Pondering Money

I always find that I get much better deals when I first decide what I want to buy then hunt for a price rather than letting someone else sells me something, but would you believe it could be a 90% difference?About either years ago two Kirby Vacuum cleaner salesmen came and demonstrated their g-six vacuum.   I have to give them credit as they showed off their product very well- or I wouldn’t remember this story!   It was an impressive cleaning machine - it picked up the Carpet Fresh that our vacuum had left over a year of weekly vacuuming!  I was convinced that it was a nice vacuum- but the price was just too high.  They starting at $1000 and the best I could haggle down to was $800.  In the end we didn’t buy it.  I also remember being very happy we didn’t as finances were a bit tight in the next few months and would have been a lot harder with $800 less.  I actually feel a bit guilty though…  The salesmen went to the extreme of eating some of the carpet shampoo to demonstrate that it was non toxic.  I really feel someone willing to eat carpet foam should get some compensation!This summer I was looking to replace our old vacuum and I remembered their demo.  I did my own search and found an even newer model Kirby selling for $150 on craigslist.   I asked if the buyer would take $100- it never hurts to ask for a discount and I noticed it had been posted for over a month.  She agreed, so I showed up with $100 cash and picked it up that day.   She told me that she was willing to accept only $100 because several people already expressed interest then never show up to finalize the deal.In the end I discovered a few things I didn’t like about the vacuum; it weighs a ton and is too big to get under some furniture but for $100 I’m satisfied with my purchase.  The next time someone is trying to sell you something- think about how much you could get selling it in a few years.  If you do still decide to buy ask for a discount- the worst they can do is say no!

Time is a required ingredient to put compound interest to work for you.   Here is how you can maximize the time for your investments to grow:

Invest now

You need decades for compounding to really kick in.  Sadly, none of us are getting any younger so we better invest as much as we can today!  Say Bob starts working at 22 and invests $6000 each year.  If he earns 8% compounded quarterly until he is 65, his final total is $2,229,668.  If he starts investing just five years later his total drops by more than $750,000 to $1,475,485. Time really is money, with compound interest each $1 you invest today will be worth a lot more than if you waited even a few years to start.   So, consider what expenses could you reduce today for a better tomorrow?

Don’t cash out

If you cash out your retirement savings, you sacrifice a small fortune in future growth.    After 3 years of contributing $6000 each year to a retirement account Bob’s investments are worth $20,520.  If Bob cashes out to buy a car, how much will that cost him in retirement?  Would you believe almost half a million dollars!   That’s a pretty expensive car isn’t it!  Investing for just three years less with 8% return totals $1,741,897 which is $487,771 less.

Keep Investing!

Even if you didn’t start early enough, or you made the mistake of cashing out you could catch up by investing longer.  Bob could try work for another three years and retire at 68 to pay off that half a million dollar car!  I wouldn’t want to count on this option for retirement as health problems could make it impossible.  However, delaying collage a year or two isn’t the end of the world.  Even a few more years could make a big difference in your final investment total.

Delay Withdrawing

If you can’t invest more, your investments can continue growing as long as you don’t withdraw too much.   In fact when you are nearing retirement the growth on you investments should be much larger than your contributions!  If Bob’s health isn’t too good and he has to retire at 65 his investment is growing by almost $150,000 a year.   Adding an extra $6,000 won’t have much of an effect at this point.  If Bob can live very frugally and work part time for three years without contributing anything his total is $2,209,147.

Why should you care?

If you want to be wealthy or even just retire in comfort then you need to understand compound interest.   There are three factors that determine your results -the amount of time you invest, interest rate you earn, and compounding frequency.  To make the right investment choices you should know the effects of each of these factors.  Of them all time is the most important factor.  After a year compound interest amounts to pocket change but after forty years it can amount to a fortune!  The interest rate is also critical, a one percent difference in the interest rate will make a big difference in your final totals.  Finally, there is the frequency of compounding- the quicker the better but there isn’t much difference compounding faster than monthly.

What is it?

Compound Interest is earning interest both the amount of money you invested and the interest you have already earned.   I am going to look at compound interest graphically- if you want to read about the mathematical details I recommend reading this detailed description from Dr Math.

Time (with compound interest) is money!

Time is the biggest factor with compound interest, take a look at this graph of $1000 earning a 10% return with no compounding vs compounding monthly over 20 years:years:

• Time is a huge factor
  • After two years only $20 more
  • After twenty years it is $4328 more!
  • After thirty years the difference is $16,837

The start investing as soon as you can.  Compound interest will only help you if you invest long enough to make a difference!

Interest Rates Matter!

As you can see compounding is a good thing, and pretty dramatic with a 10% interest rate.  Suppose, you get a lower interest rate for twenty years,  how does that affect your the returns?:

• 1% is a big difference!
  • 10% -> 9% is more than the original investment ($1318)
  • 10% -> 8% is more than 2X the original investment ($2401)
  • 10% -> 7% is more than 3X the original investment ($3289)

Compounding Frequency the Least Significant Factor

The final factor is how frequently the earned interest starts earning interest.  Let’s look at the example of 20 years with a 10 % interest rate again, but compound it with different frequencies:

• More frequent is always better but the effect diminishes rapidly
• Never to yearly is a big difference
  • More than 3X original investment($3,727)
• Yearly to quarterly is much smaller but significant difference
  • Not quite half the original investment ($482)
•  Quarterly to Monthly even smaller
  • About a tenth of the original investment ($118.5)
  • This is at about 99% of compounding instantly
• Monthly to Weekly still smaller increase
  • May buy you a dinner ($46)

I hope you found that you learned something,  I plan to follow up with a post onpractical investment lessons soon.   Unclear about something, Liked it, hated it?   Leave a comment, just be thoughtful.

Welcome to pondering money!  My goal is to provide posts that make you think differently about your money and your future.   The key for me to be successful is to get your feedback, if you don’t understand something I NEED to know.   If you don’t like something tell me how it could have been better.  Finally, if you do like something let me know- so I can provide you with the best possible posts!-Rick Francis