What your savings rate actually is

Ask someone what their savings rate is and you will usually get one of two answers. Either “about twenty per cent, I think”, or a number computed by looking at what landed in the savings account last month and dividing it by the salary.

Both are guesses. The second one feels rigorous, which makes it worse, because a wrong number you trust does more damage than no number at all.

The savings rate is worth getting right for one reason. It is the only single figure that tells you whether your financial position is improving because of something you did. Everything else on a household statement is contaminated by things you did not do: markets moved, the exchange rate moved, a car got a year older. The savings rate is the part that is yours.

The definition

Savings rate = (income minus expenses) divided by income.

That is it, and the whole difficulty is that both of those words do more work than they look like they do.

Income is money entering the household from outside it. Expenses are money leaving the household to outside it. Anything that moves between two things you already own is a transfer, and a transfer is neither.

If your ledger holds that line properly, your savings rate falls out of it for free. If it does not, no formula will save you.

The first mistake: the savings account is not the numerator

The instinctive method is to add up what you moved into savings and call that your saving.

This fails in both directions at once, which is the interesting part.

It overstates whenever money comes back out. You move 3,000 in on payday and take 1,900 back out on the 25th because the card bill was bigger than you thought. You saved 1,100. The transfers-in column says 3,000.

It understates every single thing you did that built net worth somewhere else. Money left in the current account at month end is saved. A lump into a pension is saved. Shares bought is saved. And the big one, below.

The savings account is a location, not a behaviour. Measuring behaviour by watching one location works only if that location is the only place anything ever happens, which is true for approximately nobody.

The second mistake: the mortgage payment

This one is worth its own section, because for most households who own property it is the largest single error in the whole calculation.

A mortgage payment is two things wearing one coat. Part of it is interest, which is the cost of having borrowed the money, and that is an expense. The rest repays capital, which reduces what you owe, which increases your net worth by exactly that amount. That part is saving. It is saving in the strictest possible sense: your position improved, because of something you did, on purpose, this month.

Book the whole payment as an expense and your savings rate is understated by the capital portion. Early in a long mortgage that portion is small. Fifteen years in it is most of the payment.

The same logic applies to any debt with a repayment schedule. Car finance, a personal loan, the phone you are paying off in twenty-four instalments. Interest is expense, principal is a transfer from your cash to your own balance sheet.

I hold a euro mortgage on a property in a country nobody in this house lives in any more, paid from a dirham salary. Splitting that payment correctly is the difference between a savings rate that describes what I actually do and one that quietly credits the bank with my saving.

What does not count

Three things feel like saving and are not.

Your investments went up. That is a return, not a saving. It changes your net worth without you doing anything, which is the exact definition of the thing the savings rate is designed to exclude. Include it and in a good year you will conclude you are disciplined when you were lucky, and in a bad year you will conclude the opposite.

Your currency went up. Same argument, and if you hold money in several currencies it is larger than you think and moves both ways.

Your house is worth more. Especially not this one, because the number is an estimate you chose.

There is a version of the savings rate that includes returns. It is a perfectly reasonable thing to measure, and it answers a different question: how fast is my net worth growing. Measure that too if you like. Do not call it your savings rate. And do not let the two drift into one figure, because a figure answering two questions answers neither when you need it.

Choosing a denominator, once

Gross income or net income. Both are defensible, and the arguments are less interesting than the commitment.

Net is what I use. A household cannot spend, save or move the tax it never received, so including it puts money in the denominator that was never available to any decision. It also makes the rate comparable between two people in countries with different tax rates, which matters if you have moved.

Gross has one real advantage. It is the figure people quote to each other, so a stranger’s number on the internet is probably gross.

Pick one. Write it down. Never change it, because the moment you do, your entire history stops being a series and becomes two series glued together.

The awkward case is employer pension contributions. If the money is yours and it went into an account with your name on it, it is income and it is saved, and leaving it out understates you. If it never appears in your ledger at all, your rate describes only the part of your finances you can see. That is fine. It is fine as long as you know that is what it is.

A month is not a measurement

Household cash flow is lumpy in a way that makes single months almost meaningless.

Annual insurance lands in one month. A bonus lands in one month. Two of the twelve months have three pay dates if you are paid weekly. School fees, flights home, the car service that was always coming. A month with none of these gives you an inspiring number that you cannot repeat and did not earn.

Use a rolling twelve months. Every month, recompute over the last twelve. You get a figure that moves slowly, which is annoying and correct, because your actual saving behaviour also moves slowly. A rolling year absorbs the annual insurance without you having to decide what to do about it.

The corollary: do not chase the number in a given month. Nothing you do in the last week of a month improves your rolling year, except the one thing that does, which is spending less.

What a good number is

I am not going to give you one.

Not because it is unknowable. Because every number anyone offers you comes with four things missing. A definition you were not told. A tax system that may not be yours. A denominator, gross or net, they did not specify. And, almost always, no mortgage capital in it at all. Then add the last problem, which is that people quote their savings rate for the same reason they quote their salary.

Here is what is actually useful. Compute yours to a definition you have written down. Then compare it only against your own previous number. If it is going up over a rolling year, whatever it is, the household is working. If it is going down and your income did not fall, something has crept in, and the category totals will tell you what within about five minutes.

The one absolute I will offer: a savings rate you compute yourself, consistently, and look at four times a year, beats a better rate you never measure.

It inherits every error underneath it

The savings rate is a ratio of two numbers that come out of your income statement, and your income statement is only as true as the reconcile that checks it against the bank.

Forget a few cash expenses and your expenses are understated, so your savings rate is overstated, and it is overstated by exactly the amount you are least aware of. Miscategorise one transfer as income and you have invented earnings. Both of those are ordinary, both are invisible in the finished figure, and neither is findable in the ratio itself. You have to go one layer down.

That is the whole argument for keeping a balance sheet alongside the income statement. Your savings for the year, computed from income minus expenses, should equal the change in your net worth minus everything the market and the exchange rate did. Two independent routes to one number. When they disagree, you have found a real error, and you would never have known it was there.

The short version

1. Income minus expenses, over income. Transfers are neither.
2. Split every debt payment. Interest is an expense, capital is saving.
3. Exclude returns, exchange rates and revaluations. They are not your doing.
4. Choose gross or net once, write it down, and never change it.
5. Compute it over a rolling twelve months, not a month.
6. Compare it to your own last number, not to anyone else’s.

Many people who do this for the first time find their real rate is higher than they assumed, because of the mortgage. A few find it is much lower, because the savings account was a revolving door. Both of those are worth knowing, and neither is visible until you count it properly.