Why indeed should one start to save early? For young people there is much better things to do with money than saving!
Let’s look at an example and then you decide about that again.
Meet Steve and James. They are both 24 years old, just finished college and started to work, which meant a steady salary, even though it might not be large.
Steve decides he is going to start saving early by starting a retirement annuity and puts $100 per month into it. He does that from 24 until he retires at 65. He saved for 41 years. James on the other hand decided there are better things to do with his money than to start saving. He postponed saving until he was 45 years old and started to put away $300 per month. He did that until he became 65 years, which means he saved for 20 years.
When they both reach the age of 65, this is what they had accumulated for their retirement:
Steve had $119 791 ($100 x 12 months x 41 years = $49 200 Steve contributed, the rest ($70 591) came from compound interest)
James had $107 201 ($300 x 12 months x 20 years = $71 000 James contributed, the rest ($35 201) came from compound interest)
41 years versus 20 years of saving… It might therefore surprise you that Steve will have a little more at the age of 65 than James at the age of 65 even though he actually put in less money in total!
How did that happen? Meet compound interest, the “ninth world wonder”. Compound interest did the hard work for Steve, working with his savings from the age of 24 up to 65, that is 41 years.
James however had the compound interest effect only since he started saving at 45, up to 65. That is 20 years. Even though Steve put in a third less than what James did, he ended up with more money because compound interest did most of the work growing his money over the years.
Before looking at the numbers, you need to understand what compound interest does. Compound interest is the patient version of interest, basically you get interest not only on what you put in or save, but you also get interest on the interest, on the interest, year after year.
For example: if you put $100 in a savings account and that account give you 10% interest per year, you will have $110 after year one, right? You leave that $110 in the saving account and wait patiently for another year. What will you have after year two? $120? No, you will actually have $121! That $1 extra is interest on that $10 extra you got from the previous year.
That doesn’t sound like such a big deal, but if you do that year after year, it starts to add up ever faster. The time in years is what makes compound interest very powerful. Steve had double the time than James had, but he needed to save 30% less than James did to end up with a little more than James did at age 65. Compound interest had time to do its magic!
Let’s look at it in a bit more detail:
To make things a bit easier, we keep interest at 10% per year, and inflation at 6%. Real return on Steve and James’ money is therefore 10% interest minus the 6% inflation, which give 4% real growth. (Generally you would also need to subtract investor fees, which range from 0.5% up to 3.5%, but for now we just keep it simple)
Usually you would also want to increase your contributions each year with the same amount as inflation to reduce inflation’s negative effect, but for simplicity we keep it the same amount per month for all the years they saved.
|Steve saves $100 per month from age 24 to age 65, which is 41 years of contributions.||James saves $300 per month from age 45 to 65, which is 20 years of contributions.|
|Steve’s actual money he put in is $100 per month, which is $1200 per year. After 41 years that is $49 200 in total||James’ actual money he put in is $300 per month, which is $3600 per year. After 20 years that is $72 000 in total|
|With compound interest, Steve’s monthly contribution of $100 for 41 years produces $119 791 at age 65||With compound interest, James’ monthly contribution of $300 for 20 years produces $107 200 at age 65|
|If Steve and James did wisely increase their contributions each year to match inflation, the end amounts will differ even more!|
|Steve increase his contribution each year at 6% to match inflation and end up with $354 588!||James also increase his contribution each year at 6% to match inflation but end up with only $182 882!|
In the end Steve contributed 30% less money than James did, but ended up with more money! Would you rather be like Steve or like James?