1st and 15th Financial Corner - Feb 15, 2011

February 15, 2011

Click here for all editions of 1st and 15th Financial Corner.

Before I get into building net worth, I want to explain the time value of money and compound interest... both appropriate topics for tax season.

The time value of money means that any amount of money you receive now is more valuable than the same amount of money you receive later. Compound interest is the reason for this. It’s why you don’t want a big, fat income tax return every year… adjust your withholdings to get your money NOW.

Many people like to quote Albert Einstein as saying that the most powerful force in the universe is compound interest. He probably never said that, but the point is valid. Compound interest is a mighty force.

There are many simple ways to earn interest on money. Savings accounts and CDs are two of the most common interest-earners.

Let’s say you followed along with the previous editions of 1st and 15th Financial Corner, cut $5,000 from your yearly expenses and put that savings into a CD earning 5% per year. You don’t add anything to it and just let it sit there. In 30 years, that $5,000 will be worth $20,580, which is a lot more than the $0 it would have been worth if you had spent it.

How’d that happen?

COMPOUND INTEREST

At 5%, your $5,000 earned $250 the first year. Here’s where compounding kicks in. The second year, your $5,000 earns another 5%, but your $250 earns 5% too. What happens is your interest starts earning interest, then that interest starts earning interest, then that interest starts earning interest, and on and on and on.

So, your initial capital investment ($5,000) is constantly snowballing, adding more and more to itself every day. Imagine how much momentum you could create for your little nest egg if you regularly add more to it along with the interest it is accumulating.

Excel is great for calculating compound interest, but you can do it on a calculator, too. Just enter 5000 x 1.05 and hit enter or =. That gives your value after a year of 5% gains. Hit enter or = again, and that’s your 2nd year value, and so on.

Now, check this out. If you invest in something that will get you an 8% return instead of 5%, then after 30 years, your $5,000 will be worth $46,586!

Just by increasing your annual return by 3%, you get $26,000 more.

Investing in a stock/bond portfolio will reasonably get you 8% annually… possibly more, possibly less.

If you invest $20,000 initially, 5% gets you $82,000 after 30 years, and 8% gets you $186,000.

Warren Buffett tends to think in terms of the future value of money. For example, if you buy a $4 coffee drink at Starbucks, you’ll actually have $37 less when you retire because of that $4 you spent today. That $4 didn't get to compound and that coffee drink literally went down the toilet. Add the little things up, and it’ll blow your mind how much they are costing you over the long run.

So, you can see the impact of compound interest and percentage returns.

If you think about it, this also demonstrates the importance of saving money NOW!!! The longer you wait to start building your nest egg, the less time you are giving compound interest to work its magic.

To illustrate this point, look at this chart.



See the line? It’s parabolic… it ain’t straight. Compound interest really kicks in exponentially the longer you give it to work. The exponential increase is what makes compound interest so powerful. So, don’t fall into the trap of thinking you can wait to start saving and catch up later in life.

The time value of money bites you in the butt every day that you wait.