This is a guest article by Jim. Jim writes about personal finance at Bargaineering.com. You can also find him on Twitter (@bargainr) causing a ruckus.
Consider two individuals trying to save for the future. John saves a hundred dollars a month into a magical investment that gives him 6% a year. After forty years, he ends up with a nice chunk of change: $199,149. Joe starts one year later, saves a hundred dollars into the same magical investment that gives him 6% a year. Do you know how much he gets after 39 years? $186,417.
$1,200 and an extra year gives John an additional $12,732 in savings. That’s over a ten times what he original contributed.
Let’s wait another year, what then? Let’s say we let Joe contribute the extra $1,200 and John stops his contribution. What then?
Joe ends up with $199,149, because forty years is still forty years, but John, with an extra year of savings, finishes 6% ahead – $211,098. For those keeping track at home that’s nearly $12,000 for almost nothing except waiting.
It’s Year 40, Not Year 1
Compound interest helps the person who saves early not because they started earlier, but because they have more time at the end for their money to grow. After year one, when Joe has saved nothing and John has saved $1,233, the difference looks so minor. Joe is only a little bit behind. The problem is when you look at year 40… after Joe has come to his senses. By then, the small little head start that John had in year 1 has magnified itself over forty years.
If you want a good sports analogy, golf is the perfect one. Small minute changes in your golf swing can dramatically change where the golf ball goes. If you don’t hit it square or have the club face tilted, the ball will hook or slice. Over even a hundred yards, the difference is great. The same is true for saving money and compound interest. Save early and you will reap the benefits later on.
Save Anywhere, Just Save!
One thing that hamstrings people is deciding how much to save and where to save it. Start small, just $1 a day means $30 a month. If you can manage $3, that’s $90 a month. Any amount greater than zero is better than nothing; action is better than inaction.
Where you save is up to you. If you want to put it in the stock market, invest it in index funds. If you are afraid of the stock market, put it in an online savings account or a high yield certificate of deposit where it’s 100% FDIC protected (up to $250,000). It doesn’t matter where as long as you start saving.
Don’t be like Joe, be like John and you’ll thank me in forty years. :)
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{ 4 comments… read them below or add one }
I think compound interest can be the best financial tool that people have. The mistake I often see made is that people think if they just save it will just happen. It can but if you manage your compound interest you end up far better. There are a few factors that play a role in how much compound interest can do for you. They are negative returns, time(which you focused on here), taxes and asset allocation. I wrote a post about it recently http://evolutionofwealth.com/2009/08/28/destroying-your-compound-interest/
Thanks for the opportunity Flexo!
Save anywhere, just save….
This seems to be the problem for most . While our national savings rate has increased, the bulk saved is by a disproportionately small part of our population. What turned me around was the realization that it is far easier to save money than to make money. How many hours do you have to work to earn an extra $100 that can be saved? Truth is for most if they earn an extra $100 a big part goes to taxes, then they pay other expenses leaving them with only a few dollars (5% national averge). To add $100 to savings means we have to earn thousands! On the other hand if you can cut $100 out of your expenses by eliminating the muda (waste) all of that $100 can go directly to savings.
The concept of compound interest is a powerful one. It’s never too late to start saving. But off course, the earlier you start saving, the better as this article has demonstrated. If you work hard at saving in the early days of your working life, the second half of your working life will be much easier. And as it is likely that your earning potential will increase over the years, you will be saving at an even greater rate. Hopefully – depending on whether you spend more as your earn more, as a lot of people seem to these days. As they say, it is not what salary you earn, but what you choose to do with your money, that will determine your net wealth.