How to Build Wealth: 3 Basic Steps
Updated: August 6, 2020
Financial independence is a goal that many of us want to work towards. Wealth creation is one of the factors to becoming financially independent. Many people believe that you need to have a lot of money to create wealth. This isn’t true: you can build wealth with the income you currently have. You just need to know how to save, how to use compound interest, and comprehend the time value of money.
Step 1: Understand Why the Time Value of Money Matters
Time value of money says the money you have currently is worth more than the same amount in the future. This holds because the money available now can accumulate interest. The interest generated from the present value makes it worth more today than the same dollar amount in the future. This underscores how vital time is as a factor to building wealth.
If you want to save a million dollars in 20 years, you can start saving at any time. However, it will take a lot less effort to save that money if you started now. That’s because you have the time to maximize another important saving tool: the power of compound interest.
Step 2: Realize the Power of Compound Interest
Compound interest is the interest calculated on both the initial investment and the accrued interest of previous periods. It may be applied as frequently as per day or per year.
How is compound interest tied into time value of money? Let’s say that you have $15,000 and an investment account with a constant 10% interest rate compounded annually. All you want to do is to save as much as you can over the next 20 years. The table below shows how much you could earn.
|Time invested||Value at year 20|
|5 years later||$62,658.72|
|10 years later||$38,906.14|
|15 years later||$24,157.65|
|18 years later||$18,150.00|
|19 years later||$16,500.00|
If you have a certain amount in mind, we have a compound interest calculator you can use. If you select “Calculate the Opening Balance,” you can see what initial investment you need to meet your goal.When you start saving early, you have the potential to make a lot more money than waiting till later.
Step 3: Maximize Your Savings to Build Wealth
The hard truth is that none of these is a shortcut for actually saving money. You can’t create wealth without retaining some income. Remember, it’s less important how much you earn, and more important how much you save.
- John earns $100,000 per year and saves $5,000.
- James earns $50,000 and saves $10,000.
James earns less but manages to save twice as much. He builds wealth at a faster rate than John.
Why is it so hard to save money? We have to combat lifestyle creep. This is when your lifestyle adjusts with increases in discretionary income. Lifestyle creep is dangerous, because it results in a short-term pleasure that deprives you of opportunities to save. You begin to think that it’s your right to spend money on certain things; you deserve it.
If you’re committed to saving money, congratulations. One way to make it easier is to tackle the big items that can influence your savings: house, car, insurance, bank fees or taxes. Reducing your mortgage by $150 may have a more significant effect than saving $5 each workday on coffee.
Develop Your Wealth Building Strategy
Using the time value of money and compound interest to maximize your savings are critical to wealth creation. With these tools, you can create an effective wealth-building strategy regardless of your income.