The question has been asked many times – what’s the best financial advice you’ve ever gotten?
To me, it’s an easy answer. Paying yourself first and knowing the magic of compounding interest.
Please allow me touch on both of these.
Pay Yourself First
“Pay Yourself First” is the best advice I have ever received when it comes to paying off debt, saving for the future, and trying to create a budget.
The idea is simple. You may have heard it before, but I’m going to address this idea like you never have.
Employer retirement plans are probably the easiest example of how you pay yourself first. You don’t see the money. It comes straight out of your paycheck and into your retirement account. You paid yourself before the money ever hit your bank account.
The key here is not only doing this with your employer retirement account, but also with making other payments to yourself (or your bills) automatic.
You have a budget, right? If not, check out Capital One’s page on How To Make A Budget Spreadsheet.
To me, paying yourself first means putting whatever is at the top of your priority list as the first line item on your budget.
For so many years, I paid debt and contributed to savings after all of the other expenses came out of my paycheck. Usually, there was a very small amount (if any) I had leftover to go towards debt.
Once I learned to place my debt as a priority and put that at the top of my budget, the game changed and I saw things differently. I wish I had learned this sooner.
Side Note On Retirement
There are definitely some split opinions when it comes to saving for retirement while you’re paying off high interest debt.
This is my opinion: Never stop contributing to your retirement. If your employer matches your retirement account contributions up to a certain amount, max that out and get that free money. You can still contribute to your retirement and rapidly pay off debt with dedication and drive.
Create your budget with the first priority being maximizing that matching employer contribution. Priority two should be all of your high interest debt (car loans, student loans, credit cards).
Compounding Interest
The second “secret” kept from me that I found out later than I should have is the magic of compounding interest.
Let’s use a calculator to see the impact of compound interest.
In the calculator below, enter your current savings (It’ll still work if your current savings is $0) for Invested Amount.
Annual contribution…What are you willing to pay yourself first? $100 a week? Sure, let’s start with that. So $100 a week x 52 weeks = $5,200 per year. We’re going to round that down a little and put $5,000 into the Annual Contribution field.
Next is interest rate. 5-8% is the return you’ll typically see, however, I use 6% when calculating this value as I feel that is safe.
For Number of Years – When do you plan to retire or withdraw this money? Maybe you’ve got 40 years or 20 – enter the number of years remaining here.
Compounding interest remains at 100%.
For the purpose of this exercise, this is what I’m entering into the calculator: $0 initial investment, $5,000 per year Annual Contribution, 6% interest, and 25 years remaining until I take it all in one lump sum.
Investment Compounding Calculator
Evaluate The Numbers
You contributed a total of $5,000 per year for 25 years. That equals $125,000. You paid yourself first $100 every week and let that baby sit there untouched for 25 years. You earned interest off of interest – that’s what compound interest means. That $300 in interest you made the first year compounded every year after that to build you a pretty sweet nest egg.
Final Results – Contributed a total of $125,000 over 25 years. Earned Amount in Compound Interest: $149,323.
Your total amount in this Investment account: $274,323
Over half of that final number isn’t even your money – it’s mostly interest you earned off of your money sitting in an investment account. The interest earns interest. Mind Boggling!
We used 25 years as an example, but what if you had 35 years? Using the same scenario with 35 years, your ending amount is $557,174. $175,000 was your money and $382,174 was FREE from compounding interest.
Let’s look at this a different way. Say you are 25 years old and you just inherited $40,000 (dang!). You are more responsible than most of us and you put $20,000 into an investment account and forget about it. You don’t contribute another dime. At age 65, you take a peek at that account and it’s now…..$205,714. You only contributed that initial $20,000. The other $185,714 came from compounding interest.
This shows you the importance of making smart decisions early. I didn’t do any of that and I’m in my 40’s. You may have not either and that’s totally ok. See the $100 a week scenario? We still have plenty of ways to build our nest egg before retirement. Compounding that interest and paying yourself first is one of many.
Final Thoughts
These are two really simple concepts that quickly jump to my mind when a younger indivdual talks money with me.
You are in control of changing your lifestyle and how you manage your money. Make yourself a priority.
Watching the magic of compounding interest is an exciting thing to experience.
It’s never too late to make a change.
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