There are many calls on our finances in this life — transport, food, bills and entertainment to name but a few. We always seem to be dipping into our wallet to pay someone for something. It’s easy to spend all of our money each month without really having noticed where it has gone. Of course, we will have derived some benefit from this in terms of the specific goods and services we have purchased, but at the end of the fortnight or month, what do we really have to show for our hard work?
If you want to achieve major financial goals in life (owning a house, being able to be independent from the need to work, funding your own retirement), it’s imperative that you pay yourself first. Out of every pay check that you receive, you should arrange to automatically debit at least 10% (ideally more if you can manage it) to another savings account. This money is to be set aside for your long term benefit — to buy a house or invest for your retirement. This money should not be spent on depreciating items such as cars or holidays (so if you want to purchase these sort of things, you’ll need to set up another savings account). If you are paying off a mortgage on a house, you can count the principle part of your repayment as contributing towards this goal.
It’s important to set the money aside as soon as you are paid. I have found that if I wait until the end of my pay-cycle to save, I’ll often find that there is nothing left. However, when I set the money aside straight away, I somehow manage to pull through each pay-cycle without any noticeable deterioration in my standard of living despite the fact that I put 10% (or more) away. Thus, the best way to do it is to have your employer split your wage to two separate accounts if they will do this, or if not, set up an automated payment from your main account to your savings account on the day you are paid.
It’s important to adjust your automatic savings amount every time you get a pay-rise to ensure your savings rate stays at ten percent of your salary (or whatever the target rate you set yourself). And if you get some sort of bonus or windfall (including tax refunds), I would recommend saving a portion (eg 50% or 75%) and splurging the rest on a treat.
Paying yourself first won’t change your life in a week, a month, or even a year. During the initial years of a saving plan, the interest will seem insignificant. But if you keep putting money aside consistently over a long period of time it will have a truly life changing effect. This is because of compounding.
Compound interest occurs when the interest that accrues on an amount of money in turn accrues interest itself. It’s the deceivingly simple force that causes wealth to rapidly snowball. No less a genius than Albert Einstein declared compound interest to be the eighth wonder of the world. It is what separates the rich from the broke.
This is why it’s the concept that is at the core of all finance. By saving regularly over a long period of time, your assets will grow and grow … until eventually, the rate of growth will provide a greater source of increasing wealth than your regular saving. Imagine that — earning more from your interest than you are saving yourself. If you can make a 10% return on your savings, it will take around nine years to achieve this (and that assumes you don’t increase your savings).
There are two key factors which will determine how fast your savings grows. The first, and most important, is time. The sooner you start, the better, because this will give you more scope for the miraculous compounding effect to occur. For example, if you save $5,000 per year and can achieve a 10% rate of return, then you will have $79,687 after ten years. If you keep investing your $5,000 and maintain your rate of return, it will grow to more than $255,000 in the next ten years (ie after twenty years) and to $822,000 in the next decade. After forty years, it will have grown to $2.2M and you will be earning more than $200K each year in investment earnings. This all assumes you are still only saving $5,000 each year. Given you should be increasing your savings as your salary increases, you should do even better than this.
Your rate of return is the other important factor. Given your “pay yourself” savings are being invested over the long term, you should not just put the money in the bank. Much better returns can be achieved from investing in the stock exchange or in property, and it does not have to be too complex. A simple index fund can be set up very easily and this sort of investment has delivered returns of around ten per cent over long periods of time.
To learn more about this hack read The Richest Man in Babylon by George S. Clason.
If you are struggling to free up funds to save, check out Mr Money Mustache’s blog which is full of money saving tips (I suggest you start reading from his oldest article first).
To learn how to invest your savings pile read The Barefoot Investor by Scott Pape or Making Money Made Simple by Noel Whittaker.
