I keep banging on about the need to start NOW – see articles here and here for examples of my rants. To reinforce the point, I want to remind you of something you probably learned in High School. It is what Einstein described as the eighth wonder of the world (there is some debate as to whether he actually said it, or what he actually said, but don’t let that get in the way of a good story).
This is the compound interest equation:
It is as my maths teacher said all those years ago “a thing of beauty and a joy forever”.
If E=MC2 or any other algebra fills you with dread, and reminds you of time spent in classrooms trying to make sense out of what at times appeared to be random letters on a whiteboard, bear with me, I will be gentle. (For me it was a blackboard, yes with chalk, but I am really old).
This is really important. This little equation deserves more attention than the goings on in Ramsay Street, or the latest exploits of anybody named Kardashian, or who got voted off on the Q Factor. This formula will explain to you how you need to start working on your financial goals NOW, not next week, not the week after, NOW. I’ll try to explain in the time it takes for an ad break.
The equation has a big brother, the future value of a series of regular payments. It looks like this
PMT × (((1 + r/n)^nt – 1) / (r/n)) × (1+r/n)
A = the future value of the investment/loan, including interest
P = the principal investment amount (the initial deposit or loan amount)
PMT = the monthly payment
r = the annual interest rate (decimal)
n = the number of times that interest is compounded per year AND additional payment frequency
t = the number of years the money is invested or borrowed for
Before your eyes glaze over, let me explain.
Let’s say we are going to kick off a regular investment program today with $5,000 and we are going to contribute $50 per month until we are 60 years of age.
$5,000 now $50 per month in for 40 years (start when you’re 20) = $113,411.03 @5%
Now, let’s say we are going to be like most people and start this thing later, after we get back from Bali, or when we have finished paying of HECS, or when we get around to it, or when we are old enough to think about it. We’ll just have to put in a bit more each month right? Wrong!
$5,000 in 20 years time, $100 per month in for twenty years (start when your 40) = $54,837.83 @5% (same amount in)
Now let’s say we put this off a little further, and wait until we reach what I call the “Oh S**t Moment” when we reach age 50.
$5,000 in 30 years time $200 per month in for ten years (start when you’re 50) = $39,420.91 @ 5% (same amount in)
Putting this another way, If we wait until we’re 50, we are going to need to put aside $675 per month over ten years to get the same result we would have if we put in $50 per month starting now. That looks like a world of pain to me.
The same principles apply whether you are saving for retirement or a house deposit, or any other goal that you might want to save for, the sooner you get started, the less you will have to put in. You can make this easy or hard it’s up to you. You can be like most people, or be a little smarter.
Knowing what you want to achieve and by when is half the battle of course, after that the arithmetic is what it is. Goal setting is the subject for another day, for now school’s out.
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