How to save money

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Having enough savings is very important to meet future short term needs. However most people do not have enough savings while others are not able to do it properly. To be able to know how to save money, you need to have a good strategy.

Key takeaways

After reading this article, you should be able to:

• Determine the minimum amount you need to save each month/year.
• Calculate the number of months/years you need to save.
• Estimate the number of months/years you are covered by your savings.
• Estimate your basic monthly/yearly expenses.

Factors that determine your savings target

Saving is not just a random act you do. You need to have clear goals on how to do it so as to make the best out of your savings.

1. Size of your expenses or targets

The most important thing you need to consider before you start saving money is to understand your expenses.

If the main goal of your savings is to cover certain expenses like buying yourself a car, you need to know an estimate of the future price of that car. If your saving target is for you to have a 1 year leave then you need to have a good estimate of your monthly expenses.

You need to be prudent on doing this. The best way is to overestimate the size of your future expenses.

The following article can help you to classify and estimate the size of your expenses:

• Think beyond income and expenses.

2. Duration of the cover

The other important factor you need to understand is how long you need your savings to sustain you. This is very crucial for you to be able to measure your savings progress.

If you are saving for an emergency or any unexpected events, you need an estimate of how long you will need to recover from that emergency. If you lose your main source of income, how long does it take for you to find an alternative source?

Determining the size of your savings

If you are more knowledgeable about the size of your targets or expenses as well as having a clear understanding of how long you need to be covered, then you can estimate the amount you need to save.

Assumptions

Let us make some assumptions. Let us assume that the interest from your savings is exactly the same as inflation. This simplifies our calculations and makes it easier for many people to understand. As a result of this assumption, we can assume 0% interest and 0% inflation.

Calculations

For you to be able to calculate the number of years/months you need to save (denoted by N), you need to know the following:

1. P – Yearly/monthly saving amount
2. T – Number of years/months you need to be covered with the savings
3. E – The size of your expenses or target

Therefore, number of saving years/months is given by:

Note that we can also rearrange this to get the formula for the amount you need to save. Now you need to know how many months you need to save so that you can determine the amount to save.

Therefore, the amount to save is given by:

Practical example 1:

Suppose that you can only save R 5 000 per month and you need to be covered for R 10 000 monthly expenses for 1 year. How many months do you need to save for?

What this means is that for each month’s saving, you are covering half month worth of your expenses.

Practical example 2:

Suppose that you are working on a 12-month contract and you can only save for 12 months. You want to prepare for R 15 000 per month worth of expenses for 7 months after your contract expires. How much do you need to save per month?

Changing the assumption to accommodate interest and inflation

If we change our assumption of 0% interest and 0% inflation, we introduce a small complexity to our formulas above. For a beginner or someone who want to have a rough estimate, I would recommend you to stick to the earlier formulas.

The new formulas will require you to understand present and future value of annuities.

Let i denotes the real interest rate (after adjusting for inflation). Therefore we construct the value of the annuities at the time of the first cover (that is after the last saving has been made) as follows:

This can be presented as follows:

Therefore saving amount is given by:

Now let us recalculate practical example 2 assuming that the yearly real rate of interest is 3%. The monthly savings is given below:

As you may have noticed, this monthly saving amount is slightly less than the one we calculated earlier. This is because if you save your money in a savings account with positive real interest rate then it will grow and you will not need to contribute much in savings to reach your savings target faster.

Summary

You need to know how to save your money by ensuring that you know the size of your expenses or targets and the expected duration of your cover. Knowing the amount to save or the duration you need to save is very important. This will help you to measure the progress of your saving adventure.

Helpful articles:

• How to build a habit of saving and investing
• Invest with purpose – making first steps