By ROBERT K. CUNNINGHAM, Personal Finance Coach/Consultant
RIGHT OUT OF THE GATE: This blog/website and all its content is designed and produced for information purposes only. No representation is made to guarantee the accuracy of any of the content contained on this website, nor should it be interpreted that specific investment recommendations are being made. The reader assumes any and all risk for strategies which are acted on.
Anyone who has spent even the briefest amount of time reading about personal finance has heard the expression, “pay yourself first,” but what does that truly mean?
Well, I’m glad you asked. 😉
Although it would appear to be among the most basic rules in the world of savvy money management, it is arguably the most difficult for many folks to adhere to. It is promoted as being the first rule of finance, but I hope you will agree that the previous two steps I’ve laid out in this blog over the past two weeks – summarize your income and expenses, and establish a budget – should come beforehand.
If they didn’t, you wouldn’t have any accurate idea of how much to pay yourself.
That said, the primary concern over the long haul is to actually save, rather than obsessing about how much. Establishing a habit of saving money regularly – and, preferably, automatically – will pay significant dividends, monetarily and otherwise, down the road.
With the power of compound interest – and, yes, it is every bit as cool as advertised – small deposits can eventually achieve surprisingly large results.
I always get a kick out of the demonstration of someone starting with a penny, and allowing it to compound 100% daily, for a month, and seeing how much they have after that time. When asked to guess the answers, folks usually forecast a few hundred dollars, but the truth is that if you start with a penny and double what you have every day for 30 days, you end up with more than $5 million.
While that seems amazing to me, I prefer to focus on realistic numbers. So let’s take a hypothetical 22-year old college graduate who starts with $500, and every month adds $300 to it. And let’s say she earns a 5% annual return (yep, I want to stay conservative and achievable here), each and every year, and the interest compounds annually.
After the first year, she would have saved $3,990 ($500 plus 11 months of adding $300 per month = $3,800 x 5% rate of return (ROR) = $190. $3,800 + $190 = $3,990.
How much will she have in 20 years? If you calculate 19 more years at $3,600 contributed per year, the total amount SHE put in, not including any interest earned, would be $75,800.
Now to the whole point of this exercise: At 5% compounded annually, her account balance after the two decades would actually be $123,067. That’s more than $47,000 in earned interest!
THAT is why Albert Einstein purportedly said that compound interest is one of the most powerful forces in the universe.
One other vital point: Starting early is crucial. Starting late is better than not starting at all, of course, but the power of compounding isn’t only remarkable, it’s a little quirky. To wit:
We have two business partners, who we will call Ben and Jerry (I love ice cream, but any resemblance to real people of the same names are purely coincidental).
Ben starts saving $200 per month at age 21, does so every month of every year until he reaches age 30, then stops because he gets married to a spendthrift who eats up their budget. Ben saved regularly for nine years, contributing a total of $21,600 before stopping cold turkey, never to contribute another dime for the rest of his life…
Go with me here.
Jerry does just the opposite. He doesn’t save anything at all until his 30th birthday, when he decides he’d better get started and begins putting away $200 per month, just like Ben. But Jerry goes one better – he doesn’t stop after nine years, but instead puts in that same $2,400 annually every year for the rest of his working life – until he retires at age 65. That means Jerry puts in $86,400 over the entire savings period, more than four times what Ben saved.
Assuming both earned 6% compounded interest annually, each and every year (again, it’s about the comparison – stay with me), who would end up with more money in their account at age 65?
Jerry, right? I mean, he put four times more money in. Of course he will have more in his account.
Ben’s account balance, despite putting in a fourth of what Jerry did, is just a bit less than $1.2 million. Jerry has only about $650,000. It isn’t even close.
As the character Leonard on the TV sitcom Big Bang Theory likes to reply slowly, “whaaaaat?!”
Because Jerry started late, his efforts are dwarfed by Ben’s even though Jerry put a lot more money in. Einstein wasn’t trippin’ with his statement.
OK, fine, you’re saying. That’s very cool, but what if you don’t have much to save at all? Not even 200 bucks. Sure, let’s discuss that.
Let’s say you’ve assessed your income and expenses, created your budget, and the best you can do is save $40 per paycheck. My first reaction, honestly, would be to instruct you to go back and try harder to cut expenses, acquire a side hustle, sell unneeded material possessions, etc. to improve your savings commitment.
But you tried, and it’s $40 a check or fuhgetaboutit. You’re paid on the first and 15th, so we’re talking $80 savings per month. Fine, we can work with that… as long as you commit to making your savings automatic by having the $40 direct-deposited into the bank account of your choice, a task that most companies can and will readily accommodate. If not, you will have to take the extra step of manually transferring money to a savings or investment account… IMMEDIATELY after depositing your check and before ANY bills are paid.
This is the key to the philosophy and, fairly obviously, the whole point of “pay yourself first.” These are logistical concerns, however, and for now I want to re-focus on the saving.
At $80 a month, earning 5%, you can have more than $5,500 accumulated in just five years.
Hey, I realize $5K isn’t going to buy you a Maserati… won’t even get you to a down payment on a Maserati. But it’s a pretty good start toward getting into your first home, isn’t it? Or you could knock out a big chunk, if not all, of your credit card debt with five grand, could you not?
To repeat, the true importance of this is about the habit of saving. Simply put, the ability to save – even in small amounts until such time you can afford to contribute more – is mandatory to getting ahead and, ultimately, building lasting wealth, whether you are diligent enough to build that wealth early or not.
Pay yourself first, friends. Don’t think about doing it, and don’t do so just part of the time, after your birthday or Christmas, or after you receive your tax refund. Do it each and every time you get your paycheck, without fail. The gains really will compound nicely for you.
Thanks for reading.
For more specific information on DPWLI and related strategies, please go to www.spwealthadvisors.com, and let them know that you were referred to that site via www.buildwealthearly.com.
DISCLOSURE: If you opt to purchase a product(s) from www.spwealthadvisors.com, I will qualify for an affiliate commission.