Mike, a mate I play soccer with, scoffed at my article The one trick to Saving. Mike said he only started saving when he started full-time work and that it was pointless to start saving at uni when he didn’t earn much. Mike has a point, but I wanted to do the maths and prove him wrong – that even one extra year of saving will make a difference.
Sam, the early saver
Meet Sam – he earns $250 a week while at uni. He manages to save about 10% of what he makes (or around $100 a month). By the end of his 4 year uni degree, he has saved $5,000. (Just so Sam isn’t completely fictional, his parents are extremely generous and pay for his uni degree and a round the world trip when he finishes uni!)
Sam decides to leave the $5,000 he has saved in a high-interest account and use the money from his new full-time job to pay expenses, save for a house etc. Sam starts his full-time job the same day as his friend Mike.
Mike, the late saver
Mike is the same age as Sam but for one reason or another, he doesn’t manage to save anything until he starts working full-time. After working for a year, he has saved $5,000 (10% of his $50,000 salary). Like Sam, Mike puts this money aside in a high-interest account.
The big question
Mike has started his $5,000 high-interest account one year later than Sam. Will this make much of a difference in the long run??
Simple Interest on $5,000
With simple interest, you calculate interest as a once off. So if you have $5,000 on term deposit for a year at 5% interest, you would earn $250 interest. You receive the $250 and reinvest the $5,000. If you keep the $5,000 invested, you can receive $250 every year (at 5% interest).
But you wouldn’t have the massive power of compounding your earnings (earning interest on interest).
Compound Interest over 2 years
Understanding the basics of how compound interest works isn’t hard. In Sam and Mike’s first year, they would invest the principal of $5,000 and earn $250 interest. In year 2, they would invest $5,250 and earn $5,512.50 (including interest). With simple interest you would have only earned $5,500 – so by compounding (ie. investing the $250 interest) you would earn an extra $12.50.
Although the $12.50 isn’t much, over time it will add up.
Compound Interest over 10 years versus 9 years
After 10 years of compounding at 5%, Sam’s $5,000 has grown to $8,144 compounded yearly (versus $7,500 total of simple interest, being $5,000 principle + 10 years of $250 interest).
At the same time, Mike (a year behind Sam) has only saved for 9 years. His $5,000 has grown to $7,756. So by missing out on the extra year Mike has so far missed out on $388 (being $250 of simple interest and $138 of compounding interest).
Compounding Interest over 30 years versus 29 years
By 30 years of compounding at 5%, Sam’s $5,000 has grown to $21,609 compounded yearly (versus $12,500 simple interest). But after 29 years, Mike’s money has grown to $20,580. So Mike has missed out on $1,029 by starting a year later. $1,029 is more than 20% of the original $5,000 amount.
In comparing Sam and Mike, you have to compare apples with apples.
Interest Rate – I have assumed the interest rate is constantly 5%.
Yearly Compounding – I have assumed yearly compounding in this example. The more often the money is compounded, the more interest you earn (or pay). This is why home loans and credit cards compound daily, as that will make you pay the maximum interest.
In real life, monthly compounding is realistic for a high-interest account, however term deposits usually only compound when they mature.
Creating a savings habit (or a “spend less than you earn” habit)
Even if it isn’t really worth saving a bit of money, I believe it is worth getting into the habit of putting a bit away, even if you don’t manage to keep money in an account for 30 years.