Benjamin Franklin never said “a penny saved is a penny earned”, but it’s often attributed to him. Here’ s why a penny saved is better than a penny earned for financial independence. I reckon it’s worth about 41p over 10 years if you save it consistently.
Trivia: what Benjamin Franklin actually said
A penny saved is two pence clear.
Benjamin Franklin – Poor Richard’s Almanack; 1737.
This fact was brought to my attention by The Franklin Institute itself, so I’m pretty convinced it’s true. All the same: the original phrase is a good one, so why waste it?
He’s wrong, by the way. Franklin’s point was that you didn’t have to spend a penny, so you’d reduced your expenses by one penny, but you’d also increased your savings by one penny. This would make you two pennies clear. However, he didn’t consider investments, financial independence or taxes. If anything, Franklin was way too conservative!
Three reasons why a penny saved is better than a penny earned – for Financial Independence purposes
- It’s tax free
- It might reduce your FIRE number
- Money spent is gone forever – money saved has investment potential
Reason 1: It’s tax free
When you want to earn money, it’s probably taxed at the point of earning. You pay taxes on your wages, you pay taxes on a business asset, you pay taxes on royalties… In fact, unless it’s in an ISA or SIPP or within a tax allowance, chances are that you’ll pay tax on making money.
Saving money is the opposite. If you save £10 from your expenses, it was already taxed when you earned it. Any interest or money you make on top of that £10 may be taxed later, but that £10 is yours already. If it’s a £10 saving from a budget, you’ve probably “spent” that money psychologically already, so think of it as earning an extra £10 tax free for good behaviour by not spending all your money when you could have done. Nice one!
Reason 2: It might reduce your FIRE number
I wrote a post about working out how much money you need to be financially independent, assuming that you only use investments to fund your financial independence. The rough rule of thumb for a fairly conservative estimate was 25 times the amount of money you spend in a year.
For example: if you’re consistently saving £10 from your budget each year, you can drop this FIRE number by £250. If you’re saving £10 each month, that’s £3,000 of investment assets you don’t have to have in your portfolio (i.e. £10 x 12 months x 25). Yup, for every £1 a month you don’t need to spend, you’re knocking £300 off your final financial independence number. Pretty cool, eh?
Rule 3: Money you spend is gone forever – money you save has investment potential
This one’s a simple idea to grasp but hard to work out with precision.
If you spend £10 on a beer and a burger/ renting that terrible Wonder Woman sequel/ on hair dye that didn’t work as well as you’d hoped, that money is gone. You can’t return the beer and burger (ew). You can’t recover the two excruciating hours of Wonder Woman 1984, nor convince Amazon Prime to return your money. You can’t un-dye your platinum blonde hair tips. The money was in your life, now it has been exchanged and is moving on to someone else. Bye-bye!
However, “spare” money that’s not needed for short-term needs is better. Saved money like this is better than earned money that’s just spent away: you can buy assets with it. You could spend that £10 on ETFs in your ISA, which grow in value. You could invest in property with a REIT and get rental income. You could convert it into gold and sit on it for years like a pirate, until it’s worth more money later. You could even buy a domain name for a year and start an online business with it. That saved £10 is worth more than that £10 earned: it’s also worth the potential money it could make you on top of the original £10.
This is called “opportunity cost“. Another way to think of opportunity cost is to call it “missing out”. If you spend the £10 you will (probably) get £10 worth of value, but if you put the £10 to good use you might get more than that value. By spending now, you’re missing out on what could have been.
How much is a penny saved better than a penny earned?
For every £10 a year you save, you’re at least £260 closer to financial independence. If you invest it for 20 years at invest in a global index fund, assuming 9% nominal growth and 2% inflation, your £10 saved and invested is worth £288.70.
No, really. Here’s how to work these things out.
Step 1: the base value of saving £10.
If you save £10 and don’t miss it, you don’t need to earn £10 a year from your assets. That’ll drop £250 from your FIRE number straight away, assuming that you’re planning to draw down 4% of your resources each year to spend and cover your bills. If you’re planning on a safer 3% withdrawal rate, it’s £330 instead.
I’m pretty confident that I can adapt my lifestyle to my income, so 4% works for me. Done!
Step 2: work out what you’re going to invest that in instead
I’m going to ignore crypto, because that’s a market that’s almost completely unpredictable as far as growth goes. It’s just not old enough to work this out, and it’s super volatile.
I used the average 10-year return on a global all cap tracker. Figures vary, but a bit over 9% seems to be the nominal norm. Obviously, past performance doesn’t mean long-term performance will be good, but it’s as good an estimate as we can get.
That gives us 9%, for argument’s sake.
Step 3: account for inflation
If you read my post on how money is made, you’ll know that the target rate of CPI inflation is 2%. Obviously, not the most accurate measure, but you have to go with something!
Inflation works against you, like a negative interest rate. Yup, your money next year will be worth less than your money this year. To work this out, take the inflation rate away from the growth rate of your investment. In this case: 9% – 2% = 7%. That means we’re going to use 7% as our opportunity cost rate.
