The Miracle Of Compound Interest

Katie Young
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Wednesday - August 23, 2006

Unfortunately, I’ve never been very good with my money, much to the dismay of my father and my best friend, who is an accountant. My best friend even went so far as to buy me the Complete Idiot’s Guide to Personal Finance in your
20s and 30s
for my birthday one year. But more on that later.

Not only am I not too keen on working my day-to-day budgeting, but don’t even ask me what I’m doing to prepare for the future. I procrastinated and didn’t even start my 401k until I had spent almost four years with MidWeek. Just the mention of stocks, bonds, mutual funds, annuities or IRAs and I gotta lie down for a nap.

Trust me, I don’t want to be this way - I’d love to be money-savvy. I think I’m fairly intelligent, but for some reason, when it comes to money talk, you might as well be speaking Swahili to me. I desperately needed a wake-up call -someone to sit me down and spell things out: This is what you need to know and this is what you should do.

Knowledgeable about money matters is certified financial planner Brian Y. Chang, CFP, CLU, ChFC, CFS and a partner in the firm of Deutsch & Chang.

Chang, 30, also teaches money management seminars three times a year at Kaiser High School, University of Hawaii at Manoa Outreach College and at Leeward, Windward and Kapiolani community colleges.

Brian came up with a list of five common financial mistakes for young people just starting out. Here’s what he has to say:

Mistake No. 1: Not saving for retirement now! Young people have time on their side so they can make a small change now and have a big result in retirement. If you are 30 years old and want $1 million by age 65, you have to invest about $452 per month (assuming you will earn 8 percent on your investment). Wait until you are 40 years old and now you have to sock away $1,090 a month. Start when you are 50 and that number jumps to $3,000 a month.

Even waiting one year to start investing can have a huge impact on your account in the long run. If you invest $2,000 a year for 34 years at 8 percent, you will have $338,410. Invest for just one more year (35 years total) and your account balance jumps to $368,497. That’s a $30,000 increase from a $2,000 additional investment.

It’s what Albert Einstein called the eighth wonder of the world - compound interest.

Mistake No. 2: Not contributing to your retirement plan at work if they make matching contributions. Even if your employer matches you only 10 cents for every dollar you contribute, that is a 10 percent rate of return before you even pick your investment options. It doesn’t get any better than free money.

If you don’t contribute and miss out on the matching contributions, then go to the window and start ripping up dollar bills because, basically, you are throwing money away.

Mistake No. 3 : Not increasing your savings rate when you get a pay raise. The best and easiest way to do this is by contributing a percentage of your pay and not a set dollar amount into your retirement plan at work. That way, whenever your pay increases, you automatically increase the amount you’re saving.

Mistake No. 4: Not understanding the different tax ramifications of the different retirement accounts. Where you put your money today has a huge effect on how much taxes you pay. If you put $4,000 into any investment for 30 years at 8 percent, it will grow to about $40,000 without adding another dime. If that $4,000 was put into your retirement plan at work, you will be able to deduct the $4,000 today but pay tax on the full $40,000 in retirement.

If you put $4,000 into a Roth IRA, then you will owe taxes on the $4,000 today but you get the $40,000 tax-free.

Personally, I would rather have my money growing in the tax-never account (Roth IRA) than in the tax-later account (work retirement plan.) Of course, you would always want to contribute to your retirement plan at work to get the maximum matching contributions from your employer.

Mistake No. 5 : Not preparing for unforeseen expenses or disability. Everyone should build up an emergency cash reserve of about three to six months of living expenses. If the roof leaks or the car breaks down, you don’t want to put these expenses on your charge card at 18 percent interest. You want to have the cash to pay these bills.

Also, young people have a greater chance of being disabled than dying. Most people insure “things” like buying the extended warranty on their camera, DVD player or television, but no one really thinks about what would happen if they could not go to work the next day. Where would the money come from to support yourself?

If you had a choice of insuring the golden eggs or the goose that lays them, where would you put your money? Your ability to wake up tomorrow and go to work is actually your most important asset.

As Brian has taught me, you can’t just hope it’ll never happen to you. And each day you procrastinate is just more money down the drain.

Learn to be smart about it now.

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