Okay, let's build on the two concepts that we learned in the last lesson – the magic of compound interest and the 80/10/10 principle. And we'll do it the same way Pledger Monk does with his students in the class—with a story of two hypothetical recent college graduates. We'll call them Jack and Kate. Let's assume both are twenty-one years old. And to make the math easy, we'll assume each earns $48,000 a year for their entire working career, which is a little below the median household income in the United States.
Kate understands both the compound interest and 80/10/10 principles well and puts them to use for her benefit. She saves $4,800 a year ($400 a month) and invests it wisely every year, earning an 8 percent return until she retires at the age of sixty-seven.
Jack, on the other hand, understands neither. Like many people, he spends more money than he makes every month by using credit cards to buy things he can't afford. We'll assume that he spends all the money he makes each month, plus an additional $400 a month on his credit card, for the first four years after college. With a typical 15 percent interest rate on credit cards, Jack is now almost $24,000 in debt, not an unusual amount for people in the United States with a history of bad financial decisions.
Let's then assume that Jack wises up and realizes he can't continue down this path. Instead of spending more than he earns, he makes major changes in his spending and manages to save $200 a month for the next four years that he can use to start to pay down his credit cards. That helps. But since $200 isn't even enough to cover the interest, his total debt continues to grow.
By the time Jack gets to the age of twenty-nine, let's assume he finally manages to start saving $400 a month, just like Kate has been doing for eight years now. Except with Kate, that $400 a month is getting invested and growing for her. For Jack, he's using it to pay off his credit cards, which he owes close to $30,000 on now!
That $400 a month is right around the minimum monthly payment, enough to cover all the interest and reduce the principal of the debt just a little each month. At that rate, it takes Jack twenty years to pay off those credit cards he spent only four years running up. And in that time, he's paid more than $100,000 to his credit card company because of the $19,000 worth of stuff he bought back in his early twenties. Now he's forty-nine years old and is back to a net worth of zero, exactly where he and Kate started twenty-eight years ago.
Jack and Kate continue to save $400 a month until they reach the standard retirement age of sixty-seven. And with Kate's smart 80/10/10 living, that $400 a month she put away for forty-seven years added up to a total of $225,000 saved. But because of the magic of compound interest, she actually has more than $2 million in her retirement account! Kate retires comfortably and confidently.
Jack, on the other hand, only has about $200,000 in his retirement account, only one-tenth as much as Kate. Said another way, Kate has ten times as much money saved for retirement as Jack. And while his $200,000 may sound like a lot of money, with all the inflation between college graduation and retirement, that money won't last long, and soon he'll be completely broke again.
Now, what if Jack wanted to keep working past sixty-seven to save up as much money as Kate? How long would that take? It would take another twenty-eight years! He would have to work until he's ninety-five years old to save up the $2.2 million Kate had at sixty-seven.
Think about that. Here we have two people the same age with the same income. And for most of their adult lives (starting at age twenty--nine), they both saved exactly the same amount of money, $400 a month. It was only the first four years that Jack was spending on credit cards while Kate wasn't. And then, for another four years, he saved, but not quite as much as Kate. Those early eight years cost Jack $2 million, or twenty-eight years of his life, whichever way you want to look at it.
And what did Jack get for that $2 million he gave up? He probably got a fancier car and a slightly larger apartment between the ages of twenty-one and twenty-five. Certainly not worth $2 million or twenty-eight years of extra work in his life. But people make those kinds of decisions all the time. The reason is they don't realize the enormous cost it will have on them forty-five years later. Once you understand Pledger's two principles and the story of Jack and Kate, you're in a much better position to choose.
Okay, whenever your child is old enough to start earning money from an allowance or a job is typically the best time to have this conversation. Share this story, and then have a discussion about it. Here are some questions to get you started.
What age do you want to be when you retire?
What are some other things Jack could choose to do without in order to save as much money as Kate?
Will you be a Jack? Or will you be a Kate?
What kind of things does it make sense to go into debt to buy?
Okay, in the next lesson we'll talk about how to be satisfied with less.