Budgeting and the Magic of the Savings Rate

I originally started budgeting my finances around four to five years ago. When I drafted my first budget sheet, I was a student who didn’t know much about handling money besides the fact that I sucked at it. My first budget sheet, which I drafted on Excel, was pretty simple. It listed the income and the expenses and summed up the numbers with a simple formula. Fast forward to this day, the budget sheet has evolved into an invaluable tool in managing and planning my finances. One discovery stands above others, and that is the magic of the savings rate.

How to budget

The problem I wrestled with for a long time was how to turn a budget from a log of income and expenses into a planning tool. The main question in my mind was how do I know if my budget was right. To answer this, I tried to estimate the exact amount of money I had left on my transaction account at the end of each month or before the next salary day. I even assigned a percentage value on the estimation based on how close it came. The problem with this approach, in addition to not dealing well with uncertainty, was that the main goal was basically to not run out of money.

While pondering these questions, especially close to the salary day, my life moved forward. I eventually got a regular salary, I got married, I started to save and invest, and at the same time the budget sheet grew more complex. After hundreds of hours of fiddling with the budget on the course of several years, it had taken a clear form with income, expenses, savings, and so on, on their own tabs and an overview tab to present key information. The key metric was, however, still missing and the old problem persisted. What kind of a goal should I have to know if I got my budget right?

The savings rate

I eventually found the solution on a financial blog that I was following and my curiosity was rewarded with the discovery of the savings rate. The savings rate is the amount of money that is left after expenses as a percentage of your income. A simple way to count the savings rate is to deduct your monthly expenses from your monthly net income, divide the remaining amount by your monthly net income, and finally multiply it by 100. For example, let’s say that your net income is 2000€ per month and your expenses 1750€ per month. In this case, your savings rate would be 12.5%.

I should point out that there are several ways to count the savings rate. Another way is to count the savings rate as a percentage of your gross rather than net income. For example, if your monthly gross income was, say 2700€, in the above example your savings rate would be around 9.5%. There are pros and cons to each approach and lots of material online for those who would like to learn more about it. As for myself, I count the savings rate from the monthly net income because that’s the amount of money I can influence after receiving it on my account after the withholding tax.

Conclusion

Learning about the savings rate has removed a big headache for me when budgeting. How well I manage to keep the income and the expenses balanced is reflected in the savings rate. I now have a clear goal when budgeting, which is to keep the savings rate above a certain threshold. If I want to have a bigger savings rate, I need to increase the income or lower the expenses. With an automatic formula on my budget sheet that counts the savings rate, I can budget the rest of the year and play with the numbers until I’m satisfied with the savings rate each month. I now how a clear goal and a metric to measure it.