Thanks for coming back to read Telos Financial’s blog all about different financial planning topics. The purpose of the blog is to introduce financial planning concepts that I believe are important. I want to start discussions about that will educate, benefit, and improve your financial life. Ultimately, to help you focus on your telos!
Compounding interest is not magic. Because. . .magic isn’t real; it’s an illusion designed to entertain. Compound interest, however, is real. It is also famously entertaining when you pay attention to it because it’s effects are amazing!
This fabulous principal is paramount in investing and financial planning. In a financial plan, compound interest manifests in several forms; inflation, investment growth, tuition costs, and may affect other saving and spending goals you have as well. It’s something to watch because it illustrates why time can be your friend or foe when planning.
Some say the economy is thriving right now; one way we see that is unemployment is at historic lows. Let’s say you are 22, just graduated college, and landed your first real job. Furthermore, let’s say you want to become a millionaire by the time you retire, (ignoring the fact that that is not a productive goal, for reasons I’ll talk about in another blog) how much do you need save? Let’s assume you earn 7% per year (the S&P has averaged 9.8% per year for the last 90 years), we’ll ignore taxes, and, for ease of calculation, you invest one lump sum at the beginning of each year.
If you saved $12,000 per year for 10 years with those assumptions, you’d have $1,030,243 at age 57! It’s just that easy! You would have saved $120,000 total of your money over 10 years and it grew to over a million in 35 years. Now, $12,000 is a lot to save for a new graduate just getting started, but you get the point. You could soften it by saving $1,000 per month, which changes the calculation some or perhaps you save $6,000 the first year and increase it annually. Or, like most good savers, you’ll actually save for more than ten years, you’d continue on.
Alternatively, if you saved $6,000 per year under the same assumptions, but you did it every year until age 57, not just for 10 years, you’d have $956,024. Not quite a million, but pretty darn close. In this case, you would have put away $216,000 of your earnings over 35 years and would not have as much. That’s $96,000 more of your money you spent to end up in a worse financial position. Think about that. . .
It goes back to my hackneyed statements that financial planning is important and this is a demonstration of why.
Let’s talk about the math a bit; if you don’t like math, go ahead and skip this paragraph. Why does it work like that? If you save $1 and earn 10% interest, after 1 year, you’d have $1.10 or have earned $0.10. Now, that larger amount reinvests so after the second year at 10%, you’d earn $0.11! That’s 10% more earnings than the previous year. Then you’d have $1.21, which you’d earn $0.121 on or another 10% increase on your earnings, because the amount invested increases, the earnings increase. If this is confusing to you, I have a spreadsheet that lays this our more clearly.
At a 10% annual return, your money would double about every 7.2 years. So after 7.2 years, you’d have $2, after 14.4 years, you’d have around $4, at 21.6 years, you’d have around $8, 29 years you’d have $15.86. After 29 years, that’s a total return of 1,586%!
The point here is compound interest shows why starting young is so important. You can see the dramatic difference here though, by adding those extra dollars in the beginning you’re way better off in the long run.
The longer your money has to work in investments, the more it will do for you. Now, these examples are oversimplified and I would venture to guess that most individuals won’t follow a strict plan like this, but you can easily adapt and craft a similar plan that fits your budget, lifestyle, and goals.
Please don’t misconstrue my point here. Saving a million dollars is a fine goal, but it lacks telos. And that is really what we’re after. Saving for the sake of saving (or for the sake of being rich) is okay, but if you just want to leave a large estate to your heirs (or a charity), life insurance is probably a more efficient way to do that. In financial planning, the key is to tie these numbers to real goals. Retirement, paying for college, buying a boat. To tie them to tangible goals based on the things you actually care about. Will the income produced off a million dollars be enough for you to retire comfortably? Will you use a portion to buy an RV in retirement and travel the country? One of the most difficult parts of financial planning is identifying these long term goals. We can’t see the future or know what our needs, wants, and desires will be then, but we can set targets now and modify them over time. I recommend picking something, so you can get on a path; knowing you can always adjust over time.
If this interests you or you’d like to discuss how you can take advantage of compounding interest, Telos Financial may be able to help you. Contact us to schedule an introductory meeting and we can talk more in person. Telos is Michigan’s financial advisor for high earner and high net worth millennials, recent college graduates, and small business owners.
Telos Financial is a fee based, holistic financial planning firm located in Plymouth, Michigan serving young professionals and families. Dennis LaVoy, CFP®, CLU® founded Telos in his tenth year as an advisor and uses his experience, knowledge, and expertise to help families and individuals around Metro Detroit, Ann Arbor, and across the great United States of America achieve their financial objectives.
Material discussed herewith is meant for general illustration and/or informational purposes only, please note that individual situations can vary.