Were you able to catch the solar eclipse on Monday? Total solar eclipses are really cool. They helped Einstein prove that space and time are not two things but just one thing called spacetime...Wait, I'm in way over my head. Never let a financial planner talk about astrophysics.
Today I just want to talk about time - whether it is its own thing or not.
The Time Value of Money
There's a term in finance called time value of money, oftentimes abbreviated as TVM. TVM is the mathematical way to tie together the current amount of money, the future amount of money, the interest rate, payment amounts, and number of payments per year. This concept is at the core of finance. It says that we prefer to have money in our hands, so if we have to wait in order to spend our money we need to be compensated for that. The payment we receive in order to delay our gratification is called an interest rate, or rate of return. If we lend, or invest our money, we receive this payment as a way to compensate us for our money getting used. If we borrow money, then we have to pay interest as a way to compensate the lender for giving their money to us. All of investing is based on these principles and terms, especially in determining the appropriate interest rate.
Before talking about compound interest, I should first talk about it's cousin, simple interest. If you lend me $100 and we determine 10% is an appropriate interest rate, then at the end of the year I would have to pay to $10 (100 x 10%). If I never made any payments to you I would now owe you $110. At the end of the next year I would owe you another $10, which is the interest rate, 10%, times the outstanding principal balance (principal is just the original amount of the loan), $100.
Compound interest, on the other hand, is calculated based on the outstanding balance, not just the principal balance. To use the example above again, if you lend me $100 at 10%, after the first year I owe you $10, just as above. But the next year I would owe you 10% on the new balance of $110, so I would owe you an additional $11. Remember in the simple interest example it was only $10 in the second year. You are making interest on your interest and by doing this you make your money work for you.
I know what you're saying, "So what...it's just a dollar." Well that's true. Take a look at the sketch up above, in the beginning it is pretty boring in the short run. In the long run, though, it's very exciting. If we can teach ourselves to be patient, long term thinkers, then we will be handsomely rewarded. Short term boring, long term exciting is the way to go.
For example, if I gave you 1 penny on the first of August and told you that I would double that money every day, you would have over $10 million dollars at the end of August. The last double is worth $5.3 million. That's pretty exciting! In order to get there we would have to deal with the boring stuff up front. It would take eight days just to get more than $1. Short term boring, long term exciting!
Rule of 72
The Rule of 72 is a short cut used to determine how long it takes your money to double. You take 72 and divide by the interest rate. For example, with an 8% interest rate your money doubles every nine years (72/8). It doubles again nine years after that. Then again in nine more years. This makes it easier to estimate how much money you'll have after a certain time period.
Consider this example. Jason invests $100 every month from the time he's 25 until he's 35. He does this for only those 10 years and saves nothing else, putting away $12,000. His friend Curt doesn't save anything until he's 35, but he saves $100 every month until he retires at 70. He saves $43,200, more than three times the amount Jason saved. If they get 7% interest, Curt, who saved every year from age 35 on, ends with $191,205. That's not bad, but Jason only saved for 10 years and he ends up with $202,665!!
You want to get started as soon as possible. If you haven't started already, don't fret that you missed out. You aren't concerned with what you did or didn't do in the past. You should only be concerned with where you are now, and where you want to be.
Start early! Work your way through the boring!