“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Breaking down one of my favorite quotes from Albert Einstein, we can see a clear separation between two very different types of individuals. Those that understand the power of compound interest and ride it’s wave and those that don’t understand it and are the wave. In an effort to steadfast your path to financial independence/early retirement you must be aware of a few of the forces that will sail your ass right to the front of the line. Compound Interest. Let’s take a closer look:
In its basic form, compound interest can be defined as interest on interest. That is, your investment earns interest on its principle (initial amount). This principle and the interest earned are reinvested again to earn even more interest. This is what your bank does to you when carry a monthly balance on your credit cards. This compound interest the bank is earning off of you is why some feel they can never pay them off; and they are correct.
Are the credit card companies riding the wave or are they the wave?
Let’s assume we have amassed a sum of $100,000 and we are ready to invest it. We purchase an investment that yields an annual 8% return after expenses. At the end of the year, we find our $100,000 investment has provided us with $8,000 in interest. The second year, we take this $108,000 and earn another 8%. At the end of year 2 we find ourselves with $8,640. We see that we have made $640 more in year two than year one; this is due to the compounding effect of reinvesting. The chart below shows how nicely our initial $100,000 would grow if we leave the principle amount alone for 10 years without touching any of it. Notice specifically the ACCUMULATED BALANCE column. Check out year 10, I hope this excites you.
|Year||Let's Make Money||Interest Earned||Accumulated Balance|
|$100,000 X 8%||$8,000||$108,000|
|$108,000 X 8%||$8,640||$116,640|
|$116,640 X 8%||$9,331||$125,971|
|$125,971 X 8%||$10,077||$136,048|
|$136,048 X 8%||$10,883||$146,932|
|$146,932 X 8%||$11,754||$158,687|
|$158,687 X 8%||$12,694||$171,382|
|$171,382 X 8%||$13,710||$185,093|
|$185,093 X 8%||$14,807||$199,900|
|$199,900 X 8%||$15,993||$215,892|
For you math geeks, here is the formula:
PV . (1 + R)n =FV
PV = Present Value $100,000
R = annual interest rate .08
n = number of periods 10 years
FV = Future Value $215,892
Note: This formula/example is for annual compounding. Compounding can happen on other terms such as monthly, daily, weekly etc…
Actions you take when you ride the wave: Be the man
Receiving dividends from stocks
Loaning money to banks or others
Holding income producing property (rents)
Actions you take when you are the wave: Work for the man
Carrying a credit card balance
Paying a mortgage
Paying a car loan
Financing any widget
Holding student loan debt
With the exception of children who are born into wealthy families, most of us are launched into this life and are the wave. We must kick our feet violently and splash with our arms and push that salt water out from under our bodies. We have to lift ourselves up onto that surfboard,slowly, often falling off. We start to look around at the other surfers and see most are struggling just like we are. Getting tired of our surfboard being on our head, we start to look for a different path. We notice a few surfers who have started to master getting up out of the wave and on to their surfboards. They are taking very calculated steps to keep themselves riding the waves. We start to mimic their behaviors, and after time, we learn to stand up on our board all on our own. We start to ride the wave and become very proficient at it. Maybe later in life we start to teach others to ride the wave and bring them along for the ride.
So if you are tired of Working for the Man and don’t enjoy that surfboard on your back anymore, take steps to reduce your debt and start investing and allow compound interest to quicken your wealth accumilation.
(The naysayers will state that you can not receive an 8% return on investments, don’t listen to them. In a future blog post, I will outline how I receive close to 15% return on my rental properties).