13.4: Grow Your Money

Choosing a career early in your financial life cycle is just one reason to start financial planning as soon as possible. Consider this scenario: it’s your eighteenth birthday, and you receive $10,000 that your grandparents had set aside in a trust for you. You could spend it, perhaps fulfilling a long-held dream like funding flight training for a private pilot’s license. Alternatively, your grandfather might encourage you to save it instead, taking advantage of the power of interest.

Interest is either the cost of borrowing money or the extra payment made to you by an investing institution, typically expressed as an annual percentage rate. If you deposit the $10,000 into a savings account earning 5 percent interest annually and leave it untouched until after college, your savings will grow to approximately $12,000—$10,000 in principal and $2,000 in interest. That extra $2,000 could be reinvested or spent on something else.

This prospect sparks curiosity: if $10,000 can grow to $12,000 in just four years, what might it be worth by the time you retire at age 65? A quick search using a compound interest calculator reveals that, after 47 years at a 5 percent interest rate, your $10,000 would grow to $104,345. While not enough to fully fund a retirement, it’s a solid foundation.

But let’s take it a step further. Imagine that your college education pays off as planned, leading to a good job that allows you to add $10,000 annually to your retirement savings. With consistent contributions and the same 5 percent annual interest rate, your nest egg could grow to over $1.6 million by age 65. This example underscores the value of starting early with financial planning and making the most of compound interest to secure your financial future.

Investing

Investing is what someone does when they buy something in hopes that it will grow in value over time. While students don’t have a lot of money to invest after paying tuition and their bills, it is important to start early. Investing doesn’t have to be complicated. If you can afford to invest a small amount each month as a student, it could pay off big in the long run. Here are a few investment options for students:^[1]

• Guaranteed investment certificates (GICs)
• Bonds
• Stocks
• Mutual Funds
• Exchange-traded Funds (ETFs)

If you’re in a position to start investing as a student, you can set yourself up on the right financial path.

Compound Interest

Compound interest is the process of earning interest on both the original principal and the accumulated interest from previous periods. Unlike simple interest, which is calculated only on the principal amount, compound interest allows your investment or loan to grow at an accelerating rate over time because interest is added to the principal at regular intervals.

Imagine, for instance, you follow your grandfather’s advice and invest $10,000 (your principal) in a savings account with an annual interest rate of 5 percent. At the end of the first year, your investment will earn $500 in interest, bringing your total balance to $10,500. If you then reinvest the entire $10,500 at the same 5 percent rate, you’ll earn $525 in interest during the second year, resulting in a total of $11,025. This process continues each year, with interest being earned on both your initial investment and the accumulated interest. Over time, this compounding effect can lead your investment to grow to $81,496.67 by the time you reach 65.

Time Value of Money

The time value of money is a key financial concept that emphasizes that a dollar received today holds more value than the same dollar received in the future. This principle stems from the earning potential of money: money available now can be invested to generate returns, such as interest or dividends, over time. The sooner money is received, the sooner it can be utilized to grow wealth, making it inherently more valuable in the present.

Inflation plays a significant role in this principle. Over time, the general increase in prices reduces the purchasing power of money, meaning that a dollar in the future will buy less than it can today. Additionally, the opportunity cost of delaying money is another critical factor. For example, if you lend someone money, you forgo your chance to invest or spend it now. To compensate for this sacrifice, interest is charged, which also accounts for factors like inflation and risk. Lending money to a government, for instance, might involve minimal risk, but lending to an individual introduces uncertainties, requiring higher compensation.

Ultimately, the time value of money reflects both the financial and practical realities of managing resources, emphasizing the importance of immediate access to funds for maximizing their potential. This principle underpins many financial decisions, from borrowing and lending to investment strategies.

The time value of money principle emphasizes that a dollar received today begins earning interest immediately, while a dollar received tomorrow starts earning later. For example, suppose you receive $2,000 in cash gifts upon graduating from college. At 23, with your degree in hand and no immediate need for the money, you decide to invest the $2,000 in an account earning 10 percent interest compounded annually, adding another $2,000 each year (roughly $167 per month) for the next 11 years. Note that the 10 percent rate is used for illustration and is not representative of today’s market conditions.

The orange line in Figure 13.2 illustrates how your account balance grows each year, showing your total savings at various ages between 24 and 67. By age 36, you’d have almost $52,000, and by age 50, over $196,000. By the time you reach 67, you’d have nearly $1 million. In contrast, the brown line shows what would happen if you didn’t start saving until age 36. Although you’d still accumulate a respectable sum by age 67, it would be less than half of what you would have accumulated by starting at 23. More importantly, to reach this amount, you would need to contribute $2,000 every year for 32 years, instead of just 12 years.

The reason should be fairly obvious: a dollar saved today not only starts earning interest sooner than one saved tomorrow (or 10 years from now) but also can ultimately earn a lot more money in the long run. Starting early means in your 20s—early in stage 1 of your financial life cycle. As one well-known financial advisor puts it, “If you’re in your 20s and you haven’t yet learned how to delay gratification, your life is likely to be a constant financial struggle.”^[2]

Media Attributions

“Investment, Interest, Money royalty-free stock illustration” by Tumisu, used under the Pixabay license.

“Figure 13.2: The Power of Compound Interest” is reused from The Financial Life Cycle, © 2022 by Kindred Grey, licensed CC BY 4.0.

Image descriptions

Figure 13.2

The x-axis shows age from 24 to 67, with labels in 5-year increments starting with 30 up to 65. The y-axis shows savings from 0 to $1,000,000 in increments of $200,000. Two curved lines slope up, with one line beginning with savings at 24 years sloping up to $1 million at 67 and the second line beginning at 35 and sloping up to around $500,000 at age 67. Boxes of text point to each line.

The first line reads “The 24-year-old invested $2,000 per year for twelve years. She stopped adding money in, but her total still grew. By age 67, she had almost a million dollars!”

The second line reads “Her friend did not invest until she was 35. Even though she invested $2,000 every year, by the time she was 67 she had not caught up with her wiser friend. She had less than $500,000.”

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