The Ultimate Lifetime Money Plan - Essay Example

 A Report on Compound Interest and the Power of Saving Introduction: The main purpose of this report is to look into the power of compound interest and how one can maximize ones saving capacity without making drastic lifestyle alterations. It looks into whether becoming a millionaire is difficult and whether becoming one is limited to successful businessmen and lottery winners. Further it looks at whether our retirement is totally dependent on if Social Security is still around or if there is anything we can do to ensure a successful retirement. The foundation of this report is the Compound Interest. In order to understand what compound Interest is, let us start with what Interest is. Interest in a nut shell is the cost of buying and selling money. The Banks buy money from you when you deposit money in the savings accounts or Certificate of Deposits at the Banks. The Banks give you a rate of interest on those accounts. But what do banks get out of that? They then sell the money through loans and credit cards. So let us suppose the Banks give you 3% interest rate on the savings account and get 8% interest rate on a loan they give out. Essentially they make a profit of 5 % on that money. Now what is compounding of interest? Simply put when interest is being paid on some money, that interest is added to the money and then the interest clock starts ticking on the new amount. Though it does not particularly sound exciting it is a very powerful concept and if utilized well can financially benefit anyone who understands it. To understand this concept an old parlor trick question can help. That question is, what would you prefer $1000 everyday for a month or a penny doubled everyday for the month (i.e. 1 cent the first day 2 cents the second day 4 cents the third day etc.). The mathematically astute person knows that this is a no contest and the person taking the penny doubling offer wins by a huge margin. The compound interest can be explained like this .Simple interest as we already know is the interest that is derived from only the investment in a principal amount. Say we take $100 and put it in an investment for one year at a simple interest rate of 10%. We multiply the interest rate of 10% times the principal amount of $100 to derive an interest payment of $10. This seems fairly obvious and straightforward. But let’s look at what happens in the second year if the interest is not paid out. In a "compound" investment, the interest is not paid out to the holder; it is built up within the investment. Consider our $100 above. If the interest was paid out after the first year, we would get our $10 in interest and have our original $100 still invested. If the interest is not paid out, however, we would have our original principal of $100 plus $10 in interest for a total of $110 at the end of the first year. This entire amount would bear the original interest rate of 10% for the second year. Not only would we get 10% or $10.00 in interest on the original principal of $100, we would also get $1 which is 10% on the $10.00 interest from the first year. Our total interest received would be $11. This would continue into the third year. At the end of the second year, since we have not paid out any interest, we would start with our $110 from the end of the first year plus the $11 we earned in the second year. This would give us a third year opening balance of $121 which would bear interest of 10% for the third year. Our 10% interest on $121 equals $12.10. Assuming we still don't pay out any interest, we will now have a total investment of $133.10. Well it still does not look too exciting. But let us extrapolate this further. If we leave this $100 alone for about 30 years we will end up with a $ 1000. Now that is interesting but definitely not exciting. Well how about this using the same mathematics if you save a $100 a week in thirty years that is One Million dollars. Now that without any doubt is exciting. But this sounds too good to be true, so the skeptic in me says that most likely in 30 years Million dollars would be worth a lot less. It is good to be skeptic it would be worth less, but it is possible to mathematically calculate how much less. It would be worth less because of inflation. And since we know how much average inflation is we can calculate how much we would lose to it over the course of the future. Well, it turns out all you need is an additional 5 years to have a Million dollars in today’s dollars. These are solid calculations which are made on a spreadsheet and can be checked and rechecked and adjusted for future changes in interest rate or inflation. So in a nutshell if you are able to save about $ 500 a month you should be a millionaire in about 30 to 35 years. The Future Wealth Calculator is a great tool to calculate this and make whatever adjustments which need to make now or in the future. The Interest rate can go up or down; the Inflation can go up or down. But fundamentally your monthly contribution only needs to go up. It should start with $ 500 per month and then it should go up by 20% every 4 years and never withdrawing from the savings. This requires a certain amount of discipline. And that can be done by a simple technique. Assume this $ 500 is an expense which has to be paid. Nobody ever gets the expense back. You can’t get a rent payment back and you have to pay it, regardless of what happens. So let it be with your savings. The next thing is how this $ 500 fits into your monthly budget. For that one needs to figure out how much your salary would be. There are many sites which can figure that online. Websites like Salary.com are very helpful here. And once you reasonably know how much you will be able to make, you should know how comfortably you can save this much amount. There is a flip side to saving to becoming a millionaire. At the start of this essay we briefly went over the concept of Interest and buying and selling money. As you sell money and make more money, you would defeat the purpose if you bought money as well because you are paying interest for that which not only cancels some of the interest you are earning but actually in many cases exceeds some of the interest you are earning. An example could be a Credit card. A Credit card usually does not charge interest unless the balance is carried into the next month. And this compounding actually works in the opposite way too. If you make the minimum payment, you could take as many as 30 years to pay of your credit card. Imagine finally paying off a Pizza you ate in 2008 in 2038. When you finally pay of your thirty year mortgage in thirty you have paid over three times the amount you have borrowed. And the power of a little works here in your favor too. If you just made an extra $ 100 payment on your mortgage payment you could knock of years of your mortgage payments and thousands of dollars of your mortgage payment. So your savings plan must be accompanied by a disciplined approach to debt. Never take a debt to live above your means. Never get into debt if you can help not getting into it. You may need a mortgage, but do you really need the boat loan? Every time you take debt you need to constantly ask if it is necessary. Not all debt is unnecessary but no debt should be taken without serious consideration to its purpose first. Well becoming a millionaire does sound a tad bit stifling. I can’t take debts to buy things I like and I should just constantly save. Well, not at all. What is the point of living if you cannot enjoy life? God definitely meant for us to enjoy life. Being disciplined does not mean that we will not enjoy life; in fact it probably means that we enjoy it more. Most stresses and tensions are caused due to financial reasons. Most domestic tensions and even divorces are caused because of financial reasons. Imagine a life where that tension of mismanaged finances is eliminated. Imagine when you go on a vacation , you know without a doubt that you budgeted for it and that you can afford it instead of worrying about how deep in debt you are because of this vacation. Financial discipline helps you go on the road to your dreams and the Power of compounding makes sure you get there. Conclusion: There should be no doubt in anybody’s mind on the power of compounding, but you are well served to know the traps which exist. If you get into debt, you negate this great power, indeed the money which was supposed to come to you will go to your debtors. Sooner you can start the better off you are. While in 30 years you could be a millionaire, in 20 years you are not even half way there. Time, patience and discipline will serve you well if you know how to use them. Albert Einstein, well known for being smarter than the average bear, once called compound interest "the greatest mathematical discovery of all time". But you don't need to be as intelligent as Einstein to understand compound interest. In fact, it is a very simple concept. It's very much like a snowball effect. As your capital rolls down the hill it becomes bigger and bigger. Even if you start with a small snowball, given enough time, you can end up with an extremely large snowball indeed. There is an old Chinese saying, the “best time to plant a tree was twenty years ago, the second best time is now”. So while it is best to start as early as possible it is never too late to start. References: All you’re Worth: The ultimate lifetime Money Plan, Elizabeth Warren, Amelia Warren Tyagi. Motley Fool, www.fool.com. http://www.mywealthguide.com/ www.financialplan.about.com Read More