Compound Interest Versus Inflation: The Battle For Your Money

Last week, I wrote a pretty harsh criticism of Spend Every Dime!, a Slate article that basically encouraged people not to save money because taxes and inflation eat up most of the gains.

But why is that? Let’s take a step back and look at what’s actually going on here, piece by piece. Some of this may seem very basic to some of you, but it provides a good illustration of why exactly inflation is important.

Compound interest In the past, I’ve talked about the power of compound interest and even described how to make your own simple compound interest calculator, but here’s a quick refresher. Compound interest refers to the idea that when you earn interest on an investment, that earned interest is rolled back into the investment and starts to build on itself. Let’s look at an example.

Let’s say you have $100 and you put it in a savings account that earns 5% each year, compounded annually. At the end of the year, you earn $5 in interest and it’s put into the account. The next year, thus, you’re earning 5% on the new $105 balance. At the end of the following year, you’ll actually earn $5.25, giving you a total balance of $110.25 at the end of the year. Notice that the earning has gone up, even though the investor hasn’t done anything more than just leave the money in place? That’s the power of compound interest.

Using this same example of annual compounding, after 20 years, the account will have $265.33 in it, and it will have earned $12.63 over that final year. If you multiply these numbers by, say, 10, you’ll see what a $1,000 investment would look like, and so forth.

Inflation Inflation, however, works in the opposite direction. You’ve heard tales before of gasoline for $0.50 a gallon and such, right? The increase in prices over time is inflation, and it basically means that a dollar today simply does not buy as much as it once did. For the last several years, inflation has held at about 3% annually, so let’s use that as the example here.

Let’s say you have $100 and you put it under your mattress. A year from now, that $100 will only be able to buy what $97 did the year before. Leave it there for another year and it will only be worth $94.09 in today’s dollars. Twenty years? That $100 bill will only be worth the same as $54.38 is today.

Combining the two In the real world with a real investment, you have both forces at work on your money, and that makes the picture a bit more complex. For example, if you put $100 into a savings account, that earns 5.05% APY, and thus in twenty years it will have a value of $267.87 when you check the account balance. However, if inflation stays at 3% for the next twenty years, a dollar will have the same value as $0.54 today. Combining those two factors, your nice account balance will actually only have the same value as $145.67 does today.

What about taxes? Taxes basically only effectively reduce the interest rate that you earn. So, for example, let’s say you pay 28% income tax on interest. That means that your effective interest rate on that savings account is 3.63% after paying out the income tax each year. If you use that as your interest rate, after twenty years, your $100 will have turned into only $111.09 in today’s dollars. Basically, any savings account that earns a return less than 4% or so is actually losing value over time because of the effect of taxes and inflation.

What can I do? Realize what a savings account actually is: a place to hold your money. Even a high interest one like ING Direct or HSBC Direct basically just keeps your money at its real value over time (meaning that the amount of stuff that you could buy with the money you deposit will be the same when you withdraw the money and the earned interest). If you want to strongly beat inflation, you have to look at other investment opportunities.

So why save? The point of saving is to ensure that you have money in the future while you have a surplus now. This saving enables you to make large purchases in the future or ensures that if bad things happen you’ll still have a comfortable life. If you want your money to earn money, then you need to invest your money – and investing money is an entirely different ball of wax.

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