Why is Compound Interest So Important to Your Finances


Today we go into the subject of compound interest, which can be your best friend when you’re saving and investing, but your worst enemy when you’re paying off loans and credit card balances.  If you understand how compound interest works, it will change your behavior since you’ll realize the potential gains you’re giving up and also realize how much money you’re paying out in interest when you keep balances.
Compound interest is the secret to becoming wealthy within your lifetime.  It is the reason that anyone with a middle class income who, starting in their early twenties, is willing to sacrifice a couple hundred dollars a month to save and invest, can be a multi-millionaire before retirement.  In fact, many people can become financially independent in their mid to late forties if they invest regularly due to the effects of compound interest.  The secret is starting early, since compound interest works better and better the longer you use it.

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If you are a teenager with a job and you talk to me, I’ll probably tell you to gather up $1000 of your earnings and open an Individual Retirement Account (IRA) with Vanguard, investing in one of their target date funds.  Most teenagers I tell this to get that glazed-over look in their eyes until I tell them that if they do so, they’ll have $500,000 at retirement for each $1,000 they contribute.  At that point they get far more interested.  The reason is compound interest.  How does this work?

Well, if you invest in the stock market, you can assume that you’ll get somewhere between 10-15% annualized returns over long periods of time like 15-40 years.  (Note, I make no such claim for periods of five to ten years.)  You can estimate how long it will take to double your money if you know the interest rate by dividing 72 by the interest rate/annualized rate-of-return.  For example, at 12% rate-of-return, your money will double every 6 years or so.  Taking your original $1,000 at age 16, and assuming you add nothing else from your job, this means you’ll have in your account:

Age       Balance

16            $1,000

22            $2,000

28            $4,000

34            $8,000

40            $16,000

46           $32,000

At this point you would probably be saying, “Yeah, $32,000 is nice, but you said I’d have $500,000.  I’ve waited 30 years, and all I have is $32,000.  What gives?”


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Here is where the magic of compounding comes in.  Watch how fast the balances grow as you go from age 46 to retirement age (70 years-old):

Age       Balance

46            $32,000

52            $64,000

58            $128,000

64            $256,000

70            $512,000

Notice that while you’re only making a few hundred or thousand every six years when you’re staring out, in the later years you’re making hundreds of thousands of dollars over those six-year periods.  In fact, you might easily see your account grow by $100,000 or more in a single year between the ages of 64 and 70!

The basic rules of compound interest when you’re investing are:

1. Invest early.  The more times your money compounds, the more you’ll have in the end.

2.  You get big growth at the end, slow growth at the start.  The more money you have, the more interest you’ll be generating.  You may only make a few dollars at the start per month, but then hundreds or thousands of dollars per month at the end.

3.  Wait as long as you can to withdraw money.  Again, you’re making the most at the end, so the later you pull the money out, the more you’ll have.

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4.  The higher your rate-of-return or interest rate, the more money you’ll have (by a lot).  If you take the example of investing $1,000 in an IRA at age 16, but put the money in bonds at 6% instead of stocks at 12%, you’ll only have $32,000 at age 70 instead of more than $500,000.  Note that you don’t have half as much – you have less than a tenth as much.  This is because your money will only double every 12 years at 6% interest instead of every six years as it did at 12%.  Every time it doubles, you’ll have twice as much (obviously).  Double it once and you’ll have two times as much.  Double it three times and you’ll have eight times as much.  This is why you invest in stocks instead of putting the money in a savings account if you have many years to invest.

5.  The more often your money compounds, the more money you’ll make.  Interest is applied yearly, monthly, weekly, daily, or continuously.  The more often the interest rate is applied, the more you’ll make.  This is because the interest on your interest is generated each time the interest rate is applied.  If you have a choice between two investments at the same interest rate, but one compounds daily and the other monthly, pick the daily one.

I remember a dramatic example of this published in a Richie Rich comic book back in the 1980’s.  Richie Rich was asked for a donation.  He said that he would give one penny the first day, and then double his donation each day for the next 30 days.  A friend who saw this conversation scoffed, asking why his very wealthy friend was being so stingy with his money.  The last frame of the comic shows Richie Rich giving his last contribution – a sack of money containing $10,737,418.24!  That, is the power of compounding.

