You’ve heard the saying “save early, save often.” Sure, it’s a cliché, but like many clichés it is borne of real world experiences. In this article, I’d like to explore WHY saving early and often is so important to long-term financial success. The concept in question here is focused on the calculation of interest and is applicable whether you are applying for a new loan, paying off a credit card, contributing to a retirement plan or anything else where you need to focus on the impact of interest or returns on your future economic success. It’s also important to remember that whether you’re just starting out on the road to financial independence or standing on retirement’s doorstep this concept is something everyone should understand.
Understanding interest has to do with understanding the two main ways it can be calculated and applied to an account. There are two flavors: simple and compound interest. We’ll start with simple interest. If you were to make an investment of $1,000 and were expected to earn 5% simple interest annually; then after 1 year you would expect to have a balance of $1,050. Mathematically: $1,000 + ($1,000 x .05) = $1,050. So what would your balance be after two years? To answer the question you would need to know that when calculating simple interest the interest portion remains the same (assuming you have left the original $1,000 invested). So after two years, you would expect a balance of $1,100—you would have received $50 of interest for the first year and again $50 of interest for the second year. Note, this is NOT how interest is credited or applied in most financial applications.
Compound interest calculations assume that interest is paid not only on the original deposit but ALSO on the accrued interest. So drawing on the prior example: the first year calculation would be identical, leaving you with a balance of $1,050 as before. However, rather than only receiving $50 of interest during the second year you would expect to earn $52.50. Mathematically: $1,050 x .05 = $52.50 where the $1,050 is the accumulated sum of the original deposit plus the first year’s interest. This would leave you with an ending balance after two years of $1,102.50. The compounding of interest in this simplified example leaves you with an additional $2.50 versus the simple interest example. Note, you can compound interest according to different schedules, i.e. daily, weekly, monthly, annually, etc.
If you’ve ever made your minimum credit card payment and watched the balance increase despite the payment, then you’re familiar with the ill effects of compound interest. However, we can also harness the power of compounding returns and this is one of the most important concepts to investing successfully and brings us full circle to where we began, that you should save early and save often. To illustrate, I’d like to introduce you to Jane and John.
Jane is a 23 year old recent college graduate employed in her preferred field while John is 55, has put two kids through college and is now turning his attention to “catching up” on his retirement preparedness. Let’s suppose each of them have the same goal—accumulate $1,000,000 by age 66 (John’s retirement age). For the sake of over-simplification, we’ll further assume that they are each starting with $0 balance and we’ll ignore the impact of taxes.
If you have more time, you can accept lower rates of return in order to meet your long-term objective. Let’s assume that Jane can earn 5% annually in her investments and she expects that return to be very stable as a result of maintaining a relatively conservative investment portfolio. She has 43 years to reach her goal. I’ll save you the math here. She would be required to save $552.13 every month until age 66. John on the other hand only has 11 years to accomplish that goal. If John also wants to maintain a reasonably conservative portfolio that produces a stable 5% return then he would be required to save $5,697.82 per month to meet his goal. Keep in mind that John would also have to plan on continuing to pay all of the other expenses that would be anticipated as part of his normal lifestyle.
So naturally, this example points out a conundrum that many face: lacking the time to accumulate sufficient resources to meet financial independence goals. Instead he is forced to seek out greater returns; which, in turn, equates to amplified risk. With increased risk comes increased volatility and expected drawdowns during negative market environments that could come at inopportune moments—perhaps right before retirement.
While these examples are simplified, they are indicative of the real world decisions that people are forced to make when they do not begin saving early enough. As financial planners, we plan for different time horizons and each individual has many; the planning period may be to a certain age, a certain life event or full life expectancy. In any case; no matter your planning horizon; in order to create a more robust financial future for yourself, there’s no time like yesterday to begin!
by David A. Younis, CFP ®, Director of Financial Services