I am often astonished to read tales of personal finance where the person in question is saving 40%, 50% or upwards of 60% of their take-home pay to reduce debt, plan to retire early retirement, move to an island or fulfilling some other dream. I often think that this is an insanely high savings rate. It is an incredible exercise in self-discipline as well. But I often think if there is such a thing as too high of a savings rate?
I look at the question in two ways- what is your savings rate and where is your savings going? My answers tend to be a little different for each depending on the context used. Before you think I am advocating no savings, fear not. Not including the payment of my mortgage (which I count as savings- see below), my contributions to my retirement, my dividend fund and emergency cash hovers between 20-30% of my take-home a month so its all a question of relativity to me and I am a big believer that the only thing in excess should be moderation.
As a definitional point, I define savings very broadly from cold hard cash to paying down the mortgage. I agree with the Business Dictionary which defines savings as: “portion of disposable income not spent on consumption of consumer goods but accumulated or invested- directly in capital equipment or in paying off a home mortgage, or indirectly through purchase of securities.”
My other guiding principle is that money should allow you the freedom to do things. Money is not the ends in and of itself. It is a means to something else (whatever you want that to be). What good is a pile of money if you are not enjoying life?
WHAT IS TOO HIGH OF A SAVINGS RATE?
Having gotten that out of the way, what would I consider too high of a savings rate? The conventional and ideal savings rate floor is 10% of take-home of your take-home pay should be used to invest in bonds and stocks (the rule made popular by the book The Wealthy Barber). The book The Millionaire Next Dollar (my little personal finance Bible) suggests that a savings rate, excluding mortgage payments, approaching 20% of take-home pay will, over time, lead to financial independence. I would consider anything over 30% to be extraordinary and anything over 40% to be too much.
Let me add a wrinkle to this now. Most people do not consider paying down the mortgage as savings but it is to me since you are adding equity to your home (assuming that your house is worth more than your mortgage). Most of these astonishing tales of personal finance I read involve a couple saving 60%-70% of take-home, mostly in very aggressive payment of their mortgage. Although most of these profiles are not in-depth, it also appears that other than paying down the mortgage, not that much of the savings is going towards investing in stocks or bond (I will freely admit I am reading between the lines and perhaps projecting my thought process into this; guilty as charged).
I would consider 60-70% too high of a savings rate. What kind of life are you living if 60-70% of your pay cheque is not going towards consumption? I work pretty hard for a living so I am of the view that if the mortgage is being paid down with at least one extra payment a year and 10%-15% of a pay cheque is going towards investing in stocks and bonds, which is a pretty healthy savings rate, purcashing an iPhone or a Xbox isn’t going to kill you and may actually let you enjoy your life a little.
Again, I am not suggesting that you blow all your money on consumption. But at some point, if you are a good saver and manage debt well, a few materialist indulgences here and there is not going to destroy your net worth assuming, as always, it is in moderation.
I am always reminded of a story a colleague once told me. He is a wills and estates lawyer. I called his practice “old law” since all his clients were old, and many well to do financially, and his clients always said the same thing to him. If they had to do it all over again, they would have enjoyed their money more while they were younger since they were not healthy enough to enjoy their money or money made people look at them differently.
I always struck by this story of how we sometimes don’t see the forest from the trees and the hyper-savers could be missing the point of why they are saving- to have the flexibility to do what you want and have fun before things are sagging and wrinkled.
I do respect those who want to retire early and are saving massive amounts of money to do it but I am already a cranky ex-lawyer in my 30’s. I am not sure how much I would enjoy life money-ed up but crankier in my 40’s and 50’s. But to each their own. But if you are gritting your teeth at a job you hate in order to save your 60-70% in order to retire early, how fulfilling of a life is that? You spend your working day hating your environment because it allows you to save money and then you go home to pinch pennies. Now if you love your job and want to retire early by saving lots of money that is a different story altogether…. again, its context.
WHERE ARE YOUR SAVINGS GOING?
The other consideration I look at is what are you doing with your savings? If you are putting all, or substantially all, of it to paying down the mortgage, is this not, in essence, bad asset allocation? Your net worth relies heavily on real estate which has turned into an asset which is just as turbulent as stocks. The same can be said if you took the bulk of your savings and put it into stock or bonds or private enterprises. I would rely on this principal regardless of what your savings rate is since this is simply bad asset allocation. We often think of asset allocation as simply an aggregate of our retirement portfolio but we need to add back in the equity in our home to get a trurer sense of asset allocation.
A good example would be someone with a large amount of equity in their principal residence and then buying REIT’s or investing in mortgages in their portfolio; they are simply over-weight in an asset class and need an asset which is negatively correlated to real estate to balance their portfolio.
