Once you have embraced saving for financial independence, you can track your progress using a few simple savings calculations. When working through the following equations, the savings amount will be a combination of any money you add to savings, as well as any debt principal reduction. To be clear, this does not include total debt payments, only the portion of the debt payment that goes to reducing principal. Here’s how to calculate your savings rates with ease.
1. Gross Savings Rate = Savings / Gross Income
This first savings formula measures how much of your total pre-tax income you are saving. While this is the easiest of the calculations it includes taxes as part of gross income. Gross income is the amount you are paid before any taxes are taken out. This will deflate your savings estimates since gross income is larger than the income you take home.
2. Net Savings Rate = Savings / Net Income
Measuring your savings rate as a component of net income will avoid the effect of taxes because net income is the amount of your actual paycheck after all taxes have been removed. When it comes to employer retirement matching, add this amount to both savings and income. This is money you have earned and even though it is automatically invested, it is still income and savings.
3. Savings Comparison Ratio = Savings / Spending
The previous savings formulas focus on savings from a perspective of how you use your income. This third formula compares your savings to spending. If you plan to save more than you spend, your savings/spending ratio will be above one. The higher your ratio the more you are saving and less you are spending.
The tracking and calculation of your savings rate is more important than the formula you choose. Each tells a different story, but if you stay consistent with the formula you use, you can watch as you push toward your goal of financial independence.
If you find that monthly savings calculations are too volatile, calculate these ratios on a quarterly basis. Tracking your path to financial independence is more than measuring your account balances. You need to ensure that you stay on the path by making sure that the most important part of financial independence, savings, grows or stays consistent.