Saving money from what we make is the arguably the most reliable way to build wealth. Your savings form the base. Any investment gains are built on top of those savings. If you don’t have a base, you won’t have much investment gains.
There’s an age-old rule of thumb: save 10% of your income. Then there’s a 50-30-20 budget from Senator Elizabeth Warren and her daughter in their book All Your Worth. It calls for saving 20% of your after-tax income. There are also some neat tables on the Internet that link your savings rate to how soon you can retire. The higher your savings rate, the sooner you can retire.
Whether you calculate your savings rate against your gross income or against your net income, first you have to know how much you are saving. At a first glance, your savings are simply what you don’t spend.
Savings = Gross Income – Taxes – Expenses
However, confusion starts as soon as you have mortgage or other loan payments. There was a long thread on the Bogleheads investment forum Do you consider mortgage payments as savings? After over 400 posts I don’t see a clear answer. Whether mortgage payments are savings or an expense shouldn’t be wishy-washy whatever you consider them to be.
Why does it matter whether it’s savings or an expense? It’s not for bragging on the Internet how high your savings rate is. It matters because savings are better than expenses in building wealth. If it’s savings you should do more of it. If it’s expenses you should do less of it (unless it brings income elsewhere).
If mortgage payments are savings, are you saving more when you have a larger mortgage? If mortgage payments are just an expense, do you increase your expense when you pay extra toward your mortgage or when you have a 15-year loan versus a 30-year? Are only the “extra” payments savings but the “regular” payments are expenses?
It’s not just mortgage. The same questions also apply to student loans, car loans, and credit card debt. If credit card payments are an expense, are you saving more when you make only the minimum payment on your credit card and you send the difference to your bank account? Let’s get to the bottom of this confusion. I will start with simpler parts and build up from there.
Escrow Payments Are Expenses
If your mortgage payments include escrow for insurance and property tax, that portion is clearly an expense. At best you get to hang on to the money temporarily. When the insurance and property tax bills come due, that money is gone. If we ignore the small escrow reserve and the slight difference in the timing of the expenses, month in and month out, the escrow portion of your payments is simply an expense. The money goes to the insurance company and the state and local governments.
Interest Is An Expense
Likewise, the interest portion of your payments goes to the bank. Just paying interest doesn’t increase your net worth. It’s an expense for borrowing money.
So far so good. Now we are left with only the principal part of the loan payments.
Your Expenses Don’t Go Up Simply Because You Pay More Toward Your Debt
If you receive a bonus at work and you use it as an extra principal payment on your loan instead of putting it into a savings account, your expenses for that month don’t shoot up simply because you use the money to pay down your debt. Because the interest rate on your loan is usually higher than the interest rate on a savings account, you are better off paying down a loan. You wouldn’t think using the money to pay down the loan is an expense but putting it into a savings account is savings.
If you refinance a 30-year mortgage to a 15-year term, your monthly payments go up, but you are not suddenly having a big jump in your housing expenses. You actually lower your expenses because the interest rate on a 15-year loan is usually lower than the rate on a 30-year loan. Again, month in and month out, the higher amount paid toward the 15-year loan isn’t an expense versus putting it into a savings account when you had the 30-year loan.
Your Savings Don’t Go Up Simply Because You Have No Payments
If you pay cash to buy a car outright as opposed to taking advantage of the manufacturer’s 0% financing, you are not saving more money every month simply because now your money goes toward replenishing your savings versus making the monthly payments on your car loan.
Suppose person A and person B both have $100k in the bank. Person A buys a car with $30k in cash. Person A now has $70k left. When person A puts $500 every month into their bank account, we say person A is saving $500 a month.
Person B decides to take the loan with zero down and 0% APR financing. Person B now has $100k in the bank, $30k in debt, net $70k. When person B has a $500/month car payment, it looks like an expense.
However, to an outsider, both person A and person B have the same net $70k plus a car, and they are both paying $500 out of their monthly income. If we ignore the small amount of interest person B earns from the extra cash in the bank, they will have the same net worth at any point along the way. Person A’s saving $500/month isn’t any better than person B’s $500/month car payment.
This is important. Let me repeat it. Buying a car with cash and saving $500/month afterwards isn’t any better than a $500/month car payment.
Expenses Come From the Purchase, Not From the Payments
What makes a difference, is person C, who keeps the old car and doesn’t spend $30k on a new car. Person C keeps $100k and puts $500 a month into the bank. If the old car continues to run without problems, in a few years person C will have a higher net worth than both person A and person B.
People familiar with depreciation would know the value of the $30k new car should be written down over a number of years. Both person A and person B have this non-cash depreciation expense. That’s why person A and person B are in the same situation even though one is saving and the other has payments. Person C’s depreciation and maintenance expenses are lower.
Our savings formula should be revised to:
Savings = Gross Income – Taxes – Cash Expenses – Non-Cash Expenses
Now it’s clear why person C is saving more than person A and person B. Principal payments are indeed savings, but whatever was purchased by the loan brings non-cash expenses, which reduce one’s savings.
We finally have a logically consistent answer. Loan principal payments are savings. Feel free to make additional principal payments toward your loans. Feel free to refinance your mortgage to a shorter-term. Feel free to finance when terms are favorable. The principal payments are just as valid as savings as sending money to your own bank account. However, having high loan balances as a result of larger purchases (expensive house, education, cars, …) means you have high non-cash expenses from writing down those purchases, which reduces your savings. So do less of those unless the expensive house appreciates more or the expensive education brings higher incomes.
Say No To Management Fees
If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice.