Start saving early and interest puts time on your side

Compounding: Your nest egg's growth gets a powerful assist.

Dollars & Sense

October 03, 1999|By Bill Atkinson | Bill Atkinson,SUN STAFF

Albert Einstein once referred to compound interest as the "most powerful force in the universe." Others have dubbed it the "eighth wonder of the world."

J. Michael Martin, president of Financial Advantage Inc. in Columbia, simply calls it a "phenomenal thing."

"It is unbelievable what it does," said Martin, a financial planner. "It is especially powerful in a tax-deferred vehicle. That way, you are not only earning money on your original principal, you are earning money on what would have gone to the federal government. That is beautiful."

The key to tapping this force is to start saving early to get the benefit of the compounding. "It really makes a difference," said Nancy Bryant, owner of Bryant Financial Advisory in Towson.

Bryant likes to use this example to illustrate how fast money grows when a person starts saving early: One person begins saving $160 a month when she is 30 years old. But she stops after 10 years, and doesn't touch the money until she is 65. Another person starts saving when she is 40 years old, and saves $160 a month until she retires at 65. Both earn 8 percent on the money.

Who ends up with a bigger nest egg? The person who started earlier walks away with $216,289 even though she stopped after 10 years. The second person, even though she has saved 15 years long longer, ends up with $153,179.

"It is like a geometric progression," said Edward O'Hara, a certified financial planner at Capital Asset Management Services in Silver Spring. "It expands and it expands and it expands."

But persuading a 20-year-old to save is about as easy as coaxing a toddler to stay away from the dog's food bowl. There are cars and clothes to buy and maybe an apartment to furnish.

"Part of the reason is the younger you are, the farther away you are from the reality of retirement," Bryant said. "People who really started early, they are the rare person. Usually, it comes from a discipline they learned from their parents. It is kind of like it is in their DNA."

Martin has five children and his "save early" message has sometimes fallen on deaf ears.

One summer he offered to give his three boys $3 for every $1 they saved. "You know how much the three of those guys saved? Nothing. It is a true story. Not a penny. And they all worked, but they didn't postpone any consumption."

The definition of saving, Martin said, is to postpone consumption, or put off buying something you want and save the money instead. "If you create this discipline, you will just naturally want to increase it. The reward is, you see money accumulating and it makes you feel better." Nancy Bryant Financial adviser "We all love to consume and to put it off, it is painful," Martin said. "But you need to find a way to motivate yourself to postpone consumption. Whatever you want to buy is attractive -- you have to come up with something that is more attractive. Time is really important, but, unless you postpone consumption, it doesn't matter."

But saving for something like college can be a frightening proposition, especially with costs skyrocketing. Why should someone even bother to try when it seems so far out of reach?

"Even if it is as little as $20 a month, that is better than zero," Bryant said. "Your friend may be saving $200 a month you may be discouraged by that, but what you have to do is focus on yourself."

One way to build savings is to create more income, which might mean cutting back on the number of evenings out to dinner, or trimming the amount spent on clothing or even food.

"You will find that if you create this discipline, you will just naturally want to increase it," Bryant said. "The reward is, you see money accumulating and it makes you feel better."

A good way to start saving early and without pain is to participate in your employer's 401(k) plan, Bryant said.

"It is money they never see. It is money they can't spend. It is money that is discretionary," she said.

Martin likes to use the "rule of 72" to show clients how quickly their money can double when they start saving early.

The rule works like this: Take 72 and divide it by the average interest rate that the money is earning over time. If the money is earning an average of 7 percent, it will take about 10 years for it to double.

A person who wants his money to double in five years can figure out the interest rate he will need for that to happen by using the rule. He should take 72 and divide it by five, which works out to an average interest rate of 14.4 percent.

"Doubling is something easy to picture," Martin said. "It is handy for people who aren't real quantitative."

But the bottom line is to start saving early. The investor will come to realize how powerful money is when it has time to grow.

"It is really true that time is your friend," Martin said.

Growth engine

Here's how a one-time $10,000 investment would grow, assuming an 8 percent annual rate of return, compounded monthly:

3 years, $12,597

5 years, 14,693

8 years, 18,509

10 years, 21,589

13 years, 27,196

15 years, 31,722

18 years, 39,960

SOURCE: Legg Mason

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