One of the most valuable things I learned in my economics classes (besides the words of wisdom–“buy a house as soon as you can, as young as you can”) was about the crossover point. This little pearl is the reason I actually stick to my budget and don’t by all the satin shoes I want (because as a girl who loves fashion, there are few things I would love more than a pair of Louboutin stilettos). So the crossover point is the time in your life when you interest on your savings is greater than your income. That means you get to retire and maintain your same quality of life (that means same budget, same living situation, etc).
How to figure out your cross over point depends on a few factors. First you take the balance in your savings (if it is $0 that is okay, you have to start somewhere, right?). Then you take your income and subtract your cost of living (how much you spend per year). So let’s say you have $0 in your savings, you make $70,000 and you spend $40,000 on your living expenses. That means you should have $30,000 (a bit aggressive I know) left over each year. Assuming you are happy with your quality of life then you set some parameters–inflation and interest. These are two unknowns, and I often use 3% for inflation and 8% for interest–since both number are realistic. So to determine your cross over point you just take your income, cost of living and savings and add on to them each each. So for your income and cost of living, increase each by 3% each year (since it is a safe assumption most people’s jobs and salaries will keep up with inflation). Now add the different into your savings and start accumulating the interest each year. This means, that if you are 33 years old, and you start doing this, at age 54 the interest you will be making on your income is $137032 and your income would only be $130220, and that if you were to retire and maintain your same quality of living (that means no Ferraris) you would be able to live off of just the interest from the money you saved! If this doesn’t give you an incentive to start saving I don’t know what would. 🙂
Since many people understand things with pictures I have included a graph of the above scenario. As you can see the income is gradually increasing by 3%, and the interest is exponential since it is compounding on itself. This is the true power of reinvesting interest–you earn money on the interest year over year and it grows very quickly!
Email me if you’d like a copy of the excel spreadsheet I used for this graph. For those who love numbers it is almost addicting to create all kinds of new cross over points. For example, some of my favorite scenarios are: adding in the purchase of big ticket items (like fancy cars and yachts, and of course real estate), or different interest rates, big raises in income, children (big changes in cost of living), and even lowering your cost of living (cutting back now and seeing how it pans out later). It gives you something to work for now and can show you how putting away a little bit now and can help a whole lot later in life.