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"Those who understand compound interest are destined to collect it.
Those who don't are doomed to pay it."
What is compound interest?
Compound interest may well be the greatest mathematical discovery of all time. Unfortunately, you were probably not taught about the miracle of compound interest in school.
Compound interest works like this: the first year, your investment earns interest. The second year, your investment earns interest and the earnings from your first year also start earning interest. The third year, your initial investment earns interest, and the interest you earned the first two years also earns interest. The concept of earning interest on your interest is the miracle of compounding.
Mortgage Interest you pay is Simple Interest. That means you only pay interest on the amount of money you owe. The interest you owe doesn't compound. So, if you can earn compound interest, and only have to pay simple interest, you will accumulate more wealth over time.
There are rules to follow to make compound interest work for you:
1. Start Early!
The earlier you start compounding, the more time you leave for the miracle of compound interest to take effect. If you wait one more year to start earning interest, you don't lose the small interest earned this year, you lose the interest earned in the last year and you lose all the money that the first year's earnings will earn for you. For example, if you wait one more year to start saving just $100 per month, and then retire 29 years after that, the difference is over $8,857 if you earn only 7% over those 29 years.
2. Don't squander your income on today's living
Saving isn't everything. Like most things in life it is best to strike a balance. With investing it is the balance between enjoying yourself now and providing for your future. If you only enjoy yourself today, you will have no future.
3. Over time, regular saving of quite small amounts can build up an astonishing sum of money.
If you save $200 a month for 45 years (from age 22 to age 67) and your investments compound at 10% a year how much will you have? The answer is an astonishing $1,817,469!
4. Time and patience are the friends of compounding and, therefore, of investing.
Saving for 40 years is obviously something you can't do overnight. You have to exercise patience if you want to feel the full benefit of compounding. In fact, in the early years, it doesn't seem to matter if you save or not. Just remember, the real money shows up at the end of the game, as long as the game is a long one.
The Rule of 72
Would you rather earn $10,000 a day or $1 a day, doubled every day?
The Rule of 72 is a quick and easy way to calculate how many years it takes your money to double. It states that you can find out how many years it will take for your investment to double by dividing 72 by the percentage rate of growth. So it will take 9 years for your investments to double if they grow at 8% a year (72/8=9). But it will only take 6 years if your investments grow at 12% and so on. The Rule of 72 only provides an approximate answer but it is pretty close.
The key point to the rule of 72 is to get as many doubles as you can. For example, if you wait until you pay off your student loans to buy a home, you get fewer 'doubles' of your home's value. If you wait to save until you pay off your home, you get fewer doubles of your savings.
When you get one less 'double' by waiting to start, it's not the first double you miss - it's the last double. To put that in real dollar terms, waiting one more day to start doesn't cost you $1. Look at this chart to see the earnings on the 30th day. That's what you lose when you wait to get started!
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$1 / Day, Doubled Every Day |
|
$10,000 Per day |
| Day |
Daily Earnings |
Total Earnings |
|
Daily Earnings |
Total Earnings |
| 1 |
$1 |
$1 |
|
$10,000 |
$10,000 |
| 2 |
$2 |
$3 |
|
$10,000 |
$20,000 |
| 3 |
$4 |
$7 |
|
$10,000 |
$30,000 |
| 4 |
$8 |
$15 |
|
$10,000 |
$40,000 |
| 5 |
$16 |
$31 |
|
$10,000 |
$50,000 |
| 6 |
$32 |
$63 |
|
$10,000 |
$60,000 |
| 7 |
$64 |
$127 |
|
$10,000 |
$70,000 |
| 8 |
$128 |
$255 |
|
$10,000 |
$80,000 |
| 9 |
$256 |
$511 |
|
$10,000 |
$90,000 |
| 10 |
$512 |
$1,023 |
|
$10,000 |
$100,000 |
| 11 |
$1,024 |
$2,047 |
|
$10,000 |
$110,000 |
| 12 |
$2,048 |
$4,095 |
|
$10,000 |
$120,000 |
| 13 |
$4,096 |
$8,191 |
|
$10,000 |
$130,000 |
| 14 |
$8,192 |
$16,383 |
|
$10,000 |
$140,000 |
| 15 |
$16,384 |
$32,767 |
|
$10,000 |
$150,000 |
| 16 |
$32,768 |
$65,535 |
|
$10,000 |
$160,000 |
| 17 |
$65,536 |
$131,071 |
|
$10,000 |
$170,000 |
| 18 |
$131,072 |
$262,143 |
|
$10,000 |
$180,000 |
| 19 |
$262,144 |
$524,287 |
|
$10,000 |
$190,000 |
| 20 |
$524,288 |
$1,048,575 |
|
$10,000 |
$200,000 |
| 21 |
$1,048,576 |
$2,097,151 |
|
$10,000 |
$210,000 |
| 22 |
$2,097,152 |
$4,194,303 |
|
$10,000 |
$220,000 |
| 23 |
$4,194,304 |
$8,388,607 |
|
$10,000 |
$230,000 |
| 24 |
$8,388,608 |
$16,777,215 |
|
$10,000 |
$240,000 |
| 25 |
$16,777,216 |
$33,554,431 |
|
$10,000 |
$250,000 |
| 26 |
$33,554,432 |
$67,108,863 |
|
$10,000 |
$260,000 |
| 27 |
$67,108,864 |
$134,217,727 |
|
$10,000 |
$270,000 |
| 28 |
$134,217,728 |
$268,435,455 |
|
$10,000 |
$280,000 |
| 29 |
$268,435,456 |
$536,870,911 |
|
$10,000 |
$290,000 |
| 30 |
$536,870,912 |
$1,073,741,823 |
|
$10,000 |
$300,000 |
The Mortgage interest you pay is always simple interest (not compound). So, if you pay simple interest, while you earn compound interest, you will accumulate much more wealth over time. For example, a $100,000 mortgage over 30 years at 6.375% will cost you $125,000 in interest expense. Contrast that with a 100,000 investment that earns 8% compound interest over the same 30 years. The compound earnings will grow to $1,000,266! Don't make the mistake of being so focused on eliminating your mortgage debt that you forget to save. Make Compound Interest work for you and get as many doubles as you can!
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