As Compounding Interest Week continues, I'd like to highlight some very smart thinking by No Credit Needed. He's planning his next car purchase now and saving money each month for it in a high-interest savings account. By using the interest that he's making on top of the savings he'll be paying $7800 for what is essentially a $10,000 car.
We know that the real interest rates of high-interest savings accounts, due to inflation, by summer 2010, $10,000 won't buy as much car as it does today. In fact he'll need $10,959 to buy the same car if the inflation rate is an annual 3.1%. He'll still be coming out ahead of the game, because he making $2200 in interest and only giving up $959.
However, if he could have foreseen this need 7 years in advance instead of 3 (or hold out a few more years), he was willing to take on a little more risk, and he had the means, he could have possibly done a lot better. Let's assume that he started saving in summer of 2003 and still plans on buying a car in the summer of 2010. And let's assume that the invested in the stock market in that time. We'll make one last assume that the market returned 10% as it has in the past (though by some calculations it has returned 12%). Using the great calculator that No Credit Needed found, if he spent the first 3 years putting $200 in the market earning 10%, he would have $8,361. He could put that money in a high-interest savings account in the final four years and have his $10,000. By thinking a little further ahead, he reduced the amount he needed to save significantly.
Now, I know that you may not want to put short-term money in the stock market. That's very smart. It is unrealistic to do that because the market could tank at any time and not recover when the money is needed. In today's world with so many people living paycheck to paycheck, it can be hard to plan and execute on saving for purchases this far in advance. However, there are large rewards for those that can.
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