My recent saving rate tutorial has me thinking deeply about the intimate relationship between spending and saving.
Over the last several years, a significant portion of my writing has explored the importance of healthy savings in building wealth and creating financial flexibility. I’ve written thousands of words detailing the intricacies of our lifestyle and the myriad of ways in which we save money in the pursuit of financial freedom.
Saving is the bedrock of all financial progress, and that is unlikely to change unless the global economy collapses and we return to a barter-exchange driven society. However, that doesn’t mean I can’t find ways to better present the concept of saving, a concept known as “framing” in psychology.
Specifically, I’ve been wondering if it would be beneficial to consider a personal spending rate in place of the (far-more-popular) saving rate.
What is a Personal Spending Rate?
Saving and spending represent two sides of the same coin. You can illustrate this relationship in several ways:
- Income – Savings = Spending
- Income – Spending = Savings
- Income = Savings + Spending
All three equations represent a single universal truth: All income must be spent or saved.
The personal spending rate calculation presents this truth from a slightly different angle:
- Spending / Income = Spending Rate
In plain language, your personal spending rate is the percentage of your income being spent over a defined period of time (usually monthly or annually).
Notice that the personal spending rate equation represents the exact inverse of the personal saving rate:
- Savings / Income = Saving Rate
A Personal Spending Rate Example
To illustrate the equations presented above, consider the following example about Joe:
- Joe earned $100,000 last year
- Joe spent $75,000 last year
- Joe saved $25,000 last year
Joe’s Personal Spending Rate = Spending / Income
- $75,000 / $100,000 = 0.75 = 75%
Joe’s Personal Saving Rate = Savings / Income
- $25,000 / $100,000 = 0.25 = 25%
In this example, Joe is spending 75% and saving 25% of his income annually. The combined spending rate and saving rate must always equal 100% of available income in any time period observed.
Intuitively, financial progress will accelerate when the spending rate is a smaller percentage of income (which also implies a larger saving rate). A decrease in the spending rate can be achieved by decreasing the amount of money being spent and/or realizing an increase in available income.
How to Calculate Your Personal Spending Rate
I previously demonstrated how we calculate our personal saving rate each year, noting how we’ve abandoned elaborate spreadsheets and time-consuming manual calculations in favor of simplicity and automation.
Because the required inputs remain the same (income and expenses) for both the spending rate and saving rate, we can use the exact same methodology to calculate both metrics.
- Create a free Personal Capital (see my detailed review) account and connect all financial accounts
- Personal Capital automatically tracks income and expenses (spending) across all linked accounts
- Plug the data provided by Personal Capital into the equations presented above to calculate your rate of spending and saving (either monthly or annually).
Because both equations are inversely related, you can always verify that the combined spending + saving ratio must equal one (representing 100% of your income).
How Useful is the Personal Spending Rate?
Let me first echo what I said previously in my discussion on saving rates – a personal spending rate is neither overly interesting nor insightful when calculated once and then ignored.
Both spending and saving are dynamic financial habits, shifting over time according to wants, needs, and preferences. Therefore, you should use these calculations to observe and modify your lifestyle in a way that will decrease (or increase) your rate of spending (saving) over time.
Returning to the question posed in the intro, is a spending rate more useful than a saving rate when studying the relationship between income, expenses, and savings?
That depends on which action, saving or spending, you believe comes first.
The “pay yourself first” mentality, which appears to have a cult following on the interwebs, suggests that individuals should save the first fruits of every paycheck to avoid the temptation of spending those funds frivolously at a later date. The implicit message within this school of thought is that the process of saving money is an independent decision that can be made irrespective of spending.
I would argue that the “pay yourself first” mentality is overly simplistic because it assumes that all individuals earn enough income to cover both essential and discretionary expenses, at all times. For example, someone earning $25,000/year working full-time might need roughly that amount to cover essential expenses like housing, transportation, food, health care, and clothing. In such a scenario, the “pay yourself first” recommendation appears ridiculous because all income is allocated toward fixed, necessary expenses, leaving no savings to be found.
Or, as Michael Kitces recently stated, “functionally most people don’t “choose” what to save per se… they choose what to spend, and then save the limited dollars that may or may not be left over after covering fixed/essential expenses and any discretionary spending.”
In other words, holding income constant, your spending rate determines your saving rate, and the only logical way to realize an increase in savings is by first realizing a decrease in expenses (spending).
Practically speaking, it’s much easier for most people to realize a decrease in spending than an increase in available income. Anyone and everyone can find immediate ways to decrease spending through lifestyle design, but finding additional income often requires significantly more effort and external cooperation (e.g., negotiating a raise in your current position, applying/interviewing/accepting a new position, or starting a business).
To be clear, this isn’t a debate about “increasing income vs decreasing expenses.” Both factors are equally important inputs within this discussion. Lower-income individuals (who are forced to allocate a larger percentage of income toward necessary expenses) might want to focus on finding additional income streams, as it might be difficult to realize an immediate reduction in fixed expenses. On the contrary, individuals earning six-figure incomes probably ought to focus on lifestyle modifications to decrease spending and improve savings.
In Summary:
In my opinion, the equation below is the most helpful way to frame the relationship between spending and saving, primarily because it expresses saving as a function of income and spending:
- Income – Spending = Savings
An increase in available income and/or a decrease in spending is what produces financial savings (not the other way around). Obviously, it would be best to combine both approaches, but a reduction in spending can be realized immediately through lifestyle modification.
If saving is the byproduct of prudent spending habits, the best way to evaluate that relationship over time is through the personal spending rate, which is the percentage of your income being spent over a defined period of time.
- Spending / Income = Spending Rate
Because a reduction in the spending rate will always produce a subsequent increase in the saving rate, perhaps we should replace the “pay yourself first” mentality with a new approach that emphasizes lifestyle design and expense reduction as the primary means of achieving financial savings.
What do you think? Have you ever calculated your personal spending rate and did you find it valuable? Please share your thoughts in a comment below.