You may have a moderate savings rate but if all of it is going to stocks, real estate, bonds or cash then your opportunity costs are quite large and I am not sure who is worse off- the saver who is over-allocated in an asset and loses their savings by being over-exposed or the non-saver who has little hope in the event of a financial emergency: it becomes the old sports debate- would you rather lose by 1 point in the last minute of the game or get blown out completely?
THERE’S ALWAYS AN EXCEPTION TO THE RULE…
Where my thoughts about one’s savings rate being too high goes out the window is a situation where someone is majorly in debt (which I would define as anyone using 50% or more of their take-home pay to service the carrying of the debt PROVIDED HOWEVER you didn’t ratchet up your mortgage payments to increase their debt servicing load). In cases where carrying debt consumes more than half of every pay-cheque, there is no such thing as too high of a savings rate. In such a case, the analysis moves from “what is a good savings rate in which I can still considering living a good life?” to “how quickly can I obtain financial flexibility by paying down debt?”
As Albert Einstein once noted, compound interest is the greatest mathematical discovery of all time but you sure don’t want to be on the losing end of compound interest for too long. In such a case, the longer you are in debt and not chipping away at the principal, the longer you will continue to be in debt (for a good example of how compound interest works against you, see Million Dollar Journey’s example of interest paid during the life of a 25 year mortgage compared to a 40 year mortgage).
In such a situation then I would agree it is time to go on a Kraft Dinner diet and use all available resources to pay off debt whether it be student loans, credit card debt, a mortgage you couldn’t afford etc.
I am also not particularly worried about asset allocation at this point. The major imperative is to reduce how much money is being consumed servicing debt so you can start building cash and equity savings which affords you the luxury of debating asset allocation.
In the end…
It is your typical lawyers answer. It depends (and that will be $500 please…). You have to look at your particular life situation, where the savings is going and your debt load. There isn’t one definitive, one-size-fits-all answer. Just a lot of soul-searching. But I believe the healthy balance is saving 15-20% directly to non-mortgage savings, paying down the mortgage with at least one extra payment annually and trying to enjoy what is a very stressed filled life in this day and age.
Anyone have any thoughts they care to share?
September 3rd, 2008 at 6:15 am
Great article and thanks for the mention. I believe that frugality is a lifestyle so those who choose to live this way aren’t really sacrificing anything. For us, we are “selectively” frugal where we freely spend money on things we enjoy in life (good food) and skimp on things that don’t matter as much (lattes etc).
September 3rd, 2008 at 8:05 am
Your “in the end” sounds perfectly reasonable to me. Stories like the one doing the rounds a few days ago about the San Fran couple living like paupers so they could quit at 40 and enjoy the outdoors more are really odd to me. Couldn’t you just get an outdoorsy job or a job in the mountains, plan on sticking at that until you’re 50 or 60 and live a little?
September 3rd, 2008 at 9:18 am
hey mr. cranky ex-lawyer, frugal gal ex-lawyer here. so, i’m saving for extreme early retirement (hopefully age 35) and am living on about 25% of my income. just wanted to let you know that i don’t feel deprived at all – i’m just lucky that the things i love to do cost little or no money. a bike trip is more fulfilling and meaningful to me than x-box (though to each their own). my life is pretty awesome – i enjoy my job well enough (though I’m not keen to do anything everyday for the next 35 years) but i wish to do work that is more meaningful to me in the long-term and i don’t want to have to worry about whether or not it pays. saving my half-million will let me do the things i wish to do.
i agree with you that $ is not an end in itself, it’s a means to allow freedom and a fulfilling life. living simply is freedom and fulfilment for many. how lucky am i that the exact life that i want to live costs very little money.
keep up the interesting posts.
(p.s. when i practiced, i had some elderly clients in a financial crisis because they hadn’t planned very well. needless to say that’s a bigger problem than those with too-healthy accounts.. and don’t get me started on the family law clients who appeared rich to the world but owned absolutely nothing..)
September 3rd, 2008 at 9:42 am
Saving 15-20% may be a good average figure, but as you say, individual circumstances differ. When my wife and I were fresh out of school we didn’t like having a landlord. So, we saved over 50% of our pay for a little over a year to build a down payment on a house. We continued saving at about this rate and paying off the house until we had kids. My wife then worked half time and we saved at a much lower rate. A friend of mine is saving at about 70% right now because he hates his job and plans to quit when he hits a magic amount of savings. The less you like your job, the higher your savings rate should be.
September 3rd, 2008 at 10:25 am
A household’s saving rate will also depend on whether one or both spouses are working. Savings rate for working couples could be much higher as it should be fairly easy to live on one salary and save the other.
I do agree with you about moderation. Life is fickle and it is better to have a balance between saving for tomorrow and spending today than focusing on one at the expense of the other.
September 3rd, 2008 at 12:37 pm
“What kind of life are you living if 60-70% of your pay cheque is not going towards consumption?”
