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Wednesday, December 13, 2006

The high cost of procrastination

To cut down on impulse spending, it is often recommended that we postpone the purchase to let us decide whether we still want to buy that thing after a few days have passed. Lot of times, we find out that we don't really care much for that thing any more after a few days time. However, one area where postponement can cost a lot is when it times to start saving for retirement. The reason is that one of the main drivers in determining how much we end up accumulating by the time of our retirement is how long we let the money grow. Thanks to the magic of compound interest, the sooner we start saving, the more we can accumulate even if we start with a small amount.

To highlight the magic of compounding, consider the example of two friends: John and George who both turned 25 years on January 1, 2006. Assume both had zero net worth at that point. John decides to take action and starts contributing $2,000 on Dec 31, 2006 to his retirement account. John continues to contribute $2,000 every December for next 10 years until he reaches 35 years of age at which point he stops contributing any more funds into his account. So from age 25 to 35, he made a total of 10 contributions of $2,000 each, for a total of $20,000. Assuming, the retirement age is 70 years, and his account earned a 5% return annually, his original contributions of $20,000 will grow to approximately $138,760 at age 70.

George, however, believes in living a high life of spending rather than saving, and does not get around to saving until he reaches 50 years of age. At that point, he starts making $2,000 contribution to his retirement account every December for next 20 years until he reaches 70 years of age. So his total contributions were $2,000 * 20 = $40,000. Assuming he also earns 5% return annually, he will have approximately $66,132 at age 70.

So even though George contributes twice the amount ($40,000 versus $20,000 contributed by John), his retirement fund is worth only $66,132 compared to John's whose fund is worth $138,760 at age 70, or approximately 48% of John's amount.

In the above example, the rate of return used was 5%; the worth of the retirement account for both of them would have been more if the rate of return had been higher. Similarly, if John or George has started saving at earlier age, their worth would have been more.

The example may be simplistic and may not consider all the factors but it does show the magic of compounding. George contributed twice the amount of what John contributed, yet his retirement account is worth less than half of John's at age 70. And the reason for this vast difference is the amount of time for which we let the money grow or compound. Too often we all find reasons for why not to save, however, as the example shows even small amounts can grow to a significant amount if saved earlier in life.

posted by Ruby @ 6:47 AM

1 Comments:

At 10:57 AM, Ruby said…

Am happy to say that this post was accepted for entry in the Carnival of Personal Finance #79 hosted by A Penny Saved For all the entries posted in that issue, click the link below:

Carnival of Personal Finance #79

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