What if I told you that employing one simple financial approach could set you on a path to achieving all of your money goals? Would you want to know what it is? Well, in this article, I will share with you the 40% rule and will explain how you can use it to improve your own financial position!
I don’t care what type of financial education you received while growing up, at some point in your life you became aware of the fact that it’s good to save money. Sure, you may not even have been told why it’s important to do so but you heard the phrase and hopefully it still resides somewhere in your brain because it’s sound financial advice.
Now, knowing something and acting on it are two different things. This is why, as of 2019, 21% of Americans saved absolutely none of their annual income with 69% of them saving less than 10% of their total earnings. Needless to say that for many, saving isn’t something they’re succeeding at. Now, I don’t want to judge because people’s inability to save can boil down to many reasons. First, their income may simply be too low to even cover the basic life expenses which offers them no opportunity to save. However, there are other groups of people earning moderate to high incomes that still fail to put money away which is also a financial position you want to avoid if you can.
Of course, as I just mentioned, 21% of Americans aren’t saving money year over year but the good news is that this means the majority of people are saving at least some amount of money. However, this begs the question of just how much they are stashing away. You see, for many people, saving any amount of money is a win. As I just mentioned, not everyone is making enough to save a significant amount of cash every month. However, there are others that simply have no idea what a good savings percentage is.
One very broadly spread piece of savings advice comes from the classic novel “The Richest Man In Babylon” which states that the first cure for a lean purse is “Start Thy Purse Fattening”. In English, this means pay yourself first and in the book, the main character Akkad, was taught to save 1 coin for every 10 earned. Therefore, if you were ever wondering where the advice of paying yourself 10% every month came from, well now you know!
Now, as much as I think that advice like “save 10% of your income” is good advice, there are some definite flaws that I feel compelled to point out. For starters, sure, you’re now saving 10% of your income which for many people is 10% more than they originally were. However, the real question is what to do with that money once you’ve saved it. Sadly, many people lack the financial knowledge that’s required to use this money effectively which in a way makes this advice relatively useless.
For instance, stashing away 10% of your income is great if you then use it to prop up your emergency fund or invest it in appreciating assets but when left in a savings account making next to no interest, you aren’t doing yourself much of a favour. Again, sure it’s better than spending it on things you don’t need but if you’re reading this article, I’d hope that you have more aspirations than simply just getting by.
Unfortunately, this is not the only beef I have with the 10% savings rule. The second problem with this rule is that it makes you feel like you’re doing a lot more for your financial well-being than you actually are. Telling yourself that you’re doing great saving 10% of your income is actually detrimental to your financial success. And why is this? Well, I hate to say it, but this is not a high enough savings percentage for you to make noticeable progress in your financial life. Let me give you an example to illustrate what I mean.
Let’s say you’re making $3,000 a month. Following the generic 10% savings rule, you would be saving $300 a month or $3,600 a year. For many, this is a huge step in the right direction, especially if you make up that 21% of Americans not saving any money whatsoever. However, what you must realize is that even with this money set aside, you’re just one event away from saving nothing in the year. Let me explain. Let’s say that you come home one winter day and your house is freezing cold. You go check your furnace and it’s busted. Well, there goes your $3,600 that you’ve been saving all year to accrue. I hope you’re seeing that saving just 10% of your income doesn’t quite give you the financial leeway you need to make significant strides in your financial life.
This is where the 40% rule comes in. As you probably guessed, the 40% rule involves saving 40% of your gross income. Now, if even the thought of saving 10% of your gross income seems like a battle then I sympathize with you. Saving money isn’t easy, even for those making all the efforts they can to pad their bank accounts. However, striving to hit this level of savings is crucial for your financial progression. Let me share with you some reasons why you must strive to implement this money rule.
First, saving 40% actually allows you to save money. What do I mean by this? Well, in the 10% saving example I just gave, you saw that this small of a savings percentage doesn’t leave you with enough money to actually cover unforeseen expenses. Let’s use the same figures while employing the 40% rule. If you earned $3,000 a month and saved 40%, you would be saving $1,200 a month or $14,400 a year. With this amount of savings, you can handle most unforeseen events and still see your net worth rise every year.
Next, having more money set aside allows you to have more financial security. This means that you can take more risks in your career, business ventures etc. because if have something to fall back on if things go sour.
Finally, implementing the 40% rule forces you to get serious about your money and go outside your comfort zone. For most people, saving this large of a percentage will force them to make lifestyle changes. This could mean selling off their car and taking the bus or downsizing their living space. If you look at those who become rich, they are always pushing themselves to grow and this is one ways the 40% rule helps you not only grow your money but yourself as a person.
Now, beyond just informing you as to how much money you should be setting aside every month, the 40% rule goes one step further and tells you how you should be using that money. Once you have your savings system in place, you should be moving those savings into a moderate risk investments. You see, rather than letting your money erode to inflation in a savings account which is what many people following the 10% rule do, you are instead allowing your money to grow. With the growth of this money, you can then allow it to continue to appreciate over time or use those funds to start other profitable ventures.
As I’ve already mentioned in this article, getting to a 40% savings rate is not the easiest of financial feats which is why I now want to share with you some practical strategies you can employ to do just that!
When it comes down to it, there are only two ways to achieve a 40% savings rate. The two methods are cost reduction and income elevation.
Now, I know what you’re thinking, “okay Adam, reducing costs is obvious thanks for nothing.” Well before you hold my feet to the fire, it’s important to note that there is some nuance to using cost reduction to reach this savings figure. You see, when people think of cutting costs, they are usually drawn to cutting the low-hanging fruit options. These include things like halting their trips to Starbucks or curbing their online shopping addiction. Sure, this helps but it probably won’t be enough to get your savings rate up to 40%. To get there, you need to start with the big three. Focusing on the big three expenses of housing, food and transportation will be where you’ll gain the most amount of savings traction.
Like I mentioned earlier in this article, start assessing where you can cut down on these areas of your life whether that’s moving to a place with cheaper rent or swapping out your car for a bicycle. For food costs, learn to cook and do groceries rather than eating out all the time. Only after slashing these core expenses should you move on to the smaller ones to further up your savings efforts.
Method number two is income elevation. If I’m being honest, this is by far and away the key to upping your savings rate. As you can imagine, saving more money becomes much easier as your earnings rise and in many cases, you can leave your expenses untouched and hit your 40% savings target simply by earning more money.
Let’s use an example to illustrate this point. Let’s say you currently earn $5,000 gross income every month and have living expenses of $3,000. After-tax, you have $4,000 and when your living expenses are deducted from this amount, you’re left with just $1,000. If this is your financial position then you’d be maintaining a savings rate of 20% which is your $1,000 in savings divided by your $5,000 gross income. While this is a decent savings rate, it’s not quite 40%. So in this case, you have two options, cut expenses or earn more income. If you decided to reduce your costs, you’d have to learn to live off of $2,000 which would allow you to save $2,000 which is 40% of your $5,000 gross income.
However, the reality is that reducing your costs to this amount may not be feasible. For instance, just your mortgage alone may be $1,500. Therefore, your only other option is to make more money. If you must have $3,000 to cover your living expenses then you’d need to be making $10,000 gross income or $8,000 after tax to achieve the savings rate you desire.
Now, I know that this is a large monthly income for some people however it reinforces the fact that achieving this savings rate will require you to push outside your comfort zone and get the skills you need to make more money. The good news is that by doing so, you will see your financial position reach new heights in a hurry and you’ll have the 40% rule to thank!