Depends how much you make. If you make $1M per year, I don’t think this is an unreasonable savings rate, do you?
The savings rate is too high when the person doing the saving crosses the line between frugal and cheap; ie. when their money hoarding starts to affect the lives of others.
My opinion? You pulled these percentage numbers out of your ass. I don’t think there’s any reason to criticize someone leading an acetic lifestyle and saving diligently unless they are harming someone.
September 3rd, 2008 at 1:27 pm
It’s a thought-provoking post. I would guess each case is different. It depends a large part on salary as well. A pediatrician should be able to save more than a retail worker, of course, but may not if the doctor aspires to an expected life style.
Some are able to save a large percentage of money without feeling deprived. Good on them, if they prefer bike rides to xbox. Personally, I have a hard time finding something worthwhile to spend money on. I consider most things clutter, and I have a tough time replacing things that still (kind of) work. I have an old ugly car and an old temperamental dishwasher. Considering my net worth, they should both be replaced, but hey, I’m cheap!
Great post. Very interesting.
September 3rd, 2008 at 1:30 pm
[...] Is There Such a Thing as Too High of a Savings Rate? @ Thicken My Wallet – I wish I had the problem of saving too much! [...]
September 3rd, 2008 at 6:30 pm
Excellent post!
3 different ways to think of savings: current, future and past consumption.
People often think of savings only as the flipside of spending/consumption, which is true in the short term [current].
In the long term however, savings is simply deferred [future] consumption, unless you’re looking to pass on all the money or be buried with it.
Meanwhile, servicing debt can be thought of as paying for [past] consumption for which you have not yet paid.
If your problem is only on how to allocate your earnings between current and future consumption, then that’s not too bad a problem to have.
If this is the problem, then whether or not you are saving too much depends on the utility you get from spending it now or in the future.
One major factor to consider is the time risks in deferring consumption. For many people, saving money for the future provides a sense of security, but the paradox is that the future itself holds no promise that you will be able to spend what you have saved.
September 3rd, 2008 at 7:58 pm
Interesting question. I went back and figured that my wife and I (late 40’s, early 50’s) are saving at an average of 47%. A large part of that is going towards paying off old consumer debt. Once that is cleared up we will be redirecting that money towards buying a house and our retirement.
Having not been careful with our money earlier on, we need to work harder now to be ready for our retirement.
I agree that lifestyle and income are two important factors in determining if your savings rate is realistic. Many might consider our lifestyle unsatisfactory, but we are happy with it, and the amount of saving that we are putting towards our goals.
Thanks for your posts!
September 4th, 2008 at 8:32 am
Before you invest in any type of bond, it is important to know how bonds work. Bonds can be complicated to understand at first since there are many types of bonds and therefore many rules. It is also more important to understand how bonds work when you invest in bonds because people usually invest in bonds for the interest payments as well as redemption value which are something in the future. While when a stock goes down in value you know you are losing money, when a bond goes down in value, you may not be losing money but if you understand perfectly how your bonds work.
September 4th, 2008 at 10:37 am
You seem to have the notion that your home equity is relevant to your asset allocation. It’s not. Your entire home is an asset, not just your equity. If you have a $180,000 home and $20,000 in other investments, then then you have 90% of your assets allocated to your home, regardless of your outstanding mortgage balance. Your equity doesn’t enter into it.
Hence, paying down the mortgage is not bad asset allocation; in fact, it has nothing to do with asset allocation at all.
September 5th, 2008 at 11:19 am
Expenses like an iPhone and Xbox are one time things (hopefully). You can buy an Xbox with half your paycheck one week and then go back to saving 50%.
Or if you make enough, you can put 50% away, pay your bills, and still have enough for an Xbox.
And I don’t think I’d get any use out of an iPhone if someone gave me one for free. ^_^
September 5th, 2008 at 2:28 pm
Excellent post! I agree with Patrick about the amount you make changes what % is realistic. For example, my basic spending is about $35K/year. So as our household income goes up there is a greater % that we can save without living out lives any differently.
This is just one of those sliding scale type of things.
Tim
September 16th, 2008 at 7:40 pm
We consistently save above 60%-70% of my income. I’d say we live quite well though. We travel twice a year, staying in reasonably nice hotels, we eat out every weekend, etc.
I think it boils down to two things:
1. Apart from food and travel, my passion is to build my net worth through investing–so that kinda helps a lot since I put money into that hobby and it helps my net worth! I don’t really care about iPod, iPhone, Xbox, and those stuff.
2. Our focus has always been on the “increasing income” bit instead of “spend less and less” bit. We increase our income so we can spend more AND save more. Despite being frugal (we always try to get the most value out of our money), we’re not interested in going the extreme frugal way.
Rather than halving our expenses, our focus would be to *double our income*, so we can spend more, and at the same time save more too!