So far in our SquareOne Financial Foundations blog, we have discovered the importance of saving for emergencies and the different options to earn better interest rates on emergency savings funds. Before we jump into saving for retirement and paying off debt, let’s take a moment to examine one of the most important lessons you can learn on your path to being more purposeful with your finances: the time value of money.
So, what does the time value of money mean? Time value of money (TVM) is the belief that money you have now is worth more than the same amount of money in the future due to its potential earning capacity (aka earning interest).
Money can earn two types of interest: simple interest and compound interest. Here is a quick illustration of the difference between the two:
*Open a savings account with XYZ bank that pays you 3% simple interest and deposit $500.
|Year||Beginning Balance||3% Simple Interest||Ending Balance|
*Open a savings account with ABC bank that pays 3% compound interest and deposit $500.
|Year||Beginning Balance||3% Compound Interest||Ending Balance|
Simple interest means you only earn the stated interest rate on the money you deposit into the account. In contrast, compound interest means you gain the stated interest rate on your deposits AND any previously received interest. Compound interest gives you an added boost when it comes to growing your money. Add compound interest and time together, and you’ll have a recipe for savings success, and that is the true power of the time value of money.
Now that we have a better idea about how compound interest works, let’s take a look at two examples that show the time value of money at work:
The Early Saver
Amanda starts her first full-time job after college at age 21, earning $35,000 per year. She is immediately eligible for her 401(k) plan at work and begins contributing $150 each month. If we assume Amanda makes an average annual return of 8% in her 401(k) and doesn’t increase her contribution amount, what will her account balance be at age 60?
- Starting Balance: $0
- Monthly Contribution: $150
- Annual Return: 8%
- Period: 39 years (Age 21 to age 60)
- Projected Value at age 60: $430,094.20
The Late Saver
Brandon, age 50, just started a new job that has a great retirement plan. He has not been saving for retirement, but he is eager to get started. He decides to defer the maximum allowed into his 401(k) plan ($19,500) each year. What will his account balance be at age 60, assuming the same 8% annual return?
- Starting Balance: $0
- Monthly Contribution: $1625
- Annual Return: 8%
- Period: 10 years (Age 50 to age 60)
- Projected Value at age 60: $282,487.97
Despite Brandon saving over nine times as much as Amanda each month, the shorter time horizon for Brandon’s money to grow means that he would have to save a significant amount of his income to catch up. Starting a saving plan early matters. Even if you are on a tight budget and begin small with your savings efforts, you can set yourself up to succeed with the time value of money on your side.
SquareOne: A Financial Foundations Blog is a personal finance series from The Welch Group created to help provide readers with the foundational knowledge to be purposeful with money by identifying key financial concepts to help the reader control their financial future. Foundation topics include personal savings strategies, debt consolidation and reduction, life planning, retirement planning methods, and beginner essentials of investing and taxes.
Callie Jowers, CFP ® is an Advisor at The Welch Group, LLC, which specializes in providing Fee-Only investment management and financial advice to families throughout the United States. Callie is a graduate of the University of Alabama, is currently pursuing a Master of Accounting at the University of Alabama at Birmingham and is a Certified Financial PlannerTM.
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