[Updated on May 27, 2023.]
Saving some of our income creates the foundation to build wealth. Our savings form the base. Any investment gains are built on top of these savings. If you don’t have a base, you won’t have much in investment gains.
There’s an age-old rule of thumb: save 10% of your income. Better savers save 20% of their income. More aggressive savers save 30% or 50% of their income. There are 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.
Savings versus Expenses
Whether you calculate your savings rate against your gross income or against your net income, you have to know how much you are saving. At first glance, your savings are simply what you don’t spend.
Savings = Gross Income – Taxes – Expenses
However, confusion starts as soon as you have a mortgage or other loan payments. There was a long thread on the Bogleheads investment forum back in 2015 Do you consider mortgage payments as savings? No clear answer emerged after over 400 posts. This same topic came up again eight years later in Is paying debt a saving? There was no clear answer either after over 200 posts. Some people said paying down debt was savings. Some people said it wasn’t. The moderator had to lock the thread because the discussion turned contentious.
Whether mortgage and other payments are savings or expenses shouldn’t be wishy-washy whatever you consider them to be.
Why It Matters
Why does it matter whether it’s savings or an expense? It isn’t for comparing yourself with others. 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 expenses, do you increase your expenses when you pay extra toward your mortgage or when you have a 15-year loan versus a 30-year loan? Are only the “extra” payments savings but the “regular” payments are expenses?
This isn’t only about a mortgage. The same questions also apply to student loans, car loans, and credit card debt. If credit card payments are expenses, are your expenses lower and your savings higher when you make only the minimum payment on your credit card and you send the difference to your bank account? If credit card payments are savings, are you boosting your savings when you charge a large sum on your credit card and then pay it off?
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, the escrow portion of your payments is simply an expense. The money goes to the insurance company and the government.
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 Principal 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. 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 get a 15-year mortgage instead of a 30-year mortgage, your monthly payments are higher, but you are not jacking up 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. The higher amount paid toward the 15-year loan isn’t an expense versus putting it into a savings account when you have a 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 and $30k in debt. When Person B has a $500/month car payment, it looks like an expense.
However, to an outside observer, 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 interest that 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. Person B is actually slightly better off than Person A because Person B earns more interest from the extra cash in the bank account.
This is important. Let me repeat it. Buying a car with cash and saving $500/month afterward isn’t any better than a $500/month car payment at 0% APR.
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 account. If the old car continues to run without problems, Person C will have a higher net worth in a few years 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 boat even though one is saving and the other has car payments. Person C’s depreciation 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 both Person A and Person B. Principal payments toward a loan are indeed savings, but whatever was purchased by the loan brings non-cash expenses, which reduce one’s savings. Person B has higher expenses than Person C because Person B bought a new car, not because Person B is making payments on a car loan.
Expenses come from the purchase, not from the payments. If you buy the same thing, paying cash versus financing is only a secondary issue. To really lower your expenses, don’t buy or pay less.
We finally have a logically consistent answer.
Loan Principal Payments Are Savings
Feel free to make additional principal payments toward your loans. The additional payments are still savings.
Feel free to get a mortgage with a shorter term for a lower rate. You lower your interest expenses and the higher principal payments are still savings.
Feel free to finance when terms are favorable. The principal payments are just as valid savings as sending money to your bank account.
However, having high loan balances as a result of larger purchases (expensive house, education, cars, vacation, …) means you have high non-cash expenses from writing down those purchases. This reduces your savings. So do less of those unless the expensive house appreciates more or the expensive education brings a higher income.
Saving, Then Transfer
Some people say paying down debt is neither savings nor expenses. They say it’s only a transfer from one pocket to another.
When we talk about saving versus spending, we’re talking about it in the context of one’s income. Paying down debt by selling existing assets is only a transfer but we’re talking about making debt payments from income. The income you don’t spend gets saved in cash first, and then you use the cash to pay down debt. While the last step is indeed a transfer, you already saved the money. It is savings whether the saved money goes to a bank account or it goes to pay down debt.
Available for the Future
Some others say it’s savings only if the money is available for the future. They say paying down debt is only paying for past purchases.
Going back to the car purchase example, Person A pays cash for a car and then saves $500/month for buying the next car. Person B finances at 0% and spends the next five years paying it off, but Person B has the money in the bank ready to buy the next car whenever Person A is ready. Both persons have the same amount available for the future.
When you pay down a mortgage, the increase in home equity is available when you sell. It isn’t as liquid as cash in a bank account but the money isn’t gone. It’s also available for the future.
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