Adventures in saving money from two wildly different people.

How to Make a Million Dollars

Posted: December 14th, 2010 | Author: | Filed under: Uncategorized | No Comments »

For most of us, becoming a millionaire seems a bit out of reach. Really, though, it’s all math.

Warning: math geekery ahead.

A million dollars is one thousand times one thousand. If you can save $1000 per month, then after 1000 months (83 years, 4 months), you’ll have $1,000,000. Simple.

Of course, the average person’s lifespan in North America is on the order of 75 years and we’ve been trained to expect to retire at 65. Since we don’t generally start working for enough money to even think about saving that much until we’re in our twenties, let’s assume a working-and-saving life of about 40 years (age 25 to age 65). Let’s leave for another day the question of finding $1000/month in after-tax income that we can save. So to save $1,000,000 in 40 years, you’ll have to save:

$1,000,000/(40 years x 12 months/year) = $1,000,000/480 = $2083.33/month

That’s $25,000 per year in savings. It’s a tall order for most of us.

Up until now, we’ve assuming your saved money will essentially be “shoved under a mattress”. That’s not generally the way things are done. For one thing, it’s not safe. Banks, on the other hand, are considered safe. Just make sure your bank is insured by (in the US) the FDIC, (in Canada) the CDIC, or the equivalent guarantor in your country¹. Banks pay interest on amounts in savings accounts. Interest amounts are currently much lower than has been historically normal but nonetheless, money in the bank “works for you”. That is to say that the bank, pays you a small amount when you keep your money with them. The can do this because they loan out money to others and the money they loan out is yours (it’s more complicated than that, of course, but this isn’t an essay about banking). In effect, the bank is renting your money from you.

Let’s pretend your bank is willing to pay you 4% interest on your savings. That’s a bit optimistic today but is not too far out of line with typical interest rates over the last half century. If you deposit $1000 in your bank at 4% interest, then after one year you will have $1040. The next year, it will be worth $1081.60, then $1124.86 a year after that, and $1169.85 after still another year. In reality, interest is generally paid out monthly. Instead of paying 4% per year, your bank would pay 4/12 or 0.3333% each month. After one month, your original thousand dollars will be worth $1003.33. After two months, $1006.67. Wait a year and it will be at $1040.74. The numbers aren’t much different (only 74 cents after one year) so people usually simplify explanations by working only with years.

You may notice that each year not only does the amount get larger but that the amount of increase each year also gets larger. This is because you’re earning interest not only on your original $1000 but also on the interest you had earned. The first year, you’re earning interest on $1000. The second, on $1040. The third, on $1081.60. And so on. This is known as “compound interest” and is your secret weapon in the savings game.

Each year, your savings will be multiplied 1.04 times. After ten years, your savings will have increased to 1.04 x 1.04 x 1.04 x 1.04 x 1.04 x 1.04 x 1.04 x 1.04 x 1.04 x 1.04 times its original value, or $1480.23. The formula for the value of your original $1000 deposit after n years is 1.04**n (where “**” means “to the power of”). More generally, if you name your annual interest rate i (in our case, 4%), then the value after n years is (1 + i)**n.

Eventually, your original $1000 deposit will double to $2000. That’s when (1 + i)**n = 2. We can calculate that using logarithms²: n = log(2) / log(1 + i). If we stick with our example where i = 4, then n = 17.672988 years — roughly 17 years, 8 months. After another 17 years, 8 months (35 years, 4 months), the original $1000 that had doubled to $2000 will have doubled again to $4000. After 10 doublings, your money will be worth 1024 times its original value ($1,024,000). Of course, you want to wait 176 years even less than you want to wait 83. The important point here, though, is that your money grows faster and faster the longer you leave it. The lesson is you need to begin to save as early as you can.

Luckily, neither technique needs to work in isolation. What if you save $1000/month and it earns you 4% interest?

After one year, the first $1000 will have been in the bank for 12 months. The second for 11 months, the third for 10 months, and so on. You can run the calculations yourself for n = 12, n = 11, etc. and add them up. After 12 months on this plan, you’ll have $12,263.20 in the bank. After 24 months, $25026.01. Three years,$38,308.82. Believe it or not, after 40 years you’ll have $1,185,901.21! There’s your million dollars³. And then some!

