“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein.
In a world with ultra-low interest rates, pervasive advertisements and the ability to consume at your fingertips, it’s no wonder Canadians and Canadian businesses are continuing to add record amounts of debt to the balance sheet. It seems like what previous generations taught us about the importance of saving hasn’t remained a priority for many Canadians.
A few months ago, my wife and I went to purchase a new phone. We had the option to either purchase the new phone outright and keep our monthly bill the same, or get the phone for zero dollars and increase our monthly bill by $35 per month. Being in the finance industry, I had to crunch the numbers. It turned out that by opting for the second option, we would pay 20% more in the long run.
It got me thinking about how many people fall into these monthly payment traps. For example, for many farm operators, there is often a yearly call from their equipment dealer offering to trade in a piece of equipment for a brand new one and keep their monthly payment the same. But the part they aren’t telling you about is the number of years you will have to continue to take cash flow from the business to keep paying for that piece of equipment.
Don’t get me wrong, debt isn’t the enemy—it can be a useful tool to build wealth, if handled responsibly and paid off in a reasonable amount of time. I like to categorize debt into good debts and bad debts. Taking on a manageable (the key word here being “manageable”) amount of debt to purchase your first home would be considered good debt. Going out for dinner and buying new clothes with your credit card because you don’t have the cash to pay for it would be considered bad debt, in my opinion.
I know it is not easy for many families and business owners, as costs keep going up and inflation is real. (If you don’t believe that inflation is real, remember that you used to be able to get 20 Timbits for $2.) But if you want to start making better financial decisions and keeping more of your hard-earned money in your pocket, it starts with making better choices and getting back to the basic principles that previous generations used to compound the wealth they have today. There are two very important strategies that families and businesses can employ to stop paying interest and start compounding it.
Make a monthly budget
Creating a budget and financial plan is simply choosing where you want your money to go, instead of letting your money decide for you. No budget will be perfect right down to the dollar and that is okay—it will make you aware of where your money is going and help you identify where you can cut back.
Your budget starts with a calculation of your total after-tax income. Once you have calculated all of your income sources after-tax, it’s time to list your expenses. Be sure to list all of your regular bills, such as your mortgage, heating costs, property tax, etc. After you’ve identified your regular bills, list your discretionary spending, such as meals out and entertainment. Once you have everything categorized, take the after-tax income and subtract your regular bills and discretionary spending. Be sure to track your progress to make sure you are sticking to the plan.
Make saving a priority
Warren Buffet, widely regarded as one of the smartest investors of all time, has continued to preach the importance of building up a financial fortress of savings in his annual letter to Berkshire shareholders. He notes that he never wants to risk getting caught short on cash. Yes, he may have missed out on some opportunities as a result, but he believes it is foolish to risk what you have and what you need in order to obtain what you don’t need. Every so often, economic progress will take a step back. It is during these periods of time that savers will be rewarded with opportunities to make purchases at bargain prices.
Start by saving for emergencies, so that when they occur (because they always do), you have the cash to cover them. After your savings safety net is built, start saving for your retirement, children’s education or a business acquisition.
Don’t forget that people sitting in the shade today are there because someone planted a tree many years ago.