Step 4: Decide how long you want to invest for (in years)
In my case, I want to hit CoastFI in 10 years. That means that I want at least 10 years of investing and then I’ll make a decision from there.
That gives me the answer 10.
Step 5: blow your mind with maths
This opportunity cost is worked out using this formula for compound investing, which you can type in on a smartphone calculator.
Future Value = £amount (1+interest rate as a decimal)years invested
In this case:
Future Value = £10(1.07)10 = £19.67
This means that £10 invested is worth £19.67 in 10 years. Pretty cool, eh?
Protip: When you do this on android smartphone, use the button ^ then type in the power (that’s the bit like this).
Step 6: add them both together
Add the money saved from your FIRE number to the future value of your investments and there you go!
In my case, that’s £250 plus £19.67. That’s right, saving just £10 a year from my budget and putting it to work in a single lump sum will bring me £269.67 closer to my goal.
Even better: this assumes that I save £10, then only pay £10 in once. If I keep saving those £10 notes, I’ll actually have the future value of the next £10 invested for 9 years, the one after that invested for 8 years, the one after that… you get the picture!
To save you from any more maths: saving £10 a year then investing it each year for 10 years is worth £407.84, including the last £10 that you just add in.
That means that for me, a penny saved and invested annually is worth almost 41p in 10 years time. Not a bad return on 10p total!
Wait, what about the tax?
What we’ve worked out is the value of a money spent versus money consistently saved and invested. If you actually want to work out how much better a penny saved is than a penny earned, you have to add your tax rate to the first 25x saving. I’m a basic rate taxpayer (20% tax rate), so that first £250 on the £10 saving would mean that I actually need to earn £312.50 (i.e. 25% more, so that when you take off the 20% it’s £250). There are things like the trading allowance for side hustles and passive income under earnings thresholds or within ISA wrappers though, so I didn’t add it in. It was getting a little confusing and there’s enough evidence already.
Summary table – a penny saved is BETTER than a penny earned
There were a lot of numbers thrown around here. It got messy really quickly. I’ve put these numbers into a summary table to make sure we’re all still sane and holding it together at the end.
| Scenario | Value of saving | Value of gain | Total balance at the end (what you cut from your budget plus your gain) |
|---|---|---|---|
| You spend 1p and save nothing | 0 | 0 | 0p |
| You save 1p as a one off and invest it in a global index tracker fund for 10 years, based on a real terms growth at 7% | 1p | 2p | 3p |
| You save 1p a year and invest it in a global index tracker fund for 10 years, based on a real terms growth at 7% | 10p | 40p | 50p |
| You save 1p a month and invest it in a global index tracker fund for 10 years, based on a real terms growth at 7% | £1.20 | £4.80 | £6.00 |
| You save 1p a week and invest it in a global index tracker fund for 10 years, based on a real terms growth at 7% | £5.20 | £21.21 | £26.41 |
| You save 1p a week and invest it in a global index tracker for 10 years but the world doesn’t recover from Covid-19 and it only averages 3% growth per year, probably worst likely outcome | £5.20 | £6.14 | £11.34 |
What this means for financial independence
This isn’t a perfect model. You might not earn 7% average growth on your investments. Inflation might kick you harder than expected and stock market returns after Covid-19 might be poor for the next decade. Still, with the information we have, and having ignored the tax bit, we can make two fairly solid deductions.
1. If you can live happily with just a pound less each year, you can get around £41 closer to financial independence in 10 years
This means that little things, like learning to cook or switching your hobbies from super-expensive activities to slightly cheaper ones, have a huge impact on your ability to achieve financial independence.
If you only have Netflix or Amazon Prime or Disney Plus at any one time, you’re saving yourself thousands of pounds over ten years for making that small increase into your investment portfolio. That’s potentially years of freedom bought back because you only run one TV subscription at a time, and let’s face it: you only watch one thing at a time. Did your lifestyle really suffer? Maybe it’s time to get rid of some superfluous junk subscriptions.
2. The lifestyle you choose to live will have more impact on your freedom than almost any amount of money you can earn
41p for 1p per year saving is huge. It’s 4,100% huge. This means you’re usually better off saving from your budget and investing it than you are chasing more money, as you need to make up for that extra 25x head start at the beginning before you get the benefit of investing that extra cash.
Obviously, there’s a limit. If I did this to extremes, I’d have lodgers in every room in my house, never attend social events unless there was free food, and my entertainment would be sitting alone on park benches or shoplifting. It’s not a life that I want to live and it’s not one that I do live!
What it means for me is that I’ll buy my clothes from M&S or on sale, rather than burn all my money on designer labels. I’ll eat those two veggie meals each week to save a bit of cash. I’ll live without a car when I can just rent one. I’ll spend intentionally on items that will last longer than cheaper options if the value case is better. This keeps my FIRE number low and it’s helping me make huge strides forward.
