alarm clock with notepad

“Saving for the future” is a phrase that can mean a number of things to different people, and how you interpret or apply it may depend on aspects such as your stage of life, family, personal goals or lifestyle. But despite the various meanings that may be attached to it, one thing is for certain—when it comes to saving, the earlier you start, the better.

For younger Canadians in their late teens or early to mid-20s who may either be in school or just starting a career, or young adults who may be getting married and potentially starting a family, long-term savings or retirement goals are often low on the list of financial priorities. In the grand scheme of things, while many do recognize that building savings is important, it can easily take a backseat to more immediate financial goals and needs.

Throughout this phase of life—when most are taking on greater or full financial independence—there can often be a number of expenses and purchases that impact an overall budget, and for some, it may seem difficult to set any additional funds aside. In fact, when it comes to saving via registered plans, findings from the most recent Census show that among Canadians aged 15 to 24, only about 14 percent contributed to a Registered Retirement Savings Plan (RRSP) and 33 percent contributed to a Tax-Free Savings Account (TFSA). Among those aged 25 to 34, those percentages increase slightly to about 37 percent for RRSPs and 43 percent for TFSAs.1

But when it comes to your long-term financial goals and helping to secure your financial future, it’s important to make the connection between an early start to saving and the positive impacts it may have down the road.

Build savings by paying yourself first

For some, a main challenge of saving may be taking the initial steps to set money aside. (You may even be wondering, Where do I get that extra bit of money to save and invest?) While surplus or additional funds may not seem readily available for this purpose, it often just takes a shift in mindset when it comes to your spending, expenses and overall approach to budgeting to get on the right track.

Consider the two following budget formulas:
Income – Expenses = Savings
Income – Savings = Expenses

The first formula is the most commonly used, as many have a tendency to look at budgeting simply as cash in versus cash out. By using this type of formula, however, and without proactively thinking about and deciding where your money will go, it’s likely that any remaining amounts (after your expenses are paid) will be spent rather than saved.

To help achieve financial success, the second formula becomes very important, as it hinges on the concept of paying yourself first. Instead of savings being an afterthought, with this formula, it’s the first amount to be subtracted from your income. Then, the remainder is the amount that gets put towards your expenses. This type of budget formula has two main benefits: it helps make your savings goals a priority, and it encourages you to be more conscious of what you spend your money on.

Tip:

An easy way to make your savings a priority is to set up an automatic savings plan directly from your bank account. As a general rule of thumb, aim to set aside about 10 percent of your income as a starting point each time it comes in, and then revisit this percentage and adjust it as your income increases over time. Consider speaking with your banking institution to find out what options may be available or for help in setting up scheduled savings.

For a more detailed discussion of tips and potential options, please read “Six financial planning tips for Millennials,” featured in the Spring 2017 edition of Perspectives.

The importance of interest

Once savings are structured in an overall budget, the next step is determining how to invest and build your savings in the most effective way, and this where it becomes quite valuable to understand how interest works. In general, when it comes to your investments—whether they’re in an RRSP or a TFSA, for example—there are two main types of interest that can be earned: simple and compound. Each is significantly different in how it’s calculated and how it may impact your investments over time.

Simple interest is when only the original investment amount (called the principal amount) earns interest, and it’s paid periodically (e.g. annually, semi-annually) over the investment term, which is the full time period the money is invested for.

Example
 
Initial investment: $1,000
Terms: 2% interest/year for 3 years
Annual interest payments: $20
Total interest earned: $60

Compound interest, on the other hand, is when the investment earns interest not only on the principal amount, but also on the interest that gets accumulated along the way. The only caveat is that the interest cannot be withdrawn during the investment term—in other words, you choose to receive the interest at the end of the investment period, so the periodic interest payments get reinvested over the course of the entire term. When this happens, the interest gets added to the principal amount, and it’s then able to grow period over period.

