Do you know the biggest savings mistake most people make? It's that they save only what they think is a reasonable savings percentage, say 10-15% of their paycheck, and then proceeding to spend the entirety of the remaining balance every month. Seems like a common saving/spending model, right? Why is this a problem in the long run? Let me explain.
Most people save 5-15% of their paycheck (if that) after taxes, and leave the rest sitting idly in their checking accounts to spend freely throughout the month. The idea is that since you've already saved how much you need to (or how much you think you need to) for the month, you are free to spend the rest on whatever you want. After all, it's your money, and you earned it by working hard at your job. If at the end of the month you have money left over in your checking account, you decide it's okay for you to go out and splurge at a fancy restaurant, or buy yourself a nice sweater/jacket/purse/dress, etc.
If after a few months you find out that there is consistently money left-over to spend each month for a few consecutive months in a row, you find a way to use up that money. You feel you can now increase/inflate your lifestyle safely to use up your unspent balance. After all, your budget allows for it. Maybe you go out and sign up for a new car lease, adding a repeat expense to your monthly budget. Maybe you take out a short-term loan to finance some new furniture for your living room.
Living in this manner basically means people never get around to saving more than 15% of their after-tax income, even as their income grows substantially over the year. The problem with this savings model is that once you give yourself a budget to spend x dollars, you will almost certainly find a way to do so. This is known as Parkinson's Law. Expenses expand to fill the budget allotted. People also refer to this as lifestyle creep or lifestyle inflation.
Parkinson's law has two major long-term consequences for a family's personal finance:
- It promotes wasteful expenses to use up the excess money each month, simply because you have it. For example, you might go out and buy a nice, fancy car just to use on the weekends. It is very very hard to justify purchasing a fancy new car only to be used on the weekends, especially when there are so many cheaper alternatives like Uber and such for weekend-only usage. Your money just sits idle in your home parking lot during the weekdays, costing you insurance whether or not you use your car, maybe even costing you more in the form of garage/parking fees or additional rent to pay for a parking spot in the big city.
- Pre-existing wasteful expenses are seldom revisited, meaning they stay on forever. Since there isn't a reason to go back and review your expenses on a regular cadence, you never feel the need to do so. After all, you're trying to increase your expenses to use up your unused spending budget, not decrease it! Old magazine subscriptions that you no longer read is a perfect example of a wasteful pre-existing expense. Other examples are subscriptions to online services (like Netflix or Amazon Prime) that you no longer use regularly enough to justify spending on them monthly. These never get axed out of your budget since you never make the effort to reconsider if you really need them anymore.
Fast forward this behavior for 40 years, and most people barely ever save more than 15% of their after-tax income. Meanwhile, tons of their hard-earned money over the years go to waste in the form of unused services and subscriptions, square feet like your dining room that maybe gets used once a month but you still have to pay rent, mortgage, HOA, heating and cooling on it, or a car that gets used only on the weekends, but still dragging you down everyday in the form of monthly lease, parking, and insurance payments.
This goes directly against the first rule of improving your savings rate which is: re-evaluate every aspect of your life and your expenses, and eliminate all wastage. Good ol' wastage is the #1 drag that causes people's finances to get de-railed routinely. Every time you throw out food or milk, that's wastage. It means you bought more than you should've. Have a bridal dress that you bought to use just once? That's wastage too, since you could've just as easily rented it. How many of your new clothes have you worn less than 3 times in total? How many have you worn 0 times? That's all wastage because you were too lazy to return them back to the store.
Here are Frugal Hackers HQ, we take wastage very very seriously. Having amazing finances sometimes simply boils down to just minimizing or eliminating the amount of waste in your life. The rest takes care of itself. Don't let yourself pay for stuff or services that you don't use regularly! Curb the total wastage in your life, and watch your finances soar in just a few short months.
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So what is a better savings model? Like we said in an earlier post, a savings rate of even 20% just isn't enough unless you're okay working from 9-5 day-in and day-out for the next 40 years of your life. So how do we at Frugal Hackers HQ manage our savings? How do we maintain a 70%+ savings rate which allows us to retire decades ahead of most people? What does our savings mental model look like?
It's simple. It's just a shift in perspective. Instead of saving 10-15% of our monthly income and then spending the rest, we instead spend exactly what we need to, and then save the rest. Instead of trying to maximize savings, we instead try to minimize expenses. Every month, we look at our expenses and ask which of them can be cut down, avoided, or eliminated for the following month. We only move those expenses that truly make us happy over to the next month, throwing out everything else. This model makes us re-evaluate our Netflix subscription every single month. It also means we re-evaluate our Amazon Prime subscription every single year. Each time we incur bank or credit card fees, we re-assess if we still need those cards and accounts. Every year, we ask ourselves if we can pay less on our utility bills by re-negotiating our cell phone, electricity, and internet rates, or by switching providers.
Here's how it works for most people: They earn x dollars each paycheck. Of that, taxes get taken out automatically during payroll. Maybe 5-20% of the rest goes into their savings account. The balance remains in their checking account to spend as they will throughout the pay period.
Here's how we do it instead: We earn the same x dollars. A certain percentage gets taken out automatically for taxes during payroll. The rest goes straight to our savings and investment accounts rather than our checking account. We don't spend a single dollar from it for our monthly needs. Instead we spend from our emergency cash buffer, which consists of 3-4 months of minimal living expenses. Since the emergency buffer is so important to our financial survival in case things go awry and we lose our jobs, we are very careful with and highly sensitive about what we take from it. At the end of the month, after all expenses have been accounted for, we top up our slightly-depleted emergency cash buffer from our savings account. This simple shift in mindset alone allowed us to jump from a 20% savings rate to a whopping 50%. We were officially frugal.
The simple idea of not letting yourself spend as much money as you have, but instead spending only on the things that buy you happiness while minimizing all wasted expenses leads to drastic increases in your savings rate. Never think about how much you can spend, instead think about how much you should spend. Anything more, by definition, is wastage, and is instead better served to buy you your financial freedom 10-15 years from now.
For example, if we notice we're paying for a gym membership that we don't use anymore, we cancel it immediately. We'd rather exercise for free in nature anyways. Others however would let those memberships go on for years without noticing! But if you never give yourself an incentive to re-evaluate existing expenses, old wasteful expenses continue eating into your savings month after month, year after year. Same with new furniture. We never need to buy new furniture since old furniture seldom breaks. Spending on new furniture when the old ones work perfectly fine is also a kind of "wastage". Boredom is unfortunately not an adequate reason.
If you only spend what you need to spend, you'll find that you only need to spend half or less of your take-home income, soaring your savings rate from a paltry 15% to an impressive 50%. That jump alone shaves off 27 years off your retirement age by allowing you to retire at 40 instead of 67. That's 70,000 hours of your precious life saved by not having to work or commute into work, but instead spending that time on something more worthwhile. Surely you can come up with something to do with your limited time that is more meaningful to you than working your tail off to increase someone else's profits?
