Planning your Purchases Far, Far in Advance |
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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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Tipd10 Responses to “Planning your Purchases Far, Far in Advance”
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Hi - very well said. I love high interest savings accounts. I’ve had one from ING Direct for about 6 years, and it’s paid me about $4,500 since I opened it.
The other thing NCN could also do is use a cash back credit card and pay the balance off in full every month. For example, let’s say his monthly expenses were $1,500. That would be $24,000 worth of expenses over 2 years. Many cash back cards pay between 1-5% on purchases (depending on the type of purchase it is). To keep the example simple, let’s say his “average” cash back percentage is 1.25%. On $24K, that would work out to be an extra $450 to go toward the car.
Dang - that’s $36,000 not $24,000.
What you said is quite true. I’m about to start compounding up my savings myself, and I have discovered already what a bummer inflation can be. Not to mention taxes. It turns out that you put your money in a high-rate compounding account and you are lucky if you can just keep pace with inflation and taxes. It’s like pushing your money forward so that it will stay at the same place.
Yes, if you are in a moderately high income tax bracket or a high tax state, after taxes and inflation 5% interest just holds the value of your money constant.
I think it’s great planning ahead of time for purchases. Though I think sometimes planning to far in advance is not a good thing. It’s a less of an issue with saving money because that money can be used for something else. However by saving money for tomorrow implies not spending the money today which does have a cost. Tomorrow might never come. That’s one reason a dollar today inherently is worth more than a dollar tomorrow.
I don’t like the general recommendation to save and I totally agree with dong’s comment. I wrote a longer response on The Real Value of Money but the main thesis is that one should remember time and enjoyment of money is not free. You can make anything worth huge amounts or money, or very little simply by changing the way you present the calculations and what costs or benefits you count or don’t. Take the measurements against things you value, not apparently free money.
Yes, it’s always something that you have to weigh. For me, right now, the top thing on my want list is a house in 5 years (while still retaining my condo which I rent). I wish I had started saving for this 10 years ago. There are a lot of things that I used money for “something else” only to discover that money went to waste.
Regrets . . . I have mine too :) Getting good at saving definitely builds character. I have the same feelings. Why can’t you buy your house now? Reading your bio, you have good income now. Why save in advance for a house?
The median home price in my county is $870K - and that doesn’t get you a home with two floors or a basement. I also believe in putting down 20%, which requires savings, $174K. Lastly, I don’t expect to plant roots here in California. I’d like to move back to Boston in the next 3-4 years.
[...] Man at Lazy Man and Money suggests that if you are going to make a big-ticket purchase, you should plan it far ahead. What you will gain from this method is interests you earn by setting aside the money in a savings [...]