FIT PHAM FINANCE SERIES: PERSONAL FINANCE 101
OKAY! So the very requested, long overdue series on Finance is here. Every Friday for the next month, check in to the blog for a new post about finances and how to be a BOSS at handling your budgets!
But first, here are some very important disclaimers:
I am not a financial advisor. Everything I say on finance in these series are MY OWN personal experiences and thoughts, NOT advice for you and your own situation. For advice, please reach out to a financial advisor!
My situation is not the same as yours. There are certain circumstances that are unique to my own situation. I’ll try my best to ID all of these beforehand so you can better figure out how to apply what I’m talking about to your own unique situation.
OKAY LET’S DTDT (DO THE DAMN THING).
Lesson 1: Interest
First things first: Let’s talk about interest.
There’s two kinds of interest you should know about: SIMPLE and COMPOUNDING
SIMPLE interest is calculated only on the principal amount, whereas COMPOUND interest is calculated on the initial principal amount AND all the accumulated interest. This means that savings with compounding interest will grow at a much faster rate than ones with just simple interest.
For example, let’s say you open up an account and deposit $100. That $100 is your initial principal amount.
Let’s say your interest rates are 5%.
At the end of one year, an account with SIMPLE interest will have $105. The second year, it will have $110 (5% of $100 is $5, which is what you’ll earn every year).
An account with COMPOUNDING interest, on the other hand, will have $105 at the end of one year and $110.25 at the end of two years. 25 cents may not seem like a lot more, but over time, this gap will grow and grow at a much faster rate.
Last bonus thing to know:
When it comes to compounding interest, periods (or the frequency at which your savings accrue interest) DO matter.
The basic rule is that the higher the number of compounding periods, the greater the amount of interest you will accrue. The more frequently your accounts compound, the faster the savings grow. Make sense?
To learn more, visit this site.
Lesson 2: Time Value of Money
Next, I want to talk about is a fundamental principle that dramatically changed how I viewed and approached personal finances: The Time Value of Money.
The principle is that one dollar today is worth more than a dollar in the future. Which is weird, yeah? Because a $100 bill today should have the same value as a $100 bill one year from now, right? That’s because a dollar in hand today can be invested to turn into more money in the future.
To calculate how much something is worth in the future, you use this formula:
PV = FV ÷ (1+I)^N, where:
PV is the present value
FV is the future value
I is the required return (rate of interest)
N is the number of time periods before receiving the money (in years)
SO let’s say someone says: “Okay Chi. I can’t pay you back your $1,000 today. But I can give you $1000 4 years from now once I graduate from college.
To which I would say… Okay. But assuming an interest rate of 5%, $1,000 four years from now is actually equal to…
1,000 = FV ÷ (1+0.05)^4
FV = $1,215.51
For more info, visit this site.
EXAMPLE: Retirement Funds
Okay okay, some of you might be like… what? What does that even mean, and how does this apply to me?
The best example I can give you is through retirement funds.
Many people in their 20s view retirement funds and 401ks as long, far away things for future them to worry about. Right? Anyone else think that?
Well let’s see. Imagine the following two individuals:
ASH is 21 and fresh out of college. She lands her first gig at a company and is in the middle of choosing her benefits. One benefit the company offers is providing her with a 401k account (let’s assume for the sake of simplicity that this company does not offer matching funds for 401k accounts). Ash doesn’t have much money, but she decides that she wants to put $100 every month into her retirement account.
BENTLEY is also 21 and fresh out of college. He decides that his retirement account is future problems for future him! He’s young and retirement is 44 years away! Instead, most of his salary goes towards rent/food/clothes/etc. However, once he hits 26, he does decide that he should probably start contributing. He decides that he wants to put $100 every month into his 401k (again, no matching from this company).
GREAT. You guys still following?
So the next step is calculating how much Ash and Bentley will have in their retirement accounts by the time they retire. Here, we’re going to assume that (a) there is no company matching and (b) they maintain a $100/month contribution for the rest of their lives.
To calculate, I used this website.
So if ASH contributes $100/month for 44 years (until she is 65), and we assume an investment rate of return of 5% for her 401k account (industry average), she will have $181,371.61 in her account by the time she is 65.
OF THAT $181,371.61, ASH actually only contributed $52,800 of it…. which means that $128,571.61 is from INTEREST (just the money you make from letting your money sit in an account with compounding interest).
BENTLEY on the other hand will have $136,914.03 in his account. OF THAT $136,914.03, BENTLEY only contributed $46,800 of it. Which means that he made $90,114.03 from interest.
So what does this mean?
Because Ash started saving 5 years before Bentley, she had an extra $38,457.58 from interest.
And this effect just compounds the more money and time you have.
If we changed the examples to both of them saving $300/month (instead of just $100), then….
ASH will have $544,114.82
BENTLEY will have $410,742.08
DIFFERENCE between them: $115,372.74
Y’ALL, THAT’S INSANE. Just 5 years will yield a difference of $115,000!!
Well, what about an example where Bentley contributes more, but still starts later?
Starts saving at age 21
Contributes $300/month ($150/paycheck)
Starts saving at age 26
Contributes $400/month ($200/paycheck)
The end result:
ASH will have $544,114.82, contributed $158,400
BENTLEY will have $547,656.11, contributed $187,200
DIFFERENCE between them: $3,541.29
SO, while Bentley technically will have $3k more than Ash by the time they’re both 65, he actually contributed almost $30,000 more to his fund over his lifetime. Ash was able to end up with roughly the same amount, but because she started 5 years earlier, she could do MORE with LESS money.
I’ll do a more in-depth follow up specifically for retirement funds (aka how much should you save, how much do you need, etc) at a later point. But for now, just remember: Starting early is good. Also, better late than never.
Start saving now, with as much as you can.
It may not feel like you’re doing a lot NOW, but with compounding interest and time, a little short term sacrifice can yield some dope results in the future. And if you’re more of a Bentley than an Ash, DON’T DESPAIR. Whatever more you can do now will pay off in the long run. This is just to help you figure out how and what to prioritize when you’re setting budgets!
*TLDR: Too Long, Didn’t Read
OKAY, there goes the first post! Leave a comment with your thoughts/questions/concerns. I’d love to hear from you! And if you want more, check out Post #2 in this series here!