As some of you already know, I’ve been taking classes through Penn State’s World Campus to lead me (hopefully) to become a Certified Financial Planner. My goal is two-fold. First, I think this education will help me to better help my student population. Second, I think this will lead me to a nice side-gig that I can pursue for a bit of extra income after I retire from Penn State. This semester I’m taking a class in Corporate Finance. At first I had my doubts about how practical this class would be for me. But it turns out I really enjoy it.
Last week we started learning about something I’ve been preaching about for years: the time value of money. A dollar today has a different value than that same dollar a year from now. If you put in into a savings account with a 2.0% interest rate that dollar is worth $1.02 in a year. If that dollar was borrowed from a Grad PLUS Loan with a 7.6% interest rate, the use of the dollar is costing you an additional $0.076 for the privilege of using it for the year. Whether you are saving or borrowing (I know…borrowing is much more likely at this stage in your life) it is important to understand the power of compounding interest.
There is a reason you’ll always hear someone telling you to start saving for retirement at the very beginning of your career. The earlier you start, the longer your money has to grow. The older the dollar, the more time it has to age. That dollar that was worth $1.02 after one year is worth $1.48 after 20 years—and that’s at 2% interest. With a more typical 10% retirement investment return that dollar is worth $6.73 after 20 years. $17.45 after 30 years. $45.26(!) after 40 years. The longer the money has to grow, the more exponentially it is able to grow.
Much like you want your interest to compound for as long as possible when you are saving, you want it to compound for as short a time possible when you are borrowing. Because student loan numbers can be scary, let’s look at a car loan. Let’s assume you are borrowing $15,000 to buy a used car. Your interest rate is 4%, regardless of the repayment term. If you take 7 years to pay it off you will pay $205.03 per month and you’ll pay a total of $2,223 in interest. If you shorten that to 6 years, you will pay $234.68 per month and you’ll pay a total of $1,897 in interest. Shorten it to 5 years, and the payment is $276.25 and the total interest is only $1,575. The shorter the term, the less interest you pay. The same rules apply to your student loans and someday your home mortgage. The shorter the time you take to repay it, the less you will pay in interest.
Next time you make a deposit to your savings account or borrow a little extra loan money, take a moment to think about the time value of money. Every dollar is worth more (or less) than you think!
Last week the Federal Reserve raised its base interest rate for the first time since 2006. The Fed rate is the rate at which banks lend money to each other. During the financial crisis of 2007-2009, this rate quickly spiraled down to zero, where it has remained ever since. Until last week. With the economy strengthening the Fed finally felt secure in starting to move this rate upward by 0.25%. Tiny moves like this are expected to continue throughout 2016 until we land at a Fed rate of 1%. Which is still very, very low.
So what does this change in interest rates mean in real life? Savings interest has been ridiculously low since the financial crisis. And this is not likely to change anytime soon. It will probably be late 2016 or even 2017 before we start to see any movement there, as banks are slow to pass on interest gains to savers. Consumers of credit, however, will see changes right away. Mortgage rates, car loan rates, and credit card interest rates will all rise almost immediately. If you have any variable rate debt that can be converted to fixed rate debt, it’s best to do that sooner rather than later. Most existing student loans will not see any change, as federal student loans made in the last ten years all have fixed interest rates. But interest rates on student loans borrowed after July 1, 2016 will likely have higher rates than loans made in the year prior.
This interest rate increase is a sign of hope to me. Hope that we are finally returning to a more normal economy. The reality is that a 1% Fed rate is still extraordinarily low, and while credit interest rates will be rising, it won’t be by enough to break anyone. Normalcy in the economy has been completely absent for most of the last decade, so now we move forward and learn what our new normal in America is going to be.
The power of compound interest never ceases to amaze me.
I’ve read countless articles about how important it is to contribute to retirement funds beginning with day one of employment. They say the funds will grow and grow, so the earlier you contribute, the better. But I didn’t really get it until I recently took a look at my own retirement account statement.
When I was in graduate school I received a small stipend from my graduate assistantship as an academic advisor. During those two years, a percentage was held out of my pay and went into the Ohio Public Employees Retirement System. I remember being annoyed at the time because the $300 per year that was held out of my pay was a significant amount of money to me at that point. But there was nothing I could do about it.
A few years later, when it became clear that my career was not going to be in the Ohio public university system, I rolled that small retirement fund into an IRA. It was still a really small amount at that time. Maybe $700…which is still larger than the $600 I had contributed.
Now fast forward 20 years to 2015. That IRA that I started with just a few hundred dollars is currently worth over $3,600. I never contributed another dime to that account. Just the initial $600. But it has grown to six times its original size. And it still has many years to grow before I retire. This is the power of compound interest.
When you leave law school and venture into full time employment, you should start saving for retirement as soon as possible. It may seem like a better choice to wait until you’ve made a dent in your student loan obligations. But it’s not. The earlier you start saving for retirement, the more time your money will have to grow. Contribute early. Contribute often. Retirement savings is never something that should wait until later.