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Why does compound interest work so well?  The answer is that when you leave money in an account and allow it to compound, you start earning money not just from what you originally invested, but from the interest that builds up in your account as well.  In investing parlance, this is called reinvesting.  Reinvesting is very powerful since the amount that you get in interest or from capital gains from your stocks increases each year. Not only that, but the rate at which it increases grows every year.  The first year you get maybe a $10 return, the second you get at $12 return, the third you get a $15 return, the fourth you get a $ $20 return, and so on.  The interest on the interest from the interest from the interest from your original investment makes interest.  This means that the longer you wait, the bigger your income each year will be.

Compound interest is great when you’re saving and investing, but it works against you when you’re borrowing money.  That’s because then the interest that builds up in your account over the month or even over the day generates interest on itself.  This means that when you’re paying back a mortgage or student loan debt, you’ll end up paying back way more than you borrowed.  We’ll talk about this in the next post in this series.

 This is the second post in a series on improving your financial literacy.  To find the while series, select “Financial Literacy” in “Posts by Category” on the right sidebar.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

3 critical habits of leaders people want to follow


This is a great article from Business Insider everyone will want to read.  The best part is talking about how to provide positive feedback.  People want to be able to make a contribution and to get recognized when they do so.  Think of ways to say, “Thank you!” to coworkers and those who help you at work (and at volunteer activities).   Read the full article here.

 

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The basics of finance: What is money?


Many studies, such as that by the National Financial Educators Conference,  have shown that many young adults have a poor financial literacy.  As a result, many adults have no savings; many college students are moving back home after graduation; and student loan debt when leaving college is averaging over $25,000 per year.  To help address this need, The Small Investor is starting a series of posts on difference aspects of finance to help provide the basic financial background needed to be successful financially in life.  These will all be in the category of “Financial Basics.”  The first post will start with the very basics:

What is money?

Most people do not really understand what money is.  They know they like money.  They know that they like having money.   But they do not understand the very fundamental concept of what money is.  As a result, they believe myths like money is finite and that you need to take from one person for another to grow wealthier.  Truly learn what money is, and you’ll understand that everyone can have money.  One person does not need to become poor for another to become wealthy.

Perhaps you’ve heard the expression “Time is money”, but in actuality,

Money is time.

A twenty dollar bill or a jar of pennies is an IOU for something you want.  If you want something like an ice cream cone, your home cleaned, or a new car, you give some of those IOUs to someone else in exchange for the thing you want.  In exchange for those IOUs, you get some of someone else’s time – time to make the ice cream and the cone, time to clean your home, or time to dig up the materials and make a new car.

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To gain those IOUs, you provide your time to other people, doing things that they want.  They give you an IOU for your time, which they received in exchange for providing some of their time to someone else.  You don’t usually get IOUs from other people for doing something just you want to do, even though many artists feel that they should paint, or write, or sing what they want and others should pay them to do so.  Likewise, I can write about things I want to write about, but people won’t read the blog (and hopefully buy a book or click on an ad so that I can receive some money for my time) unless I write about things they want to read about.  By giving you money, people are giving away some of the time that they spent doing things for other people, and they want to get something they want in return.  Likewise, people producing things for you do so because they want to be able to get something they want for their time.  For example, if I don’t sell enough books or get enough money from advertising on this blog, I’ll probably eventually stop writing it and do something else with my time.  Likewise, an artist who is painting pictures you like but who is not paid much money for them may decide to paint things they like instead.

Note that money takes the place of direct exchange.  In the past, you would need to find something someone else wanted that had the thing you wanted so that you could trade.  If you grew a bushel of corn and wanted a box of nails, you had to find someone with a box of nails who wanted corn, and wanted it right now.  With money, you can produce a bushel of corn today and trade it to someone who wants corn now, get a “gift certificate” good for virtually any other item called “money,’  then exchange it for the item you want when you’re ready.


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Just because you’re getting money instead of goods doesn’t mean that you don’t need to produce something to get money.  Just as you couldn’t go to the person with the nails and get them without producing the bushel of corn for them, you can’t expect to get money from someone without producing something in exchange.  Sometimes people might just decide to give you something (or give you money so that you can exchange it for what you need) because they feel like you need help.  This is charity.  Also, you might just take something or some money  from someone else, but this is called robbery.  Finally, you might get the government to go and take things from other people, but if the people who the government is taking these things from do not really want to give it to you, that is still robbery, even if it is legal.

