Earlier this year, we facilitated a client survey with a subset of our client base. One of the resounding desires for many was insights or tips for how to pass along financial knowledge to their children. So, over the coming months we plan to write a series of blog posts to provide such insights. Important to note, these will be very high level and, in some respects, very simplistic, which in our view makes them easy to forward on, communicate, and implement. As is the case in many of life’s situations, providing a framework to operate in and allowing fluidity within is the best way to make long-term progress toward one’s financial goals.
In this article, we will touch on two key money related concepts:
1. The Five Uses of Your Money
2. The 8th Wonder of the World, Compound Interest
The Five Uses of Your Money
Every dollar that is earned can be used in one of Five Ways:
- To Live (spend)
- To Give (away)
- To Pay Debt
- To Pay Taxes
- To Save
The allocations to each of these areas will change over time, but if a person can start with the disciplines of saving and giving early in their lives, they will create healthy habits that will help later in life when things become more complicated. Saving modestly prepares us for the future, giving modestly can break the power money might have on us.
For someone in their teens or twenties, we would recommend the following five uses of money ranges:
Live (spend) 40-60%
Give (charity/other) 1-10%
Debt 0-10%
Taxes 0-15%
Save 10-15%
As time goes on and healthy debt becomes part of the picture (mortgage, etc.) and/or taxes increase due to increased earning power, the Live and Save may have to dial back a bit. In the article Five Uses of Money, we go into more details with this concept. We also provide ideal ranges to carry forward throughout one’s entire life.
The 8th Wonder of the World, Compound Interest
Albert Einstein once called compound interest the eighth wonder of the world, further stating that those who understand it will earn it and those who don’t will pay it. The Save component of the Five Uses of Money should be allocated towards productive assets to take advantage of this “eighth wonder.” Embracing the idea of compound interest is mission-critical to the long-term financial success of all investors, with young investors having the added benefit of time on their side. The key factors that make compound interest so powerful are time and consistency. By starting early and consistently contributing to an investment account, individuals can take full advantage of the compounding effect over a long period of time.
In sum, compound interest is the concept of earning interest on BOTH the initial amount of money (principal) and the accumulated interest.
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- For example, if one invests $500 per month and achieves an average annual return of 8%, those monies would be worth $173,000 in 15 years (with $90,000 as the total contribution).
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It is important to note that compound interest can work both ways. Credit card debt is the best example of the detrimental effects of paying high interest instead of earning it. For example, let’s say you have $20,000 in credit card debt and you’re paying 20% interest on it. By making the minimum payment of 2% of the balance each month, it will take you 21 years to pay off the balance in full.
As part of our service offering, we’re willing to meet with the next generation to help them make informed financial decisions. Feel free to reach out to us and engage our help.
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Pittenger & Anderson, Inc. does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction. Additionally, the information presented here is not intended to be a recommendation to buy or sell any specific security. To learn more about our firm and investment approach, check out our Form ADV.
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