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The Secret to Saving Money
Without a savings plan, the chances of saving enough money to meet long-term financial goals are very slim. Like financial success, saving money doesn't happen by accident. It requires smart buying, cutting costs, planning, and understanding a few basic financial concepts like the magic of compounding, the Rule of 72, the time value of money, and the danger of inflation.
The Magic of Compounding
The magic of compounding is the biggest reason that it's so important to start saving in your early 20s. People who wait until their 40s to start saving will have to save much more than those who started in their 20s. What's worse is that they will never be able to catch up with those who started in their 20s without saving and investing drastically higher amounts than would have been necessary had they started at a younger age.
Methods of Compounding
There are two basic methods of calculating interest: simple interest and compound interest. Simple interest is calculated based only on your initial investment. Compounding means that you earn interest on your interest as well as on your initial investment. The difference may not seem like much, but the effect that compounding can have over a long period of time is astounding, especially with larger initial investments and higher rates of return. To illustrate how compounding works, assume you invest $1,000 at 10% interest compounded annually. At the end of year one you'll have earned $100, for a total of $1,100. At the end of year two, the interest is calculated on $1,100, so you'll earn $110, for a balance of $1,210.
Frequency of Compounding
Interest is usually compounded annually, monthly, or daily. The more frequently compounding takes place, the faster your money will grow. As the balance grows larger, the difference between simple interest and compound interest becomes greater. Let's say you put $5,000 in an account that earns 10% interest. Here's what your investment would be worth at the end of ten years if you didn't add another penny to it:
Compounded annually: $12,968
Compounded monthly: $13,535
Compounded daily: $13,589
To illustrate the effect of a longer period of time on compounding, consider Bill, who contributed $2,000 at 6% interest to an IRA beginning at the age of twenty-two and continued doing so each year until he was thirty (nine years). By the time he was sixty-five his $18,000 investment had grown to over $579,000. His friend Jim made a $2,000 contribution every year for thirty-five years, for a total of $70,000, but because he started at the age of thirty-one, his nest egg only totaled $470,000. Even though he contributed much more than Bill ($70,000 versus Bill's $18,000) he ended up with 23% less money.
The Rule of 72
The rule of 72 is a nifty mathematical computation used to estimate how long it will take a certain sum of money to double at a certain interest rate. You can use this simple rule to quickly determine how long it will take your savings or an investment to double, or how long it will take a debt to double. Try it out on some of your investments or debts.
Calculating How Quickly Your Money Will Double
The calculation is simple: divide 72 by the interest rate or expected rate of return. The result is the number of years it will take your money to double at that interest rate assuming you reinvest your earnings. As an example, you have $10,000 and you want to know how long it will take to double that amount if it earns 8% interest: 72 divided by 8 = 9, so it will take nine years. You can also use the Rule of 72 to estimate what rate of return you'd need to earn in order for your money to double in a certain number of years, for example, ten years: 72 divided by 10 = 7.2, so you'd need to earn 7.2% annually for your money to double in ten years.
How Many Times Will Your Money Double?
The power of the Rule of 72 doesn't stop there. It illustrates how important differences in interest rates are, because the lower the interest rate the longer it takes to double your money, and the real key to growing your money is to double it as many times as possible. Look at this example of $100 doubling eight times:
As you can see, the real growth comes after the money has doubled several times, which is important when you're saving or investing for long-term goals like retirement. By using the Rule of 72, you can calculate how much you'll have by a certain time and you can compare the long-term effects of interest rates on various investments that you own.
Double Savings, But Don't Double Debt
You can use the Rule of 72 to see how long it will take your credit card or other debt to double, too. If you have a $5,000 credit card balance with an interest rate of 10%, your debt will double in 7.2 years. If the interest rate is 19%, your debt will double in only 3.8 years. You can see why it's so hard to pay off your credit card debt, especially if the interest rate is high. If you're only paying the minimum payment each month, it doesn't take long for your balance to double.
The Danger of Inflation
Inflation is the effect of rising prices on your buying power. Inflation is often left out of the equation when calculating how much money you'll have available at some point down the road, but inflation can make serious inroads into the buying power of your money. The average inflation rate since 1994 has been approximately 2.5%, but in the early 1980s, we experienced double-digit inflation. Since 1980, the price of goods and services has increased 80%, so an item that cost $100 in 1980 costs $180 in 2002. Since much of our financial planning is done for years into the future, it's important to consider the impact of inflation when determining how much money you'll need in retirement, for example.
You can use the Rule of 72 to estimate the real buying power of a sum of money at some point in the future, taking inflation into consideration. If the inflation rate is 4%, prices will double in eighteen years (72 divided by 4 = 18), so if you plan to retire in eighteen years, and you need $3,000 a month in today's money, you'd need $6,000 a month to retain the same buying power you have today.