The fuel that fires the burners in the financial fiasco is that wonderful concept called compound interest. If you don’t know what that is, here’s a simple explanation.
When you borrow $100.00 from someone and they expect a payment of $110.00 by a certain date, you’re paying a total of 10% interest on the money you borrow. If you don’t pay them, aside from late fees, the next time they calculate interest on your balance, they’ll use $110.00 as the basis, not $100.00. So, for the first month, 10% of $100.00 is $10.00, but the second month, 10% of $110.00 is $11.00. On the third month, 10% of $121.00 is $12.10.
(keep in mind, we’re charging 10% per month in this example, which is an insane rate [sorta like a title loan company or check cashing company] just to show the sheer awesomness of compound interest.)
My Emergency Fund
Putting $1000.00 in the bank, in an easy-to-access, fee-free account is exactly what you need to do to manage Murphy’s Laws of Diminishing Returns. In other words, emergencies. Before you start making plans to get rich, or get out of debt, or whatever, you need to set aside at least $1000.00 to handle possible problems, which I might add, will happen. It’s not a matter of if. It’s a matter of when.
- Tire blows out
- Alternator fails
- Air conditioner dies
- Water heater dies
- Son breaks arm (deductible)
- you name it, it will happen…
In July of 2009, I transferred enough money into my ING Savings Account to equal exactly $1000.00. At the time, the interest rate on the account was a measly 1.3%. Let’s be clear about savings accounts designed for emergency funds: They’re not meant to make you money. They’re meant to handle emergencies, so the interest rate isn’t important. However, thankfully, there is actually a rate on this one, which means I get to watch it work for me, even if it’s only a few bucks.
It’s now November 18th of 2010 and I have been paid interest every month on the balance of the account for 16 months. Below is a graph of my account, which shows positive growth with no effort from me whatsoever. Watching money work for you is exciting! It’s measurable progress, and that’s what we’re looking for in our finances. We want to be earning interest, not paying it. We want the fundamentals of compound interest to work in our favor.
The orange line represents the balance of the account, and the blue line is the amount of interest paid each month. The blue line fluctuates because the interest rate fluctuates. The orange line increases steadily over time because nothing is taken out of the account. The is the direction your money should be going. If you’re spending less than you make, then you’ll see this trend on your net worth. What you don’t see here, is that the orange line is actually a curve that gains momentum as time passes.
The goal, in your financial life, is to reach a point where the interest paid on your nest egg covers all of your basic living expenses. But, before you can get there, you need to remove the dead weight of compound interest being charged to you, instead of paid to you. Get that $1000.00 socked away as fast as possible.
