Saturday, February 7, 2015

Step one - Start saving early

While there may be no better time than the present to start saving, an even better time to start saving would have been some time in the past.

This is not to say that all hope is lost for anyone reading who may be is off to a late start in saving, but one simple illustration shows that the time your money has to grow can actually be more important than how much you've saved!

Let's assume you start investing $100 per month at age 25, and for whatever reason at age 40, you decide to quit investing, but leave the money invested until age 65. Let's say that you have a friend who is the same age, and hasn't started investing yet, but sees how your $100 a month has grown and then gets motivated to start investing too. Your friend starts to save $100 at age 40 and keeps doing so until age 65. We'll assume that you are both investing in the same thing and you average 8% on your investments.

Who do you think has more money at age 65? You, who put money in for 15 years and then let it sit for 25 years, or your friend who started later, saving the same amount each month, but for 25 years?

Even though you only put in $18,000 and your friend puts in $24,000, you would actually end up with more money at age 65. Not only would you have more money than your friend, you would have A LOT more money. Despite having invested $12,000 LESS than your friend,  you end up with over $240,000 while your friend has about $96,000. How is this possible? Compound interest.

Compound interest is deceptively powerful in its simplicity. Think of it this way, when you earn interest on your money and keep everything invested, you then begin to earn interest on your interest. This can take several years before it is noticeable, but eventually you reach a tipping point where you earn more interest on your interest than you do from your initial investment. In fact, by the time you reach retirement, the majority of your money should actually be growth!

Here in the DIY$ household, we have seen the power of compound interest first hand. Even though we were able to save about 18% of our household income into retirement accounts in 2014, the growth we had from our existing investments was an even greater amount of money. We have seen this in multiple years, but it takes time and patience to get to that point.

While I have worked with people who started saving late and still accumulated significant assets, the key is generally to start early. If starting later in life, you will simply need to save more than someone who started saving younger. In my simple example outline above, for the person starting saving at 40 to end up having the same amount of money at age 65 as the person who started at 25, they would have to save about $315 per month instead of just $100.

We'll dig into details later, but for now the lesson is this: Start saving as early and as often as possible. If you haven't started yet, start now! If you're starting late in life, understand that you will need to save more than if you had started early, to accumulate an equivalent nest egg.

Have you witnessed the power of compound interest?

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