estimate Inflation at 3% to 4%
Prices always go up. This means that your buying power goes down. Inflation erodes your real returns, and this can cause problems later on when you try to make your money last. When saving for the future, you need to consider inflation. Most rules of thumb suggest that you estimate inflation at 3% or 4%. If you estimate it at 4% you are more likely to be pleasantly surprised. Simplistically, if your savings yields 6% annual returns, but inflation is 4% a year, your real returns are closer to 2%. If the calculator you use doesn’t adjust for inflation, subtract it from your expected yields on your own. This means that if you want 6% real returns, your savings investments will need to yield between 9% and 10% annually. This is doable, but not if you are using cash. (If you are using cash as your only savings, you could end up with negative real returns.)
7. 20x Your Income to Live Comfortably in Retirement
One of the retirement savings rules of thumb that is rather common is that you will need 20x your annual income amassed in order to live indefinitely on your yields. This rule assumes that you continue to earn 9% a year, live off 5% and lose 4% to inflation. However, this rule applies to amassing a huge amount of money and then living off it with no additional income. Some experts suggest that you look for ways to cultivate different income streams so that your monthly expense needs are met in retirement, rather than relying a large lump sum.
Automate Your Savings
Instead of waiting to consciously put money into savings, many financial types suggest that you automate your savings. This takes the “pay yourself first” concept to the next level. You have money from your paycheck automatically deposited into a retirement account and/or a savings account – before it goes into your checking account. Or you set up an automatic transfer from your checking account so that 10% (or more) of your income is automatically put into your savings account and/or your retirement account. This way, it is done without you having to do it, and you learn to budget what you have after your saving is done, rather than simply putting in what is left after you’ve spent most of it.
Adjusting for Circumstance
Of course, it is important to remember that every situation is individual, and that you will need to adjust for your personal circumstances. Your savings needs may be higher than others’, or they may be lower. Rules of thumb should never be treated as the final word in money. However, they can provide useful guidance as you map out a savings plan that will lead to financial freedom.