In today’s post I wanted us to continue the discussion on personal finance basics by focusing on investments.
Do you know how much it costs to wait to invest? What if I told you that a couple of years could cost you more than a million dollars over time. Would you care? Would you do something about it? or would you just read this and carry on the same way? Many people think they can play catch-up, but it is much harder and much more expensive to do so.
Are you like most people? Do you wave your arms forward and say something like: “Ah, no problem, I will start investing when I get my student debt paid off?”. Then it’s: “I will start investing when I am done saving for a house”. Then, “I will start investing when my kids move out”. Then, “I will start investing when my house is paid off”. Then, your life is over. Sound grim? This was most of the excuses I heard while working in the field. I realized that most people always had an excuse not to invest no matter where they were in their lives. I think people would be more likely to invest sooner if they knew what the price was to wait.
Let’s look at an example of two people who want to invest for their retirement, let’s call them John and Dave. They are both twenty-five and just finished college. John starts investing straight out of school, even though he knows he has school debt to pay. He is ok with paying off the debt a little slower to start investing right away. Dave wants to focus on paying his school debt off first. As a result, he starts investing 5 years later. Each contributes $200 a month. John contributes for the first 15 years and then stops. Dave contributes each year until retirement. Who has more money for retirement in 40 years at age 65? Figure 1 illustrates this example:
Figure 1: Contribution and Portfolio Value at Retirement (Personal Finance Basics)
Assumes a rate of return of 8%
|Year 1||$2, 400||$0|
|Year 2||$2, 400||$0|
|Year 3||$2, 400||$0|
|Year 4||$2, 400||$0|
|Year 5||$2, 400||$0|
|Year 6||$2, 400||$2, 400|
|Year 7||$2, 400||$2, 400|
|Year 8||$2, 400||$2, 400|
|Year 9||$2, 400||$2, 400|
|Year 10||$2, 400||$2, 400|
|Year 11||$2, 400||$2, 400|
|Year 12||$2, 400||$2, 400|
|Year 13||$2, 400||$2, 400|
|Year 14||$2, 400||$2, 400|
|Year 15||$2, 400||$2, 400|
|And on Until 65||$0||$2, 400|
|Total Contribution||$36, 000||$84, 000|
|Value at 65||$507, 996.26||$458, 776.50|
Wow! Did you expect that? John contributed $48, 000 less as still has $49, 219.76 more for retirement than Dave. What if John contributed all the way until 65? I just happen to have those numbers too: John would have a value of $698, 201.57, which is $239, 425.07 more than Dave. Remember, we are only talking about 5 years here! So, the question to ask yourself is: who would you rather be? Would you want to be the person to get it over with sooner, or do you want to play catch-up your whole life? The choice is yours.
Who would have thought that only 5 years could make such a difference? The first time I read this I was in shock too. Part of learning to manage your money is the understanding that money has a time value associated with it. Meaning that money is more valuable the longer you must grow it. What about you? Are you the type of person that wants to wait until the mortgage is paid off to start investing? There are many people out there with this type of mind-set. Part 2 of this series will look at how much it costs to wait that long, as well as how much interest did John pay on his student loan vs. David’s. Who was ahead at the end of the day? Stay tuned.
Many people want to pay off debt before they start to save. Figure 2 shows the excuse debt and how much it will cost to play catch up. For this example, we will use a fixed total amount to save for, let’s say $500, 000 by age 65:
Figure 2: How Much Will It Cost to Play Catch Up?
|Debt Excuse||Monthly Contribution||Value at Age 65||Monthly Amount Needed to Get To $500, 000|
|Pay off Student Debt (Age 30)||$200||$458, 776||$226|
|Save For House (Age 35)||$200||$298, 072||$348|
|When I Get A Better Job (Age 45)||$200||$117, 804||$881|
|Pay For Kids (Age 50)||$200||$69, 208||$1, 499|
|Pay off Mortgage (Age 55)||$200||$36, 589||$2, 836|
Now, I’m not going to tell you what you should do. That is for you to decide. I just provide the information. It’s up to you to decide what action you take. All I will say is that if you have the chance to start early, it would be a heck of a lot easier than trying to play catch up. The above example shows that you would have more than ten times more cash for retirement just by starting early.
One question people often ask is about paying off debt. They would say something like “I thought it was good to pay off your debts and save interest”. This is true, you want to pay your debts off, but you also need to allocate some cash to investments for the future, even if it’s only a small amount to start with. Let’s look at the example from the first post in this series. If you missed it, it was posted on Mar 27. 2009. To recall, John and Dave were both saving for retirement. John paid off his student debt slower so that he could start saving 5 years earlier than Dave.
Let’s assume they both had $30, 000 worth of debt. Dave is going to pay his off in 5 years. That would make his payments $594.04 a month assuming 7% interest. John is going to put $200 a month less towards this debt as this money is going towards his investments. So, John’s payments are $394.04 a month. According to my calculations John will end up paying $4, 138.53 more in interest and it will take 8 years to pay off.
Finally, let’s compare total cash out of pocket and see who’s better off. The following chart will show this:
Extra Interst On Loan
|Total Cash Contributed||Total Out-Of-Pocket Cash||Value of Portfolio At 65||Total Value Minus Out-Of-Pocket Cash?|
|John||$4, 138.53||$36, 000||$40, 138.53||$507, 996.26||$467,857.73|
|Dave||$0||$84, 000||$84, 000||$458, 776.50||$374, 776.50|
Incredible! John has $93, 081.23 more than Dave. He contributed $48, 000 less than Dave and stopped 25 years sooner, all the while racking up $4, 138.53 more in interest. Yet he is still ahead. At the end of the day this is all that truly matters. How much cash you have after it’s all over, and how well you can sleep at night. Let the numbers do all the talking. This is how I base my financial decisions. Numbers don’t lie, that’s why I loved math in school.
You can see by the following examples that there is a high price to pay for waiting to invest. You can try to play catch-up, but it will cost you a lot more to get to the same destination. Take the time to crunch the numbers and then make your decision. If all you do is just start, then that is defiantly a step in the right direction. When is the best time to plant an oak tree? Twenty years ago. When is the second-best time to start? Now. Take the first step and start. You will be amazed at how much easier it becomes.
I hope this post on personal finance basics has shown you how you are losing out by dillydallying on investing your money. The little you invest now will add up in time and you will be pleasantly surprised when you retire how your small investments have played out.