You're Underestimating Inflation: How 3 Percent Inflation Destroys Savings Over 20 Years

If there’s one thing that is constantly in the back of my mind when it comes to personal finances, it’s inflation. The effects of inflation on your financial health and retirement are devastating.

Like many people, I used to brush off inflation as just a minor annoyance to put up with. But then I finally sat down with a calculator and saw how 3 percent inflation destroys savings over 20 years.

And that’s when I had another oh, shit moment because I realized we were screwed if we kept doing what we had been doing. Simply working, saving, and hoping for the best wasn’t going to cut it.

WHY PEOPLE UNDERESTIMATE INFLATION'S EFFECT ON RETIREMENT

Simply put, inflation is the rate at which prices for goods and services rise over time. Or, looking at it from another direction, inflation is the rate at which your money’s buying power decreases. Either way, you’re spending more money to buy the same thing from a year earlier.

The average person can give you the basic definition of inflation, but most don’t realize its true impacts.

Everyone is concerned when inflation is unusually high, as it was in 2022. Inflation hit 9 percent in June of that year. It was the highest since the early 1980s when inflation was in the low double-digits. It was all over the news. People were concerned and angry.

But most of the time, inflation hovers around 3 percent. It doesn’t make the news, and nobody really thinks about it. And that’s what makes it scary.

At a 3 percent inflation rate, something that costs $10 today would cost $10.30 next year. You might shrug off the extra 30 cents as no big deal.

And what if I told you that it compounds another 3 percent the following year? And the year after that? You might still dismiss it as trivial. After all, $10 compounding at 3 percent annually for four years is still just $11.26.

“What’s another $1.26,” you might say. “And besides, my employer gives me about a 3 percent raise each year. ”

I used to think that way, too. Three percent inflation might not sound like a big deal, but let me explain why it is.

HOW 3 PERCENT INFLATION DESTROYS SAVINGS OVER 20 YEARS

When working with small numbers such as 3 percent, it can be extremely difficult to see their impact. The key is to stop looking at it with a short-term lens of one to three years. Look at things through a long-term lens, like twenty or thirty years. After all, I’m sure you plan to be alive for many more years.

So, what does 3 percent annual inflation look like in the long term? Well, something that costs $100 today will cost $203.28, or roughly double, in 24 years.

Here’s an even better way to look at inflation. Remember, inflation can also be viewed as the buying power of your money decreasing.

Imagine you’ve diligently followed your parents’ advice and saved your money in the bank for years. Mom and Dad would be so proud. But for the sake of this story, it’s not in an interest-bearing savings account. Instead, you decided to save all your money in a non-interest-bearing checking account.

Still, you feel a sense of satisfaction and security because you’ve managed to save $400 thousand. That’s a pretty nice nest egg!

Then tragedy strikes one day. While strolling past a high-rise, movers drop a piano on your head from the second story. Cue Wilheim scream.

You miraculously survive but end up in a deep coma. When you wake up 24 years later, you wonder how much the world has changed.

Amazingly, the cost of living hasn’t changed. Everything costs exactly the same as 24 years ago, and you remember your $400 thousand nest egg. You pat yourself on the back for smartly putting that money in the bank. You’re older, but you still have many years left. “I may even be able to live it up a little since I lost 24 years,” you optimistically say to yourself.

You head down to the bank, ready to rebuild your life. But when you check your bank account balance, the blood drains from your face.

Instead of $400 thousand, you now only have about $200 thousand. Half your life savings has disappeared.

Take out a calculator and see for yourself how 3 percent inflation destroys a $400 thousand nest egg. To do that, you'll divide 400,000 by 1.03.

$400,000 divided by 1.03 = $388,350.

So, inflation will wipe out almost $12,000 in just one year! Continue dividing the result by 1.03 nine more times. Watch how fast that nest egg shrinks.

Year 2: $377,039

Year 3: $366,057

Year 4: $355,395

Year 5: $345,044

Year 6: $334,994

Year 7: $325,237

Year 8: $315,764

Year 9: $306,567

Year 10: $297,638

After 10 years, that nest egg is already worth less than $300 thousand. By year 24, that turns into $196,773. You never spent a penny, yet your buying power went way down.

That, my friend, is 3 percent inflation. Oh shit, indeed.

HOLES IN YOUR FINANCIAL BUCKET

Imagine your finances as a bucket of water. Water flowing into the bucket represents money coming in, such as your salary. Your bucket can hold an infinite amount of water, but it also leaks from variously sized holes.

Your bucket’s largest holes will probably be housing, transportation, and food. Maybe you have some school loans as well. Smaller holes may be things like your monthly Hulu subscription or gym membership.

We all want to fill our buckets, and ideally, keep them full. Ensuring your bucket fills faster than it drains requires checking for holes periodically. Usually, it’s easy to spot money outflows because there’s a paper trail in the form of receipts and bank statements.

But then there is inflation. It has no paper trail. Three percent inflation is a pinhole in your bucket. It’s difficult to see, but it’s there.

Drip. Drip. Drip. Your financial bucket is draining at a slow but steady pace of 3 percent each year.

A pinhole leak may seem minor. But imagine if this were an actual water leak left unchecked inside the walls of your home. Moisture spreads. Mold grows. Wood begins to rot. Small leaks can cause big problems down the road.

Inflation is a sneaky drain on your finances. And it’s the one hole in your financial bucket you can never plug.

A savings account might help a tiny bit, but you’re still losing money. Generally, savings accounts don’t offer interest rates higher than the inflation rate. And if your savings account is with a traditional big bank like Bank of America, Wells Fargo, or Chase, your interest rate is probably close to zero.

Realizing the effects of inflation was my scariest oh shit moment. Simply stashing money in the bank and hoping for the best was a guaranteed path to trouble. This was my wake-up call to create an inflation-beating plan.

I invite you to see the effects of 3 percent inflation on your finances. Total all the money sitting in your savings and checking accounts right now. Calculate the buying power of your money when you turn 50, 60, and 70 years old. Just divide the total by 1.03 for every year into the future.

How do you feel about the results? Is it an oh shit moment for you? Leave a comment below.

See you at the finish line!

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Disclaimer: I’m not a licensed financial professional. This blog shares my personal experiences and opinions around money, investing, and early retirement. It’s for informational and educational purposes only—not financial, legal, or tax advice. Always do your own research or consult with a qualified professional before making any financial decisions.