Looking back to your mid-20s… things like retirement, emergency funds, compound interest and saving for the future weren’t subjects we commonly talked about. It always seemed like you had plenty of time to prepare for those things. Then time passes, and you realize you’ve missed out on early savings opportunities. Shockingly, the average person probably doesn’t start thinking seriously about saving until their early 40s, missing twenty years of early savings.
As financial planners, experience has taught us that saving smaller amounts earlier in life may build wealth substantially faster and in greater amounts than saving larger amounts later in life. Here are some tips to get an early jump start on your financial plan.
Compounding Interest & Time
Don’t underestimate the power of time and compounding interest over your lifetime, particularly how monthly compounding of your interest may grow your savings faster than annual compounding.
What happens if you invest $10,000 at a 4% interest rate for one year?
- With interest compounded annually, you’ll earn $400, ending with $10,400.
- With interest compounded monthly, you’ll earn $407, ending with $10,407.
At age 25, if you invest $100 per month for 40 years, earning 6% rate of return compounded monthly, this could grow to around $200,145 over the 40-year period. If you waited until age 45 to start saving, to get to the same approximate $200,000 in savings you would have to invest about $430 per month over the next 20 years. This is the power of compound interest and time on your side.*
Maximize Tax-Free Accounts
Maximizing annual contributions to tax-free accounts such as Roth IRAs, health savings accounts and 529 education savings plans will allow your earnings to grow tax-free over time. You could save thousands of dollars in taxes on the earnings if these accounts are used properly. These three accounts are some of the most powerful savings vehicles on the planet. If you start early with them, you could accumulate some serious wealth over time.
Take Advantage of Free Money
Some employers offer company retirement plans to their employees with a generous “employer match” contribution. If your employer offers a 4% match to the company 401(k), you should do everything in your power to ensure that you’re withholding 4% of your pay to get an immediate 100% return on your contribution. In addition, you’ll get tax-deferred growth on your future earnings or possibly even tax-free growth if you utilize the Roth 401(k) plan option if available.
Own vs. Rent
When you get to a comfortable financial position in life that allows you to buy a home, furniture, vehicle, or business tools/equipment versus renting them, you should jump on this opportunity to build equity in certain assets that appreciate in value over time. Renting is a good short-term option early in life, but as you look toward building wealth you should consider buying as soon as you have the opportunity.
Good Debt or Bad Debt
Not all debt is necessarily bad if you are using it to leverage your money to buy an asset that typically appreciates in value over time such as a house, rental property, or maybe even your education that could lead to higher future earnings… these could all be considered as “good debt.” However, loans for vehicles (depreciating assets) or for credit card balances are typically considered “bad debt” because they come with higher interest rates and typically do not go towards an asset that appreciates in value over time - this debt should be paid off faster if possible.
Life experiences can teach us many financial lessons that textbooks and classrooms overlook. Think about what you know today and how your children or grandkids could benefit from your financial knowledge if you shared it with your friends and family. Unless you win the lottery, building personal wealth is a disciplined investment journey for most of us and typically not an overnight process. Putting your plan in motion at a young age may significantly reduce how much you’ll need to save later in life to reach the same end result.
*(Dinkytown.net, Financial Calculators, “Compound Savings Calculator”)