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Save early and save often.
You work hard for your money; shouldn’t your money work for you?
Principle #3: People usually decide at the margin (give a little, get a little).
Objectives:
Use a compound interest calculator and marginal analysis to investigate the impact of saving early and often.
Why you want to learn this This is one you really don’t want to miss. You are about to discover an incredibly powerful financial tool --- compound interest. People who hear about this for the first time in their forties and beyond often ask the question, “Why didn’t someone tell me this earlier?” Well, we’re telling you this now!
There is a way to make your money work for you but the catch is that you have to earn it and then save it. Once you do that, the process takes care of itself. Assume that, by some miracle, you have found some fool who promises to pay you 100% interest per day for every cent you have in a savings account. “Well,” you say to yourself, “I can save one penny.” So you do. And you walk away. The next day, you check your account balance and, sure enough, you have two cents. Next day, four cents…still not very exciting. You have to go away for a few weeks and you don’t bother checking your balance….one cents, two cents, four cents…nobody is getting rich here. Except you are! After about a month, you return and you figure you should check it out. You look at the balance and it blows your mind. You have $10,737,418.24…almost $11 million from ONE PENNY!!!!! There must be some mistake! But there is no mistake and no one took your money to Vegas. In one month, compound interest has increased your money from one penny to close to $11 million. No tricks, no sleight of hand, no gambling, no risk…just $11 million.
Here's the catch. The example assumes that you are going to earn 100% interest daily and that is not going to happen. But the point is the same; compound interest will turn your savings into a much larger sum. The even better news is that you have control over how much that larger sum is by making marginal decisions about how much you will save and for how long. Take a look at the worksheet below.
A Tale of Two Savers
Let’s look a little more closely into this compound interest thing; be prepared to be amazed. Retrieve the spreadsheet, “A Tale of Two Savers.” Assume two savers, Kris and Jordan, are committed to saving enough money to live a comfortable life after retirement. Kris begins saving at age 22 and saves $2500 annually for 12 years at an annual interest rate of 7.5%. After age 33, he doesn’t save another penny, but he also doesn’t touch his savings so the money continues to accumulate interest until he is ready to retire at age 65. Kris saved for 12 years, deducted $30,000 from his income and ended up with over a half a million dollars.
Jordan started saving a bit later…age 34. Same amount saved per year, same interest rate, but she saved for 32 years. Surely she will end up with more money than Kris; but no, that is not the case. Her account balance at age 65 is $327,000. Kris has 50% more than Jordan! How did that happen since Kris only saved $30,000 of his income compared to Jordan’s $80,000.
The answer is clear; he began saving early and then let his money work for him. Play around with the spreadsheet, changing the amount saved in cell H4 and the interest rate in cell H5. You can even change the number of years that Kyle saves if you like. It should be clear that the interest rate has a major impact on the final numbers. We will discuss more about the interest rate in later summaries.
Bottom Line
Compound interest is powerful. It works because the interest you earn each day, month, or year earns interest itself, so your money is making money for you. Variables that affect how much money your savings earn are the amount of money that you save, the frequency of your saving, the interest rate your money earns, and the amount of time your money sits and earns you money. If you wish to take advantage of the power of compound interest, follow the rules below.
Search for the best interest rate, start saving early, save as much as you can, and save often.
Hint: if you have your saving automatically deposited in an interest bearing account, you will never notice it is missing.
Three Caveats
Inflation will erode the purchasing power of your savings. There will be more about this in a later summary.
If your savings are taxable, you are likely to move into a higher tax bracket.
The interest rates used in this worksheet are fairly high over a long period of time. They are not impossible but require a skilled financial analyst to attain them.
1. At age 21, Rebecca begins saving $200 per month at 8% compound interest for 10 years and never saves again. At age 31, Lee begins saving $200 per month at 8% compound interest and saves the same amount monthly until age 65. Who will end up with the most money at age 65?
a. Rebecca
b. Lee
c. It depends on the rate of interest.
d. It depends on the amount of monthly saving.
2. The reason that compound interest is so powerful is because:
a. Savers know what future economic conditions will be.
b. Savers determine interest rates.
c. Savers are smarter than borrowers.
d. Savers earn interest on their interest.
Compound interest worksheet
Assume that you have just finished high school, you are 18 years old, you have a baby, and you and your spouse both have $15/hour jobs. You are making it, but just making it and some wise guy suggests that you should be saving part of your very skimpy income. You have done your best to make a reasonable budget and you just don’t see how you can do it. You finally do some marginal benefit/cost analyses and find $100 to save each month. Fewer trips to the hairdresser, more meals at home instead of fast food, more babysitting by Grandma and you have your $100 per month.
Go to the Compound Interest Calculator on EconEdLink.
Scroll down to the Compound Interest Calculator
We are going to fib a little bit and tell the calculator that you are 54 years old because we want to see how much you will have in 10 years and the calculator only lets you save until you are 63.
Your estimated annual interest rate is 8% (You have a trusted financial advisor who has been able to average 8% over the ten years.)
Your initial deposit (investment) is $100.
You monthly saving is $100.
Click on the Calculate button.
Scroll down to watch your saving grow.
How much do you have after 10 years of saving 100 per month (total earnings)?
How much of that amount did you save (the principal)?
How much interest did you earn? (Total earnings minus Principle)
What is the ratio of interest to principle? It’s ten years later and you have accumulated #1 above. You are now able to save $1000 per month. (Life has been good to you and you both have worked hard to make a good life for yourselves and your (now) two kids.) Take the amount that you have from #1 above and make that your initial deposit. Your annual saving now is $999 per month. Assume that you save that amount to age 63.
You are 28 years old
Your estimated annual interest rate has fallen to 6%.
Your initial deposit (investment) is your total earnings from #1 above.
Your monthly savings are $999.
What are your Total Earnings at age 63?
How much did you save from age28 (Principle)?
How much interest did you earn through the year (Total earnings minus Principle)?
What is the ratio of interest to principle? Assume that somehow you had been able to start saving $999 per month at age 18 at 6% and continued to save that amount until age 63.
What are your Total Earnings at age 63?
How much did you save from age 28 (Principle)?
How much interest did you earn through the year (Total earnings minus Principle?
What is the ratio of interest to principle?
Use this exercise to write an essay explaining the phrase, “Save early and save often.
How does this exercise exemplify marginal analysis?