“A penny saved is a penny earned.” – Benjamin Franklin
We’ve all heard it before, so it must be true – right?. Well, not really. At least not for the majority of us.
You’ll read all sorts of advice regarding personal finances, but a good proportion of them will eventually tell you to increase your earnings because that’s how you can really start socking away some money. And that is partially true. But there are a few problems with that.
Earnings Shouldn’t be Your First Focus
First, folks who focus on that advice tend to be the kind that also like to say that paying someone else to do things for them is wise use of mine because they make more than that in an hour. It’s rarely the case that someone can truly hire out mowing the lawn or cleaning the house and make up for it by using the time to work more hours at a higher rate than they are spending.
Second, it diverts attention to trying to increase income without taking the first step in reigning in spending. The reality is that you typically need to put in quite some time to up your income. You can ask for a raise to try and bump it quickly, or go job-hopping. But for most people it’s really about getting a higher education or more prestigious degree; or starting to do additional work: get another job, become a landlord, invest, start a side project, etc. It’s all things that take time and effort – you can’t typically just decide you want to make more money and have that happen overnight.
Lastly, and most importantly, a penny saved is not a penny earned. The old quote isn’t true. Saving a penny, or a dollar is worth **more** than earning another. Let’s examine why.
Savings matter more
When I earn a dollar, I don’t ever get to see that dollar in full. The tax man comes along and grabs his share at both the state and federal level, as does Medicare, Social Security, and disability insurance. All told I see roughly 80% of my gross income after all those taxes. My effective tax rate ends up being around 20%, and you can see the effective tax rates of US families over time here: http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=456. Yours probably looks pretty similar.
So when I save a dollar, if it’s after taxes that $1.00 saved is the equivalent of earning an additional $1.25! This is why the best advice you’ll get is to trim your excess spending as much as you can. You’re saving more than the face value. It’s much easier to cut a dollar out of your spending than it is to earn an additional $1.25.
Savings Compound, Earnings Don’t
When I save my dollar it will go to pay down debt, build up an emergency fund, or get invested. So that dollar is actually working for me. If I pay down debt, it’s the equivalent of also earning the interest rate of the debt (caveat: tax advantaged debt, like a mortgage where the real rate is lowered by tax benefits/write-offs). Or the interest rate my savings account is paying. Or the rate of return of my investments. That dollar is actually going to become worth much more to me than a dollar.
If I invest $1.00 in the stock market and earn 7% for 10 years. It will become $1.97. Even after capital gains taxes of 15%, that is $1.82.
If I use $1.00 pay off credit card debt with a 14% rate that is the equivalent of saving $1.14 in the first year. If I let that debt sit around for 3 years? That’s the equivalent of $1.48!
(You can play along by using your own favorite compound interest calculator)
What are you really Earning?
Let’s take this further: The typical worker has a commute time of 25.4 minutes each way (There’s a neat website up for looking up the average commutes near you). So really that worker is spending an additional 51 minutes a day just getting to and from work. That’s time you can’t get back and time that should be factored into your pay rate. So while you thought you were getting paid for your 40 hour work week at a given rate or salary, you’re actually using up 44.25 hours working plus commuting. If you extrapolate that out to roughly 48 work weeks in a year (2 week vacation plus 2 weeks worth of holidays) that means an extra 204 hours. That’s right, you’re not getting paid the equivalent of 5+ weeks worth of time spent driving back and forth to work.
And a great deal of you are driving to get there. Alone. Over a typical commute of 16 miles each way. So add in that you’re driving 32 miles, and let’s assume a 30 mpg vehicle and gas prices around $3.50. So we’re paying $3.73 for the privilege of driving back and forth to work over 50 minutes each day. That’s assuming gas doesn’t go up, but that’s not a very good assumption. Oh yeah, and remember that $3.73 is post-tax money spent on gas so that’s actually the equivalent of $4.67 in earnings (at our 20% effective tax rate). And that’s juts one day – in a year that means you’re paying $896 to commute, or $1120 worth of earnings.
If you took the $74.67 you’d typically spend on your commute each month and invested it, earning 7% over 10 years you’d end up with $12,924.24! If you started this when you were 22 years old and continued saving this amount monthly through a typical career working until 62 years old, you’d end up $195,994.82 richer ($171,971.84 after 15% capital gains).