Save! Save!

And Save Some More!

I cannot say this often enough.  Save!  Save!  And Save Some More!

Throughout our lifetimes, we will be faced with making various financial planning and purchase decisions, many of which will have significant impacts upon our lives.  Amongst these are:

  1. Emergency Fund
  2. Major purchases:
  3. Residential home
  4. Motor vehicles
  5. Vacation home
  6. Rental property
  7. College educations for our children
  8. Retirement
  9. Holiday shopping
  10. Vacation travel
  11. Various other good reasons, including giving to charities
  12. And of course, the proverbial rainy day

Isn’t that list daunting?  Scary?  Absolutely.  The most important of these is an Emergency Fund, which is why it’s listed first.  None of us can foresee what the future may hold for us.  To provide cash in the unlikely event that some unforeseen circumstance (illness, loss of job, vehicle accident, etc.) does occur, establish an Emergency Fund that contains enough cash to cover at least six months’ worth of your living expenses.

We Americans are constantly bombarded with messages to spend.  Merchants try convince us that we will enjoy happiness only when we live in the right town, own the right home or vehicle, have the most ornate kitchen, wear the right clothes, take the most exotic vacations, send our children to the “right” college, take the right medicines, etc.  And they don’t care one iota how much debt you will have to incur in order to enjoy all of these material things.

The key to enjoying a comfortable, satisfying and less stressful financial life is to save first, then spend as needed.  Start savings for all of the above situations as soon as you begin working and continue to do so throughout your life.  Yes, this is hard to do.  But if you develop the self-discipline to save every day, you will look back one day and realize just how easy it really was to do.  And you will cherish that good feeling that comes with living a less stressful financial life.

Save!  Save!  And Save Some More!

Pay Yourself First

The key strategy to building significant savings nest eggs is to begin by paying yourself first.  Set aside a portion of the salary and compensation you receive for the above purposes before you pay your bills.  If you participate in a 401(K) Plan or HSA at work, you’re already doing this.  Good for you!  If not, get started immediately.

The Power of Compounding

The power of compounding is the fundamental, underlying principle behind all investment strategies, education savings and retirement plans.  Compounding is the process by which an investment asset’s earnings from interest, dividends and capital gains are reinvested into that same investment year after year to generate additional earnings over a (hopefully long) time period.  It is the reason why individuals should pursue a strong savings and investment strategy as soon as they begin working and continue to do so throughout their working lives.

For example, suppose that you make one investment of $1,000 into a bank account, bond, mutual fund, stock, etc.  And suppose that the yield on this investment is 5% per year.  After 5 years, your investment would have grown by $276.28 to $1,276.28.  Here’s how this occurs:

Year Principal Amount
Income Subtotal
1 $1,000.00 $1,000.00 $50.00 $1,050.00
2 0 $1,050.00 $52.50 $1,102.50
3 0 $1,102.50 $55.12 $1,157.62
4 0 $1,157.62 $57.89 $1,215.51
5 0
$1,215.51 $60.77
$1,000.00 $276.28 $1,276.28

The beauty making such an investment is that you did not have to work even one minute of your life to earn this investment income of $276.28!  The earnings returned on this investment did all of the work for you.

Let’s modify the above example slightly.  Suppose you make the same investment of $1,000 into a bank account, bond, mutual fund, stock, etc., but you do this EACH YEAR.  The yield on this investment is the same - 5% per year.  After 5 years, your investment would have grown by $801.91 to $5,801.91.  Here’s how this occurs:

Year Principal Amount
Income Subtotal
1 $1,000.00 $1,000.00 $50.00 $1,050.00
2 $1,000.00 $2,050.00 $102.50 $2,152.50
3 $1,000.00 $3,152.50 $157.62 $3,310.12
4 $1,000.00 $4,310.12 $215.51 $5,801.91
5 $1,000.00
$5,525.63 $276.28
$5,000.00 $801.91 $5,801.91

That’s nearly triple (actually, 290.25%) than the investment result of $276.28 realized in the first example.  Astounding!  This is the real effect of compounding – the result realized by reinvesting earnings into that same investment year after year to generate additional earnings.  It is the underlying fundamental principle behind all investment, and retirement and college tuition savings plans.

The earlier that one starts putting funds aside for investments, the more effective and dramatic the power of compounding will be.

The power of compounding can also be a double-edged sword that works against you in certain circumstances: 

  1. If you carry large balances on your credit cards and have been making only minimum monthly payments that do not cover the interest charge assessed by the bank.  On the next month’s statement, the bank calculates the new interest charge on the sum of the unpaid principal balance outstanding on each credit card plus the unpaid interest.
  2. If you have a home equity line of credit (HELOC).   Most HELOCs are structured as what are known as a “balloon” loans, with interest-only monthly payments and the entire loan balance due at the end of the term – usually 10 years – hence the term “balloon”.  Often, the interest rate is variable and tied to the Prime Rate.  If you have been making only the minimum monthly payments (i.e., just the interest) without including some additional amount to pay down the loan balance, you will keep paying the same amount of interest every month until the HELOC loan balance becomes due.  If the Prime Rate goes up during the life of the loan. so does the interest you pay.

The Leverage of Cash

Building up a substantial cash savings position may provide you with additional leverage when you decide to make a major purchase.  By offering more cash, you may be able to negotiate a better price for that purchase.  If you need to borrow funds to consummate the purchase – say, a mortgage for a home or a loan for a vehicle – you may be able to negotiate better loan terms, i.e., a lower interest rate or a reduction of fees charged.

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