Dough has a Savings Calculator tool you can use to experiment.

1: There is a limit on the amount of your bank deposit that is insured. For total safety, when you start to get close to the deposit insurance limit, create another account and put half the first account balance into the second.

2: There is a simple “back of the envelope” rule for approximating “doubling time” without a calculator: divide the annual interest rate into 72. The quotient is roughly the doubling time in years. In our 4% example, 72/4 = 18. This is a very close approximation to the 17 years, 8 months the actual formula produced. Given that interest rates vary over time, the best you can hope for is an approximation anyway.

3: For exactly $1,000,000 over 40 working years while earning 4% annual interest, you could save a little less per month: $1000 x ($1,000,000 / $1185901.21) = $843.24. With the variability in the interest that you’ll earn, not to mention bank fees and other expenses, not to mention planning for unforeseen problems, you’re always better to “play it safe” by saving a little extra.


Personal Finance 101

Posted: April 29th, 2010 | Author: | Filed under: Uncategorized | No Comments »

I promised practical how-to advice.  I really will but this posting is all about background.  When we speak of Personal Finance we are describing habits and attitudes related to how a person manages their money.  It’s really all about three basic principles:

  1. Spend less than you earn
  2. Build and maintain an emergency fund
  3. Pay yourself first

Assuming your income grows at least at the rate of inflation, if you follow by these principles you will be able to maintain your adopted lifestyle indefinitely, you will have some protection in case of unexpected expenses or income interruption, and you will build up a nest egg to support you in your retirement.  This is financial security.

Personal finance principle #1: spend less than you earn

This is the fundamental concept.  It’s obvious but it’s just too important to leave unsaid.  Money in your possession is often compared to water in a well.  When you draw out a bucket of water the level in the well drops.  The water level slowly rises again as groundwater seeps in.  If you draw too much water from your well too quickly it will run dry and you may die of thirst waiting for it to fill up again.

The parallel with money, of course, is that money comes to you only so fast.  As long as you keep your expenses down to the point that you spend less than you earn, you’re not going to run out.  You’ll be able to maintain your adopted lifestyle for as long as the money keeps coming in.  You might need to control your spending and live without some desired luxuries but your well will never run dry.  The alternative is very ugly: your money will run out and your chosen lifestyle will come to a halt.

In reality, no matter how slowly you draw from it, a well’s water level can only rise so high (the water table).  Money doesn’t share that limitation.  If you spend less than you earn then you get to keep the difference, no matter how much you already have!

This first principle is great when your income and your expenses are predictable and steady.  The real world isn’t quite so simple.  The second principle is intended to help you deal with uncertainty:

Personal finance principle #2: build and maintain an emergency fund

It could happen at at time: your car breaks down or you get sick or injured and have to take unpaid time off work.  An unexpected expense or an interruption to your income can make it suddenly much more difficult, or even impossible, to spend less than you earn, at least in the short-term.  Let’s consider some typical emergency scenarios:

- your car dies and requires a tow and expensive repairs

This is a one-time hopefully infrequent expense.  It will irritate you for a few hours but you won’t spend three months worrying about how you’ll pay off your credit card (and the high interest amount).  Instead, you just pay for it out of your emergency fund and then rebuild that.  Think of the emergency fund as a miniature insurance policy.  If something goes wrong, you’ve got some money there to handle the immediate costs.  You might be a little stuck if a second thing goes wrong but you’ll be in much better shape than if you hadn’t had the fund in the first place.

- you lose your job

Clearly this is a much more serious problem.  Instead of a one-time expense leaving you with a shortfall in a single month this will drop your income to zero.  Spending less than you earn might be impossible until you find a new job.  By drawing on your emergency fund and cutting your expenses back to a bare minimum you buy yourself some time to react to the new situation.

How big should your emergency fund be?  There is no hard and fast rule.  A good place to start would be to save enough to pay your “rock bottom” living expenses for three months.  If others depend on you to provide for them (for example a spouse or children) then you would be wise to have a larger fund that could support you for a longer period.

Your emergency fund won’t replace car, home or life insurance and if you do have to dip into it, you must begin to replenish it as soon as you are able.