With compound interest, using the same example of a $1,000 investment that earns 2 percent interest each year for three years, the following would happen:

  • In year one, you’d earn the same $20 as you would in the simple interest scenario.
  • In year two, because the interest from year one ($20) would be reinvested and added to your original investment amount, you would earn more interest because the starting value would be higher ($1,020).
  • In year three, interest from years one and two would be added to the original amount, so the interest for year three would be calculated based on an even larger value.

Simple vs. compound interest

The following graph illustrates the differences in what happens to the principal, or original investment amount, when simple or compound interest is applied. With simple interest, the principal flat-lines because it remains fixed over the term. With compound interest, the principal increases year over year (or period over period) as the new interest value gained is added, creating a valuable compounding investment return that grows over time.

Simple interest
its about time simple interest bar graph chart

Principal (Remains fixed over term)
Compound interest
its about time compound interest bar graph chart

Principal (Grows period over period)

The impact of time

When investments are earning compound interest, because of the compounding effect, the longer the money remains in this form of savings, the faster the savings will grow. From a timing standpoint, that means the earlier you get started with this type of saving and investing, the more time the funds will have to grow and compound.

girl with glasses with notebook and pencil on grass

Leveraging the power of compound interest

It was the famous physicist Albert Einstein who once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t, pays it.” The message he was trying to convey is that if you take the time to understand how compounding works and then put it to use properly as part of your investment strategy, there’s real power in how your overall savings can grow over time. Even if it’s a smaller amount invested early on, the effects of compounding can have an exponential impact on the long-term growth of your savings.

Given the nature of compounding, time becomes a very important element to consider as part of your savings and investment approach, as its value becomes increasingly evident over longer time periods. In other words, by starting early, you have time on your side to maximize your savings and the faster you may be able to achieve your long-term financial goals.  

For help estimating what your savings may be worth down the road with the impact of compound interest, see RBC’s RRSP Compound Interest Calculator.

The benefits of investing early—a case study

To illustrate the value of starting early and the positive effect that compounding can have on investments, consider the different approaches of Tim and Peter. Tim and Peter are both 30 years old and have a longer-term goal of saving for their retirement. Tim is keen to start saving for retirement this year. Peter is more focused on his current lifestyle needs and wants, so he decides he’ll start saving 10 years from now; he figures he’ll still have time to catch up with his savings if he contributes more over a shorter period.

Details Tim Peter
Start date Immediately In 10 years
Starting age 30 40
Retirement age 60 60
Total term 30 years 20 years
Investment amount and frequency $200/month $300/month
Compound interest rate 4% per year 4% per year
Total contributed over term $72,000 $72,000
tim peter value at retirement chart header image

The only aspects that differ between Tim’s and Peter’s savings approaches are the time period and the investment amount. Here’s how these approaches unfold over time.

Note: For illustration purposes only; not reflective of current interest rates and market conditions.

End results

At age 60, Tim will have almost $30,000 more than Peter saved for retirement. Even though he contributed a smaller amount each month, he will be substantially ahead of Peter because he started earlier and capitalized on the power of compound interest. With more time to earn compound interest, his money will grow more over time.

Building sound financial management skills with the RBC Wealth Management (RBC WM) Financial Literacy program

The core concepts of saving and budgeting, as well as what interest is and how it works, are important components of financial literacy, and building knowledge in these areas helps to develop confidence when it comes to making informed financial decisions.

RBC WM understands the value of financial literacy for all age groups, and at the same time recognizes the heightened importance of helping to ensure younger generations and young adults have the tools and resources they need to take on financial independence.

With this in mind and to help bridge the current gap in financial education, RBC WM has launched the RBC WM Financial Literacy program, offering an RBC advisor-led comprehensive approach to building sound financial management skills for those who are 16 years of age or over.

To find out more, please read the Fall 2017 Perspectives article, “Introducing the RBC WM Financial Literacy program.”

Reference:
  1. “Census in Brief. Household contribution rates for selected registered savings accounts.” Statistics Canada website, release date: September 13, 2017. https://www12.statcan.gc.ca/census-recensement/2016/as-sa/98-200-x/2016013/98-200-x2016013-eng.cfm