Financial Concepts
These concepts will help you develop a better understanding of your own finances
The Rule of 72: How It Works And Why It Matters
Every investor needs dependable estimates on how much their investments will grow in the future. Professionals take advantage of complicated models to answer this question, but the rule of 72 is a tool that anyone can use.
What Is the Rule of 72?
The rule of 72 is a simple way to estimate the number of years it takes an investment to double in value at a given annual rate of return. It’s calculated by dividing the number 72 by the annual rate of return.
For example, if an investment has an 8% annual rate of return, it would take approximately nine years for it to double in value (72 / 8 = 9).
Investors, business owners and financial planners can use the rule of 72 to project return on investment (ROI) for different strategies. The rule can also be used to estimate the impact of inflation on investments. It can also tell you the annual rate of return offered by an investment given how many years it will take to double in value.
The Power of Compound Interest
Compound interest is the interest on savings calculated on both the initial principal and the accumulated interest from previous periods. “Interest on interest,” or the power of compound interest, will make a sum grow faster than simple interest, which is calculated only on the principal amount.
Start Saving Early
Young people often neglect to save for retirement. They may have other expenses they feel more urgent with more time to save. Yet the earlier you start saving, the more compounding interest can work in your favor, even with relatively small amounts. Saving small amounts can pay off massively down the road—far more than saving higher amounts later in life.
High Cost of Waiting
So, the sooner you start saving, the fewer dollars you’ll have to put away each month to reach your retirement goals. Don’t pay the high cost of waiting!
Want to save $1 million by age 67? You’d better get started soon.
The longer you wait, the more you’ll have to put away each month to reach your retirement goals.
- 27 years old? You have to put away $214 a month to reach $1 million.
- Start at age 37, and you’re putting away $541 a month to reach your goal.
- Begin at age 47, and you’d have to put away $1,491 a month.
- Wait until age 57, and you’re putting away a hefty $5,168 a month.
- Wait until the last minute (age 62) and you’d have to stash $13,258 a month to reach $1 million by age 67.
Pay Yourself First
What Does It Mean to Pay Yourself First?
Putting your money into savings, retirement or investments before paying your bills and spending could help you stop living paycheck to paycheck and finally save toward financial goals. Automated retirement contributions and savings transfers can help.
Are you a successful saver, or do you find there’s never anything left at the end of the month to put away for a rainy day or retirement?
A recent study from the Canadian Payroll Association (CPA) indicates that Canadians prioritize spending over saving. According to the CPA’s research, almost half of us are living paycheque to paycheque. A whopping 47 percent of working Canadians say it would be tough to meet their financial obligations if their paycheque was to be delayed by even one week. For millennials in their 30s, the study found 55 percent would have difficulty, while 51 percent of Gen X-ers in their 40s felt the same way. These stats are all the more disconcerting given that most of us have certainly faced an expensive emergency — a broken down car or a sudden plumbing disaster, for example.
However, paying yourself first doesn’t always make sense and can end up working against you if you have high-interest or “bad” debt. Outside of building an emergency fund, if you’ve got all of these bad debts, you don’t want to pay yourself first. The reason for this comes back to simple mathematics. If you’re paying 20% interest on a credit card, there’s no realistic investment you can put your money in to get more than 20%. So you’re kind of working against yourself.
Resist the temptation to make unplanned withdrawals, so your savings and investments can grow. Saving toward retirement and building up a substantial emergency fund improves your long-term financial health; saving up for major expenses can help make big financial goals like homeownership or college possible.
Debt Stacking
Debt stacking is a debt management strategy that focuses on efficiently targeting multiple accounts, one at a time, while still making payments on all accounts. As account balances disappear, the amount of money available to attack your next debt increases, and debt disappears faster.
The debt stacking method isn’t complicated. Here’s how it works:
- You budget one large payment monthly for all of your debt.
- Choose which account to target first, and make large payments to that account.
- Make minimum payments on others.
- When the targeted account has a zero balance, you target the next account to pay off.
- Since you have one less bill to pay, you now have more money to apply toward the remaining debt.
The debt stacking method makes payments manageable, gives you budgeting focus – saves a huge amount of money in interest! – and results in you being debt-free.
Debt stacking can mean either targeting the card with the highest interest rate, or the one with the lowest balance. We’re going to focus on a strategy that targets the cards based on the highest interest rates
Theory of Decreasing Responsibility
What is the theory of decreasing responsibility?
This theory establishes a connection between resources and responsibilities throughout life. In other words, it connects your wealth or the money you have with your financial obligations.
This relationship will determine the level of protection you need at any given time, which is calculated by the difference between one and the other.
To help you understand this better, imagine a typical person’s financial and life history. When you are young, you have little money, but also few financial responsibilities. After all, no-one is depending on you and you may even live with your parents. Consequently, you don’t need a lot of additional protection.
As life goes on, you earn more money and increase your wealth, but you also increase your obligations and responsibility. For example, when you buy a house, you will have a huge mortgage debt, and probably little or no money saved if you have just bought the house.
If, in addition, you move in with your partner and start a family, your current and future responsibilities will suddenly grow, again beyond your current income and assets. Naturally, you will want to take care of your children and guarantee them a future no matter what happens to you and your income.
Time will go by, your children will go to college, they will start working (or not), and you will finish paying off the house. In other words, your personal and financial responsibilities will decrease over time.
