Now that you landed a job and you’re bringing home a regular paycheck, you probably can’t wait to celebrate. But before you plunk down your plastic on a new pair of Jimmy Choo shoes or the latest iPhone, there’s something else you should put at the top of your shopping list:
If you put a portion of each paycheck aside –15 percent of your gross pay is ideal, but 10 percent is a good place to start – you’ll not only create a financial cushion, you’ll be able to take advantage of what Albert Einstein called one of the greatest wonders of the world: the magic of compounding. Compounding means that not only does the original money you invest – the “principal” – earn interest, but the interest earns interest, too. That supercharges your savings, and the earlier you start, the more powerful the magic.
Now think about the $500 you were planning to splurge on the latest designer shoes or tech toy. If you invested that $500 today, and it earned 7 percent a year, that one purchase would be worth more than $5,700 in 35 years.
Many people who swear they’ll save part of every paycheck after they take care of their other expenses find they don’t have anything left at the end of the month. But if you pay yourself first before divvying up the rest of your money to cover your current costs and pay your bills, you’ll be on the path to a secure future.
Get the message? The earlier you start saving, the better.
When you’re in your 20s and 30s, you may not have a lot of money in the bank, but you have two valuable assets: your “human capital” – the skills that will allow you to earn a living – and time. You have decades ahead of you to get promotions, increase your salary and maybe switch jobs.
But even if you get a late start, the magic of compounding can work in your favor. You’ll just have to save more to end up at the same place.
For example, say you start saving $100 per month at age 22 for 10 years and then never squirrel away another dime, but those savings continued to earn 7 percent per year. Your $12,000 principal would grow to about $175,000 by the time you’re 65. But wait 10 years to start saving, and you’d have to save $100 every month for the next 33 years to come even close to what your savvier 22-year-old self could have stockpiled. That’s right. The $39,600 you invested over 33 years starting at age 32 would grow to about $155,000 by age 65 – $20,000 less than the first amount even though you saved 23 years longer!
Want to be a millionaire? Save $286 per month starting at age 25 and earn an 8 percent annual return, and you’ll have $1 million by the time you’re 65. Wait until 45 to start saving and you’d have to save nearly $1,700 a month to amass $1 million by your 65th birthday.
Now, here’s a reality check:
At today’s low interest rates, you’re not going to earn 7 percent or 8 percent a year by stashing your money in a bank account. A bank account is a great, safe place to park your cash for emergencies, such as a needed car repair, rather than racking up a big credit card bill. (Compound interest works in reverse, too. Your credit card bill can snowball when you’re paying interest on top of interest until the bill is paid off).
But for your long-term money, such as your retirement savings, you can afford to take more risk in exchange for the likelihood of higher returns. That means a bulk of your retirement savings should be invested in stocks, which historically have returned about 10 percent a year on average (with a lot of ups and downs in between). And the best ways to invest for retirement are through your employer’s 401(k) plan or on your own in IRA.
Award-winning veteran journalist Mary Beth Franklin puts the focus on issues that seem far in the future for younger readers – retirement security, taxes and Social Security – by delivering timely information and actionable advice, with a sense of hum or. A senior editor for more than a decade at Kiplinger’s Personal Finance magazine and editor of Kiplinger’s annual Retirement Planning Guide, she is a contributing editor at InvestmentNews and appears frequently on national news programs including NBC’s Today show and Meet the Press, the CBS Early Show, CNN and PBS’s Wealthtrack program.