The Time Value of Money

Why does it matter to invest as much money as you can, the earliest that you can even if you stop later in life? Because of the Time Value of Money.

I showed this example to my kiddos several years ago and it was a lesson I learned some 20+ years in the distant past. Everyone (well, those that have a frugal mindset) will always tell you to buy a Used Car vs. a New Car and if possible, to pay cash. The main argument is that you don’t want to take the initial financial hit by driving the car off the lot. Let someone else take that burden. Many estimates suggest that the car loses 15% to 20% of it’s value once you leave the dealership. But, that never resonated with me when I was younger. I made decent money and since I earned my money, shouldn’t I have something nice to show for it and shouldn’t I drive the car of my dreams (within reason, of course). All of those things may be true, but let’s talk about investing that money instead.

Normally when I show this example, I would use an estimated monthly car payment of $350. WOW! Is that dated. I did a quick search and found that the average monthly car payment in 2020 for a new car is $568 per month. $397 per month for a used car per Credit Karma. Although the average loan term for a new car is now 71.5 months, let’s just use the old 60 month term (5 years). And we’ll use an industry standard of 7% growth in the stock market (note, some use 8% or 10% but I like to be on the conservative side).

How does the math work if you invested that $6,816 per year ($568 per month X 12 months) into the stock market from the ages of 20 to 25? That would mean that you invested $34,080 into the stock market at the end of 5 years. And, how does that compare to waiting to invest that money until you are 26, 30, and 40? What are the differences in the amount of money you paid in and the length of time you had to do so in order to grow your money to be equivalent to an earlier start?

The below table shows that if you took the first 5 years to invest that money, it would take you the equivalent of 8 years if you waited until 26, 12 years at the age of 30. And what about starting at 40? Well, you would invest for 25 years and would still fall $170,000 short compared to your younger 20 year old self. And, you would have invested 5 TIMES the money ($177,216 vs $34,080).

At the bottom of the above table, I also included a “Safe Withdrawal Rate” and an “Annual Pay Yourself” rows. The safe withdrawal rate is the industry standard of a withdrawal rate from your investment account to pay yourself… basically, giving you an annual salary from your investments. By using a 4 percent safe withdrawal rate, this should take into account the average stock market gains (remember, 7 percent) and inflation to give you an annual salary WITHOUT drawing down the base.

In the example above (using the first column), you invest $34,000 the first five years (ages 20-25), don’t invest any more money, and will have a nest egg of $637,000. Then, at age 65, you can take out $25,000 per year to pay yourself for the rest of your life. When you pass away, you can leave behind the $600,000 to your heirs. Or, you could also increase your draw against the balance as you age.

What if you need more than $25,000 per year to live on? Most likely you will. This is just an example. If you want to beef up the annual salary you pay yourself, or if you want to retire at 60 and not 65, keep on investing. Add more than $6,800 the first few years or don’t stop at the fifth year. More to come on this in an upcoming post.

Thanks for reading. -Stephen

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