Budgeting And Compound Interest
October 15, 2020
By: Hanson Feng
Let’s Explore Different Budget Options
Let’s talk about money! No matter how ‘taboo’ this discussion is, it is crucial to discuss this with people you’re close with.
You need to build a budget that suits your needs and long-term goals
We’re going to discuss a few popular ways people like to budget. But most financial advisories agree on the following things;
Never spend more than 30% of your income on housing
Consumer debt like credit cards must be paid off in full at the end of each month
A budget needs to be written
Always have an Emergency Fund – as an adult, this should last you for at least six months of living expenses
Pay Yourself First:
How do I budget? 100% of my income is disposable income, no bills, loan payments, or other financial obligations. I use the pay yourself first method – I know how much I’m being paid as I’m on a salaried payroll sequence, I know when and how much each paycheque will be. On a spreadsheet I set aside a certain amount of my paycheque that will be saved, the rest will fulfill my wants. When you become an adult, this works the same way, you put money into your savings before you pay any bills. Here’s an example of what that looks like (do this on excel, the formulas make it easier):
*For illustrative purposes only, numbers are entered at random*
This spreadsheet should reflect your paystubs issued at work. This also comes in handy during income tax filing as all your information is written clearly.
PROS: You make financial decisions when your brain is in a mode which isn’t impulsive, you can run your chequing account to zero on or after payday without fear as money has been set aside.
CONS: This doesn’t break down where your spending money is going – housing, bills, loan payments, etc.
This method is very popular as it was created by Elizabeth Warren. The method details that 50% should be spent on needs, 30% on wants, and 20% on savings. There’re multiple ways to track this type of budget; via a spreadsheet by manually logging every transaction, via an app by tagging transactions, or by having three envelopes and only spending in cash.
Your take-home pay is $6,500 a month. Remember your 50/20/30 is calculated on your net pay, not your gross pay.
Needs: Maximum spent is $3250
Rent and utilities: $1700
Groceries and one meal out a week: $600
Student Loan Payments: $350
Misc. Needs: $200
Remember needs aka no clothes, but laundry detergent and shower gel
PROS: It’s pre-calculated for you and there’s no reshaping the budget every month.
CONS: This strategy doesn’t take into account your income. For example, it doesn’t work if you make $18,000 on welfare with two kids but also doesn’t make financial sense if you’re a single millennial earning $540,000 a year after taxes. I also personally view 20% savings to be very low.
This idea has been taken into different types of contexts as well, each with their own ratios; 70/30, 60/40, 80/20, etc.
Whatever your budget is, it should always reflect your long- and short-term goals financially while allowing you to enjoy your paycheque to a certain degree.
Want more budgeting advice? Check out The Financial Diet’s blog and YouTube channel on an adult look at finances. Here’s a great video about budgeting: How To Make Your First Budget (At Any Income).
Let’s Talk Compound Interest, it’s Exponential Growth on Money
Investing young is a great way to lay a strong foundation for your future. When you invest in a diversified portfolio, your growth isn’t about your initial deposit, but rather the time your money spends in the market. This can make a huge difference.
Compound Interest over decades means more digits in your bank account
Let’s run an example. This summer you saved $5,000 from your summer job and want to invest it in the broad market. We’ll use iShare’s S&P 500 Index ETF (CAD Hedged) as the fund you’ll park your money in (this article is not sponsored by iShares).
Over the last 10 years, the iShares S&P 500 Index ETF (CAD Hedged) has seen an average annual return of 12.05%*. Assuming you put your full $5,000 in this fund for 10, 20, 30, or 40 years, no additional deposits, and no withdraws from the initial $5,000 (which is called the principal of your investment). The figures below do not include capital gains tax or dividends distribution;
10 years: $15,598.71*
20 years: $48,663.93*
30 years: $151,818.90*
40 years: $473,635.71*
50 years: $1,477,620.98*
60 years: $4,609,795.47*
The graph below shows the importance of starting early, say you instead deposit $50,000 and invest it in 40 years. The total value of your investment and returns, if placed in the same portfolio, would be valued at just under $3.8 Million*, which is a sizable amount. However, you’re losing out on about $800,000* because you choose to deposit it later. Starting early is important as you’ll be able to ride out the recessions and more importantly gain momentum so the curve on your return graph continues to straighten.
What Am I Investing In?
That ETF there is something I’ve bought into. It’s a great beginner’s ETF that provides exposure to the largest 500 companies in the United States. If you’re into the Canadian Markets, an S&P/ TSX Composite Index ETF is a great pick (there are tens of hundreds of options). To look into ETF options, go to your bank’s investing section for a list of managed funds, for larger banks go to the global asset management section, or go to companies like iShares and Vanguard which are companies that exclusively offer low-fee managed portfolio solutions.
Got a burning personal finance or budgeting question? Dm, our Instagram page @thewrittenrevolutions and it may be the theme of the next personal finance article!
*Under certain market conditions. Returns are not guaranteed, speak to a certified financial advisor and/or investment advisor before making any financial or investment decisions.