I have to say that there are some really strange ideas out there about savings. The math of savings is really simple but people tend to complicate it, mostly to feel better about themselves and how much they think they’re saving.
The very simple math of savings is:
Total income — total expenses = savings
(savings/total income)*100 = savings rate
Some people will say that they figure their savings rate based on after tax income. At best this will result in a similar savings rate as including taxes but will over complicate the formula. At worst it will lead to an inaccurate figure. Why ignore a major expense?
Taxes are an expense, and like many expenses, they’re variable and can be reduced through proper planning. Taxes can also sometimes be higher than normal through certain circumstances such as capital gains or the sale of a business.
Figuring your savings rate on after tax income is a lie, a cheat, a way to make yourself feel better about something rather than facing the true cost.
The most egregious abuse of the savings rate calculation is including mortgage principal repayment as savings. This is a loan, an obligation you have to repay a large amount of money that was lent to you. The fact that some of it is principal doesn’t change the fact that it is a loan.
It’s important to understand the difference between liability reduction and savings. Yes, the principal portion reduces your liability but the liability, an amount you owe for something you got in exchange, remains.
If I take a loan on a car is the principal amount savings? Of course not, so why would it be for a house?
One argument is that a house is an appreciating asset but there is no guarantee of that and the bursting of the housing bubble in 2008 should prove that once and for all. But even if you assume that the house will appreciate, and it does, that doesn’t mean that the payment, the money you owed the bank, is savings.
Tell the bank that you’ll only send the interest payment since the principal is really only savings anyway and see what they say.
Keep the math simple and work on the areas you can control, like your spending, to increase your savings rate rather than using tricks to make yourself think you’re saving more than you really are.
Using my simple formula from above, in 2016 I had a savings rate of 31.44%.
136,384.48–93,507.80 = 42,876.68 savings
42,876.68 / 136,384.48 = 0.3144
0.3144 * 100 = 31.44%
If I ignored taxes then my savings rate would have been 40.35% but, oops I used gross income instead of net, a common but inexcusable mistake people make which boosts their savings and makes them look even better.
136,384.48–81,352.16 (total expenses except taxes) = 55,032.32
55,032.32 / 136,384.48 = 0.4035
0.4035 * 100 = 40.35%
Using the correct formula I would still have an inaccurate savings rate of 34.51%.
124,228.84 (gross income minus taxes)–81,352.16 (total expenses except taxes) = 42,876.68
42,876.68 / 124,228.84 = 0.3451
If I also included my mortgage principal payments as savings then I would have had a savings rate of 44.03%. The last number looks great but it’s a lie. The fact is that I only truly saved 31.44%, the original formula from above.
Since I track all income and all expenses, I can see complete and accurate numbers on any expense category I want. Taxes? I spent only 8.91% on federal taxes and 17.95% on all taxes. My mortgage, the full principal, interest, taxes and insurance (PITI) was just 12.72% of my gross income that year.
There is a lot of good advice out there and there is plenty of really bad advice as well. Remember that simple, and honest, is always better.