You are taking people’s time from them when you take their money and don’t provide anything in exchange.  If you take too much of the time that people spent producing things and giving them nothing in exchange, particularly if they are forced to give it to you, either because you threaten them with a weapon if they don’t hand over money, or the government threatens them with prison if they don’t pay taxes, they will stop spending their time producing things.  They certainly will stop producing more than they absolutely need for themselves, so there will be nothing left to give away as charity.

Likewise, you cannot expect to get paid more than what you provide is worth to someone else.  To do so would be asking someone to give you more of their time than you are providing to them in value.  Would you spend the time and the energy to make a double-decker cheeseburger with special sauce, fries, and a coke for someone else in exchange for a cup of tepid tap water?  Would you agree to spend three hours cleaning someone else’s whole home in exchange for them spending a half hour cleaning one room in yours?  This is exactly what you’re doing if you expect to get paid more than the market is willing to pay for your job by legislative decree.  If you try to force others to give you more of their time than what you’re providing is worth, they will stop agreeing to trade with you.  You will then no longer have a job.

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Because money is an IOU for doing work and producing something that someone else wants, it is not finite.  There is no fixed amount of wealth in the world – it grows or shrinks depending on whether people as a whole are producing things or consuming things faster. Just because I go and build a house and increase my wealth by one house does not mean that someone else will lose a house when I do so.  If we both put in the time to build a house, we will both end up with houses.  Just because the wealthy increase their incomes does not mean that they are taking money from middle class and poor people.  They may have developed a way to do things more efficiently, which means they produce more things per unit time, causing their income rate to grow.

Many wealthy people also set up something like a business and then hire people to produce things.  The person working does so because the wealthy person has already set up the product, the location, and the methodology to produce things, along with advertising the product and filling out all of the government forms, meaning all the worker needs to do is show up and produce or sell the products and he/she gets to keep much of the money made in producing/selling the product.  In exchange for the work the wealthy person  did in setting everything up and maintaining the ability of the working person to make/sell things, he/she gets a small percentage of the money from selling the products.  The wealthy person makes money by hiring more workers, not because he/she is taking an unfair share of the wealth produced by the person working.

Understand also that the value of something is not based on the actual amount of  time the person giving it to you spent making it;

To you, things are worth the time you would be willing to exchange for them.

Someone might spend a week carving a bowl from a log by hand, but that does not mean someone else will be willing to pay a week’s salary for it.  There may be someone willing to pay that much, but someone else may only be willing to pay a hour’s salary, or maybe nothing at all.  Someone may also be able to create things very quickly that other people would be willing to spend a lot of time to acquire because they have special abilities, have created tools to make them more efficient, or because they have even created a factory or a company to make those things quickly.  This leads to the final truth about money:

People who are more productive through things they learn and tools they make can earn more of other people’s time than they provide in exchange.

People who put in the effort and time becoming doctors, lawyers, or engineers are able to provide things that people are willing to exchange a lot of their time for because the things they provide are very valuable to the other people.  They can therefore earn a lot more money per unit of time than many other people who provide less-valuable things.  A person who has a tractor and can cut a lawn in five minutes, and therefore can cut five lawns in the time needed for someone who has a push mower to cut one lawn, can make five times as much as the person with the push mower.

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To review:

1.  To make more money, become more productive through skills and tools.

2.  You cannot expect to get paid more than the value of what you produce.

3.  You make money by spending your time doing things that other people want, not what you want.  People who do the things that many other people desire get the most money.

4.  You cannot expect people to continue spending their time doing things that you want unless you provide them with IOUs to regain that time getting something that they wish to acquire.

If you feel that this article is valuable to you and worth some of your time, consider purchasing a book (which hopefully will also be valuable) or clicking on an ad and buying something you want from Amazon.  Doing so will provide me incentive to continue spending my time writing similar articles.  Then again, if this article is not valuable to you, you would probably have stopped reading by this time anyway, and I should therefore not expect to receive any of your time in exchange.

Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.