Your emergency fund exists to help you get through a temporary condition.  It cannot, for instance, support you in your retirement.  For all that you need to follow the third principle:

Personal Finance Principle #3: pay yourself first

One day you will retire from your job.  When you do, your employment income will drop to zero.  Your employer might offer a pension plan and you might also qualify for government retirement benefits such as Social Security.  For the most part retirement benefits are designed to provide for basic cost of living.  Furthermore, you don’t have to look very hard to find someone convinced (or trying to convince you) that Social Security will collapse for one reason or another.  As long as everything goes according to plan you should be able to live comfortably (if frugally) into old age.  What if it doesn’t?  The economic upheaval of 2008 and 2009 (and into 2010) should give you pause.

While it’s far more likely that a Social Security disaster will not take place but why gamble? Take control of your destiny.  Save for your own retirement.  If the worst happens you’ll be self-sufficient.  You won’t have to survive by eating pet food and you won’t burden your family with your care.  The worst-case scenario if things go well is your pension might get clawed back because you’ve been too successful.  That is, as the saying goes, a good problem to have.

Building your savings should be part of your plan every time you get paid.  That’s what “pay yourself” means.  When you deposit your pay from work, transfer your monthly savings amount immediately.  That’s the “first” part.  Because the money isn’t there in your bank account you use for your day to day spending you won’t be tempted to use it.  If your bank allows you to set up an automatic transfer then you can have it do the transfer for you on each payday.  That makes it even easier for you.

Start out by using the “pay yourself first” strategy to build your emergency fund.  Once you’ve built up your desired emergency fund, start transferring into your long-term savings instead.  If you have debts you will probably want to divert some of your savings into extra payments on your debts.  Making extra payments on your debts means you’ll pay them off quicker.  When you’re debt-free the amount you were paying on your debts is freed up for other things.  The sooner that happens the better.  Paying debts off early also saves you money on interest.  If you go into debt repayment overdrive, though, be sure to take a balanced approach: decide on a minimum amount to put into retirement savings and do that even while putting the rest into debt repayment.

This article has outlined the principles only.  Little has been said about how to put them into practice and almost nothing on the subject of debt and debt repayment.  I’ll begin to delve into all of this in future postings.

Further reading

A great personal finance blog I highly recommend is http://www.thesimpledollar.com.  Along with plenty of other information and advice you’ll find a truly great posting: Everything You Ever Really Needed to Know About Personal Finance on the Back of Five Business Cards.


Long Delay

Posted: April 29th, 2010 | Author: | Filed under: Uncategorized | No Comments »

Neither Tim nor I has had the time lately to post anything to the Your Dough blog.  It all comes down to time and priorities.  We had an idea for an app for the iPad and wanted to get it into the App Store for the iPad launch.  If you’re interested, the app is called The Dossier.  You can take a look at the product blog here.

I’ve got lots I want to say and intend to get back into the swing of things here shortly.


Welcome to Your Dough!

Posted: February 28th, 2010 | Author: | Filed under: Uncategorized | No Comments »

Your Dough is about personal finance.  In other words, it’s about helping you save your dough.

We’re James and Tim. We’re two thirty-something friends who grew up two blocks apart and, years later, started a company called Without Software.  You can find out more about our company here: http://www.withoutsoftware.com and about the two of us here: http://blog.yourdough.com/?page_id=2

There are lots of personal finance (often shortened to “PF”) blogs out there.  What’s special about ours?

If you read PF blogs then you already know the first rule of Personal Finance: Don’t talk about Fight Clu… er… Spend less than you earn!

That’s a nearly unbeatable catch-phrase. It’s short. It’s powerful. It’s also not at all helpful. It’s vague philosophy without practical guidance.

That’s where Your Dough comes in. We’re all about the “how-to”. And sometimes a little math geekery*.

We’ve got tons of ideas and links to pass along as we go forward.  As important, though, is the companion website we’ve created at http://yourdough.com. There you’ll find an ever growing suite of free calculators and other quick tools as well as our personal finance toolkit. You can sign up and use it immediately for free. We designed it to be used with your spouse/partner so you can always know where you stand, at least financially. The idea is to keep track of your spending (it’s really, REALLY easy) and after a month or two turn your history into a forward-looking budget. It works best if  you turn it into a bit of a game.

* We can’t promise we won’t sometimes skip the math part.